Sun | Feb 18, 2018

Thompson & McGregor | Trumponomics and its impact on capital markets

Published:Friday | February 3, 2017 | 12:00 AM
Nicole Thompson
Daren McGregor
Presidential candidate Donald Trump walks behind President of Mexico Enrique Pena Nieto after delivering statements in Mexico City, Wednesday, August 31, 2016.

Donald J. Trump was sworn in as the 45th President of the United States on January 20.

His message was: America first, buy American, hire American, protect American borders, eliminate Islamic terrorist extremists.

The rhetoric is in stark contrast to the globalisation road the world has been on for several decades.

Trump specifically stated that he would be placing America first in terms of trade, taxes, immigration and foreign affairs. His 16-minute speech was consistent with his campaign utterances. So to try to formulate a picture of the world ahead, we need to go back to see what he promised in order to strategise on the best way forward for local investors in a small, open Caribbean island.

Trump has promised to bring jobs back to the American people. In his inaugural address, he spoke of the fall of industrial America and bringing back the US manufacturing sector. He has promised to overhaul regulation, and he has spoken on the direction that his trade policies will take towards protectionism.

Let's examine what these mean for the markets.

Fixed income

Prior to the November election, in general, the markets were not expecting a Trump win. Nevertheless, interest rates had been trending upwards as the US economic recovery took hold, with a Fed rate increase highly anticipated throughout much of 2016.

Come election night, when Trump's victory became apparent, apart from an overnight blip, markets recovered, and even surged to new highs, and in December, the Fed raised rates for the first time in 2016, with at least three more increases expected for 2017.

The single 25 basis point increase by the Fed in 2016 represented an outcome far more dovish than the original guidance of four rate hikes for the year. There may not be a repeat this time around as many of Trump's proposed initiatives, if implemented, are likely to be inflationary in nature. Factors exemplifying this risk include his focus on the revitalisation and expansion of American infrastructure, which calls for investments of up to US$1 trillion.

On the flip side, Trump has also called for individual and corporate tax cuts in order to stimulate consumption and, by extension, economic growth. He has stated that his additional expenditure need not be funded by additional taxes, as his tax breaks and the resultant economic growth would so stimulate revenue collections that these projects would be fully funded.

Should the new administration follow through on this agenda, the likely inflationary pressure would be supportive of a more hawkish approach to monetary policy and, by extension, an increased likelihood of rate increases.

Consequently, rate increases on US instruments mean yield increases for emerging market bonds to reflect differentials in risk. Higher rates would mean depressed emerging market fixed rate bond prices, including Jamaica's.

As such, in an environment where interest rates are likely to increase, investors should shift towards variable rate securities rather than fixed, thereby increasing interest income and mitigating the price risk associated with fixed rate securities.

With the potential for US rates leading the way for higher global interest rates, Jamaican interest rates may have hit a floor, unless there is an acceleration in the performance of the local economy, and a decline in the perception of risk associated with Jamaica in the financial markets, strong enough to justify a lower risk premium for Jamaican securities.

Currency movements

Between Trump's election and his inauguration, the US dollar has strengthened against a basket of 10 major currencies, compared to a slight weakening for the year until the election.

This is consistent with the market's anticipation of a Clinton win, where the status quo was expected to be maintained.

The surging dollar is consistent with the expectation of higher interest rates in America relative to its counterparts, but this may clash with Trump's pledge to create millions of new jobs by reviving US manufacturing to some degree, given the price escalation this would imply for importers of US products.

If indeed the Federal Reserve raises interest rates as planned, this would attract more dollar investors and drive the US dollar even higher.

This is good for Jamaican exports and service sectors largely serving international markets, such as the tourism and BPO sectors, but, overall, would likely have a negative impact on the country, given the degree to which imports outpace exports. It would also negatively impact the relative value of Jamaican dollar denominated assets.

However, given the adequacy of local reserves to meet demand for dollars in the market, the effects on the Jamaican dollar in the short run are likely to be subdued.

Stock price movements

Sentiment could take US equities higher in the near term, notwithstanding recent hesitation.

However, stocks in the S&P 500 have already climbed almost five per cent since the election; this after climbing only about 5.5 per cent in the 11 months prior. This means that stocks are trading at approximately 25.4x earnings, which is quite high for US stocks.

Stocks may now be slightly overvalued - the mean is 15.6x - which could lead to a pullback short-term as companies will take some time to grow into this new valuation.

One of Trump's main campaign issues was that of the cumbersome regulatory structure surrounding business in the US. Subsequent to his inauguration, he issued an executive order geared towards expediting the approval process for the construction of manufacturing facilities and easing the regulatory burden surrounding manufacturing.

This may serve as a tailwind for growth in US domestic manufacturing as an ease in regulatory burden is likely to lower the cost of doing business.

The proposed decreases in direct corporate and individual income taxes would also complement an easing of the regulatory burden by incentivising capital formation and the creation of jobs.

This, however, remains prospective in the interim. In such an environment, small cap stocks are likely to benefit disproportionately relative to the larger players in the market as the cost of dealing with regulation represent a larger percentage of their overall cost structure.

Also, if strength in the US dollar does in fact persist, larger companies, which are more dependent on foreign trade and operations, may lag small and mid-sized enterprises in terms of growth, due to the relative importance of the domestic market to the smaller players.

On the local side, a stronger USD would mean US products would be more expensive to Jamaicans. It may also necessitate the deepening of ties with other trade partners, and a reduction in dependence on the US as a trading partner as American goods become more expensive.

A stronger domestic manufacturing and business sector would be positive for our local equity markets, stimulating increased activity and fostering new listings and even listings on overseas markets.

Oil prices

Trump has vowed to end US dependence on OPEC's oil supply, citing the America's vast untapped domestic energy reserves. Furthermore, US oil drilling has shown some signs of adjustment to the lower price environment, as production recovers. Meanwhile, OPEC has already cut its supply by 1.5 million barrels per day, compared with its target of 1.8 million bpd, in an effort to bolster world prices.

Last week, Trump signed executive orders approving the Keystone XL and Dakota Access Pipelines, which will provide a cheaper logistical solution relative to rail delivered oil, and increase the domestic oil supply, both of which are factors likely to put downward pressure on oil prices.

These competing pressures could cancel out the other, with international oil prices remaining weak going forward.

A Trump administration is neither good nor bad inherently from an investment perspective. However, it is certainly not business as usual.

At a time like this, it will be more important for investors to be aware of their risk exposure and how it may be affected by policy shifts.

And, it will be important for investors to maintain flexibility in the structure of their portfolios, with a focus on liquid securities and cash available to capitalise on opportunities which arise as things become clearer.

- Nicole Thompson is manager, Research & Stockbroking, and Daren McGregor is research analyst at Victoria Mutual Wealth Management Limited.