Republicans will soon control the US Congress and presidency. Mark Rider considers the implications.
In a surprise to investment markets, the US voting public elected Donald Trump as US President in a ‘clean sweep’. This means the American people voted in one party – the Republican party – to control both the executive arm of power (the presidency) and the legislative arm (Congress).
A clean sweep is the exception rather than the norm in US politics. Since 1945 there have only been 13 clean sweeps of power. In most cases Democrats have held this advantage (11 times) compared with Republicans (which have had two ‘clean sweeps’). Republicans will hold this powerful position until the House of Representatives is up for mid-term elections in two years.
The issue is whether this power will be harnessed for constructive policy action or be dissipated (possibly by trade wars) as was the case in recent clean sweeps.
An open door for policy action
Trump’s clean sweep gives him a mandate for concerted fiscal-policy action including tax cuts, infrastructure spending and tax/regulatory reform.
Clean sweeps have generally been associated with more stimulatory fiscal policy and ANZ’s chief investment office expects this will be the case under the Trump administration. On average, fiscal policy has been eased by around 0.5 per cent of gross domestic product under clean-sweep regimes. Based on Trump’s comments throughout the election campaign we expect a somewhat larger fiscal stimulus to be delivered by this administration.
US administration 'clean sweep' years: 1963-2016
Source: BOFA Merrill Lynch Global Research
A crucial advantage of the Trump clean sweep is that it has been achieved in an environment that is favourable for domestic policy reform. For example, the Obama clean sweep (2009) occurred around the onset of the global financial crisis, while the Bush clean sweep (2003) was mired in Middle East conflict and the onset of the global financial crisis.
We consider the anticipated fiscal and trade-policy initiatives under Trump will be key drivers of markets under the Trump administration. Fiscal policy is largely a partnership between the Congress and the president, while trade policy sits more within the presidential discretion, with limited checks and balances. The main risk to the fiscal agenda is the potential for this opportunity to be compromised by international events, as was the case in other clean sweeps since 2000.
Trade policy’s the main risk
What happens with fiscal and trade policy is crucial to assessing market reactions to the Trump presidency.
The sharp turnaround in markets over recent days from the initial negative reaction to a resurgence, likely reflects markets factoring in the anticipated favourable impact of the Trump fiscal stimulus. Clearly, tax cuts and infrastructure spending would support growth. Moreover, with the US unemployment rate slightly below 5 per cent, government spending and tax cuts could exert a meaningful lift in growth and, as a result, inflation and inflation expectations.
This direction is reinforced by Chinese stimulatory measures through 2016 which at least in part will need to continue into 2017 to maintain growth momentum above 6 per cent.
However, America’s allegations of Chinese currency manipulation and proposed large tariffs directed against China could disrupt Trump’s domestic agenda and hinder growth if a significant trade war with China were to develop.
While markets have reacted favourably to the expected Trump fiscal agenda, we consider it is premature to judge that the risk of a trade war with China has disappeared. This is likely to be a critical point for markets in the months ahead.
Market volatility rises
Markets swung sharply on the Trump victory. The initial reaction saw the ASX 300 plunge by almost 4 per cent to a low of 5020, by Thursday the ASX 300 was trading at 5280, around the level of the end October and a 5 per cent swing from the intra-day low.
The intra-day swing in US equities was also violent with S&P 500 futures falling approximately 5 per cent overnight to eventually rally back and close 1.1 per cent higher.
Within the market there has been a rotation towards cyclical sectors, such as healthcare, metals and mining, and away from yield proxies.
Reflecting the likely impact of anticipated stimulative fiscal policy, US 10-year bond yields have spiked from around 1.78 per cent pre-election to around 2.1 per cent after Trump’s victory. The US dollar experienced similar volatility with the DXY index, an average of the US dollar versus the other major currencies, initially falling by 4 per cent before more than reversing this in the subsequent 24 hours.
Risks and implications
The market reaction over the past couple of days has illustrated the opposing economic forces of the upcoming Trump presidency. The initial reaction was one of fear and uncertainty, with the potential reversal of trade agreements and a rollback of globalisation coming to the fore. But by late afternoon (AEDT) markets appeared to embrace Trump’s election and clean sweep, with rising bond yields an early sign, only to be followed by the US sharemarket rising through the day and more than reversing the 5 per cent fall in S&P 500 futures. The focus seems to have shifted (rather quickly) to what positive changes Trump may make.
Longer term, the Trump clean sweep does open the window to shift policy from a heavy reliance on monetary policy, with low and even negative rates, to fiscal expansion. This would be a real change from markets being heavily influenced by low interest rates and money printing to actual spending, job creation and earnings.
This year China has already moved to an expansionary fiscal policy. While this expected shift will likely place upward pressure on bond yields, we consider bond yields would remain capped, at least relative to history, by the US Federal Reserve continuing to adopt a gradual approach to policy tightening. However, we remain concerned that a lift in yields could be a headwind to equities as the sustained decline in yields in recent years has been an important factor supporting higher PEs rather than solid earnings growth.
While markets appear to have rewarded Trump’s expected fiscal plan, we remain concerned that disruptive trade policy could cancel the benefits of any fiscal stimulus measures and become a major event risk. While his acceptance speech was measured, conciliatory and maybe even “presidential”, how long this will last is critical.
In light of these two concerns, ANZ’s investment portfolios remain positioned according to our view of likely elevated market risk due to higher bond yields and policy uncertainty attached to the Trump clean sweep. As protection against these risks, our portfolios remain defensively positioned to “underweight” growth assets. We also remain “underweight” on the Australian dollar and take an “underweight” position to bonds with an “overweight” position to cash.
We’re waiting for the dust to settle a little before changing strategy following what has been a remarkable political and market event of unexpected twists and turns. Our response comes down to balancing the significant negative but difficult to quantify risks of a Trump presidency with potential and maybe somewhat easier to quantify positive polices, at least from an economic and market perspective.
As long-term investors, we have built portfolios that are designed to withstand bouts of market volatility. It is important to note that trading on extreme volatility can result in real losses to wealth, and in times of uncertainty taking a long-term view is of even greater importance.
The views in this note are the writer’s, and do not necessarily reflect the views of ANZ.