- A simple resolution to an uncertain election has let the market focus on positive economic trends.
- Optimism for pro-growth policies may give way to impatience with the legislative process.
- Italy's ongoing banking crisis underscores Europe's policymaking discord.
Rising GDP, interest rates, and energy prices have helped the market
What a difference a day makes — in this case, Election Day. From August 15 through two days before the U.S. election, the S&P 500 had slid almost 5%, and failed to post a meaningful gain in the nine straight trading days ending on November 4. In the weeks since the election, in contrast, the index has reached eight new all-time highs. The financial press has generally attributed the post-election rally to a surge in animal spirits spurred by optimism surrounding the new administration's talk of lower taxes and deregulation. We would offer an alternative explanation: that the simple resolution of election uncertainty has allowed attention to focus on an uptick in macroeconomic activity in developed markets generally and in the United States in particular.
The Putnam GAA Economic Surprise indicator, which aggregates the variance of domestic economic data as actually reported from consensus estimates, bottomed in the middle of 2016 and has been trending steadily higher since then. Activity in other major economies has also either ticked up or stabilized in the second half of the last year. An uptick in interest rates around the world has also alleviated some of the pressure on bank profitability, which should be supportive of earnings in the financials sector in 2017.
Furthermore, the OPEC deal to limit production in concert with similar commitments from other important non-OPEC countries has brought an end to the two-year bear market in oil prices. The inflection point in oil prices is a positive development for S&P 500 earnings growth, as the drag from money-losing energy companies has been an important factor in the earnings stagnation at the index level for the past 18 months. A bottoming in commodity prices should also help the earnings picture in 2017.
Lowering business taxes may take some time
These changes — more robust economic activity combined with a turn in the prospects of two important sectors in the market — are certainly important. In addition, there is clearly scope for the nascent surge in animal spirits to continue the previously mentioned prospects for lower taxes (particularly for corporations) and a less burdensome regulatory landscape. For example, we estimate that a change from the existing effective tax rate for S&P 500 companies to the 15% rate proposed by Trump, discounted back at the current cost of capital, would represent an immediate boost to earnings of somewhere between 15% and 20%.
Keep in mind that the optimism surrounding the pro-growth Trump policy talk is, at this point, still just that: talk. A precedent worth considering is that President Reagan had similar ideas for reforming and reducing business taxes, yet, despite his winning 49 out of 50 states in his re-election for a second term, it still took almost two full years to deliver tax reform. The legislative process for reform is much more burdensome than a simple change in any particular tax rate.
One fear is that at some point, there will be an air pocket between the pro-growth expectations, and the deliverable reality. We don't think we are there yet, primarily because, as we said, the current market environment may simply be reflecting the improved macro picture of the past several months that has gone somewhat unnoticed.
Some of Trump's campaign proposals could undermine growth
The larger fear is the current uncertainty regarding some of Trump's anti-growth rhetoric of protectionism during the campaign. Announcing that Peter Navarro will lead a newly created National Trade Council is a red flag in this area. Navarro has been one of the most vocal critics of China's mercantilism and will very likely be an advocate for making it more painful for other countries like China to send exports into the United States.
Anyone who has taken even an introductory economics class knows the equation GDP = C + I + G + X, where C is consumption, I is investment, G is government, and X is net exports (and where net exports = exports minus imports). Protectionist policies seek to raise GDP by raising X. But protectionism runs the risk of retaliation, putting exports at even greater risk, and perhaps reducing X unintentionally, and of increasing the cost of C. In addition, the United States for many years has also been the beneficiary of population growth, an unequivocal benefit to economic growth over time. At this time, it is also unclear what impact a Trump administration might have on future population growth and the growth dividend it provides.
Europe continues to confront policy challenges
We have also been highlighting the dangers presented by political risk over the past couple of quarters. While markets shrugged off both Brexit and the Italian constitutional referendum, we continue to monitor political risks in 2017, a year of major leadership elections in Europe, and a party Congress in China, a forum that takes place every five years and determines national leadership.
As we write this, the fate of the weakened Banca Monte dei Paschi di Siena (BMPS)* is still unresolved. The bailout via public/private partnership was unsuccessful, and the Italian central bank currently estimates a rescue will cost $7 billion (USD). Mere days into his new job as prime minister, Paolo Gentiloni described the solution to save Italy's bad banks "will be long and complicated." His cabinet has approved a plan to earmark 20 billion euros for bank rescues. It took only hours for the Germany Finance Ministry to lecture the European Central Bank, cautioning it to monitor cheating against the new Bank Recovery and Resolution Directive.
*As of December 31, 2016, Banca Monte dei Paschi di Siena was not a holding in Putnam portfolios.
Barely 70 years ago, Winston Churchill gave a speech in Zurich in which he said, "Yet all the while, there is a remedy which, if it were generally and spontaneously adopted, would as if by a miracle transform the whole scene, and would in a few years make all Europe, or the greater part of it, as free and as happy as Switzerland is today. What is this sovereign remedy? It is to re-create the European Family, or as much of it as we can, and provide it with a structure under which it can dwell in peace, in safety and in freedom." The European family is clearly going through some holiday squabbles. It is also somewhat ironic that, three generations after Churchill's speech, the United Kingdom would rather be a friend than a family member.
Optimism may be warranted for the near term
All that said, we are inclined to give risk assets the benefit of the doubt for the time being, albeit on a short leash. As the new administration turns words into actions, we will be actively assessing the proper multiplier to assign. For now, the inflection points in growth, in inflation expectations, and in the earnings prospects for the financials and energy sectors are enough reason to stay bullish.