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What's changed since the election?

Question of the Week - February 13, 2017

Guest Post - Monday, February 13, 2017

What's changed since the election?

Unsurprisingly, not much on the front of actual economic data, but it's still very early in the new administration agenda-setting and negotiation process. For markets, what has changed most notably has been the improvement of 'animal spirits,' which is the optimistic/bullish business and investing sentiment associated with pro-business expansion. While hard to measure with precision, we know that catalysts that either add incentives or cut disincentives can be incrementally additive for economic growth. However, these do take time to play out and there could be a number of roadblocks and compromises in the meantime. We've already started to see a bit of this, with pushback from Republican leaders on a variety of issues—the sentiment hasn't been helped by some early controversy in the initial few weeks, which, if it continues, could keep even some Republicans skittish about jumping on the Trump train.

What about the populist pre-election promises? The tone is still there, but the practicalities might necessitate some tempering down of the extremes discussed on the campaign trail. Many of these issues are very nuanced, anyway, so were far more difficult to drill down into during stump speeches. For example, 'punishing' China for trade and currency behavior could be much more difficult than it seems, since adding tariffs and conducting in currency wars can backfire through a variety of retaliations by intended targets. Since most classically-trained economists (which often include those advising Presidents) generally believe free trade and globalization are healthy and beneficial to all nations involved, sharply reversing course toward protectionism might be less popular internally.

As has been mentioned before, globalization is a double-edged sword, in that it can allow companies to manufacture in cheaper locations, and offers consumers the benefit of cheaper imported goods. This is something we've become quite used to, and has provided all levels of society a higher standard of living (e.g. even the lowest-income Americans seem to enjoy big-screen TV's, smartphones and internet service). On the other hand, the relocation of jobs offshore has been a negative for U.S. employment in a variety of industries. This has traditionally affected manufacturing, but increasingly those on the services end as well. More extreme de-globalization is likely not possible or desired, but small shifts to help the U.S. compete a bit better could be the best case scenario. However, the replacement of jobs by technology (computers and/or robots) is a trend that doesn't seem to be going anywhere soon. From an investment standpoint, many themes in the asset allocation portfolio are aligned to these futuristic trends (although these are not only future-based; they're happening already).

What else might help? On a corporate and personal level, lower taxes create more investable income. A simplified tax system is also a desired goal for a variety of reasons, although the rub is that most are hoping for a 'revenue neutral' outcome, meaning that such a reshuffling won't leave a gaping revenue hole in the federal budget—resulting in a deeper annual deficit—or unduly burden one segment of the population over another. A cut in corporate taxes is favored by many pro-business legislators (as statutory rates in the U.S. are among the highest in the world, albeit effective rates are less onerous). There are several segments to this on the corporate side, some of which are in the news while others have been under the radar. The possible restructure of corporate taxes to a 'destination-based cash flow' system will favor some corporations (like exporters) and penalize others (like importers), so analysts are busy attempting to determine possible earnings growth impacts going forward under various scenarios, not to mention other potential economic impacts of higher inflation, stronger dollar, or neutralizing counter moves by affected trade nations. The possible removal of the corporate interest deduction hasn't been discussed as much for whatever reason, but is also meaningful, as it could affect the bottom lines of companies who issue significant debt.

The regulatory environment hasn't changed drastically yet, but the promises of action are there. In the financial industry, the new DOL rules are slated to begin in April, but filings have been submitted in an attempt to delay implementation, allowing for further review. The same is the case with Dodd-Frank, which faces stiffer opposition, so appears to have morphed from an outright repeal to a 'fix'. While these all lie in the political rather than economic or financial markets realm at face value, changes will affect both costs and corporate strategy. Insofar as consumer protections and anti-trust legislation, Trump had taken a populist stance to a large extent, bashing tax-oriented mergers and the financial and healthcare industries in particular; however, this runs counter to pro-business sentiment characteristics of Republican doctrine followed by more traditional members in the House and Senate. This inconsistency has caused markets to weigh the pros/cons of comments in several of these affected sectors on company prospects, which is no easy task.

Trump has been critical of the Fed, in a perceived excess of accommodation through quantitative easing and low rates, and of the Fed's leadership. However, again, with most Fed board members and potential new chairpersons being classically-trained economists, chances for a radical change in policy are less likely. What a radically different policy would even look like is another matter completely, and could be counterintuitive, such as implementing sharply higher interest rates in a slow-growth economy without inflation pressures, etc.

Now, it's important for follow-through for the optimism to be sustained. This doesn't mean markets will necessarily decline on a dime if setbacks occur, but some optimism for catalysts of change has now been priced into things—but also include a degree of policy uncertainty—rendering valuations in a variety of risk assets higher.

Read our Weekly Review for February 13, 2017.

Read the previous Question of the Week for January 30, 2017.

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