Market Commentary

The “Trump Trade”

By Rob Sigler, MBA

December 2, 2024

Human beings tend to look for patterns and connections even when none truly exist in an effort to simplify complex situations and create order out of chaos.  Scientists refer to this as apophenia.  In the roughly three weeks since the Presidential election, CNBC and virtually every Wall Street strategist has rushed to deliver their take on what the Trump and Republican congressional victory means for markets.  Drawing heavily from the 2016 Trump election, and the outcomes that it produced, there has been broad unanimity amongst prognosticators, so much so, that the forward playbook is simply referred to as the “Trump Trade.”  While hardly exhaustive, the main tenets of this market outlook are catalogued below.

1. US equities will lift based on lower corporate taxation and less regulation.
2. Bonds will underperform based on larger deficits and fewer tax revenues.
3. Small cap equities will dramatically outperform given insulation versus tariffs and their heightened sensitivity to changes in corporate tax rates.
4. Emerging and International markets, and China specifically, are to be avoided at all costs given punitive tariffs that will impede growth in those markets.
5. Legacy oil companies, oil field services, and other domestic energy providers will flourish based on less regulation, more US energy independence, and a slower alternative energy transition. On the other side of the coin, decarbonization plays will languish.
6. Banks and other financials will be prime beneficiaries of lower regulation and lower tax rates. Improving CEO confidence will usher in a resurgence of mergers and acquisitions as well as open the IPO market.  On the other hand, interest sensitive areas like REITs and Homebuilders will struggle with higher long-term interest rates.
7. Industrials and other manufacturing industries will be relative outperformers on the assumption that tariffs will help their relative competitiveness.
8. The U.S. Dollar will soar relative to other currencies while gold equities will wilt in the face of that powerful headwind.

In the words of American broadcaster and football coach, Lee Corso, “not so fast.”  At Westshore we believe the paint by numbers market outlook being touted by the professionals is exceedingly simplistic.  In actuality, the probability tree that we are looking at is quite the opposite.  It is a gnarled mess of interdependencies where the consideration set is quite unpredictable.  As we have mentioned ad nauseum to our clients, your starting point in investing matters.  What does that mean?

The core policies of corporate tax relief, less regulation, punitive tariffs, and immigration control were all focal points of the first Trump administration.  Economic growth exploded until it was upended by the Covid pandemic.  Why wouldn’t this process simply repeat?  Let us examine each policy initiative and explore its likely impact on economic growth and market dynamics.

When Trump first came into office post the 2016 election, the United States’ federal corporate income tax rate topped out at 35%, the highest amongst developed nations.  By lowering corporate tax rates from 35% to 21% in the Tax Cuts and Jobs Act, Trump largely eliminated the incentive for corporations to offshore their businesses and manufacture overseas.  Where they could, companies responded to that economic incentive by returning jobs to America, something that we refer to as reshoring.  That had the effect of dramatically accelerating economic growth within the U.S.  Additionally, tax relief boosted corporate profitability with S&P 500 profits growing nearly 40% in the first two years of implementation.  It also allowed for better wage growth.  Census Bureau data shows that 2019 was a historic year for Americas’ living standards.  Real median household income reached a record high, and poverty reached a record low.  Will this be a repeat?

The scope of corporate income tax relief, from 21% to 15% is smaller in this Trump administration proposal than prior, but nonetheless would likely boost corporate profits by 6-7% per annum (according to Goldman Sachs).  It is highly likely that a healthy portion would translate to higher wages which would be great for American living standards.  However, it is important to understand that our starting point is different.  At present, our 21% corporate tax rate is amongst the lowest of all nations.  Lowering rates further to 15% will help corporate profits to be sure, but its power to produce further reshoring is questionable.  Furthermore, our federal balance sheet is in a dramatically different place.  With lower taxes, rising interest rates, and burgeoning government spending, our federal net debt is now 120% of GDP.  Interest expense on the federal debt now consumes 13% of our federal budget.  One must question whether Congressional authorities will vote for sweeping tax reform if the marginal impact to employment is negligible.  Our sense is that the market may be overestimating the positive force that this will deliver.

Regulation is a hard concept to pin down.  Clearly less friction and expense related to running businesses unlocks profits and efficiency.  On balance, we believe the Trump administration will be broadly favorable for financials, energy, agriculture, transportation, industrials, and real estate.  That said, when we look at some of the Trump nominees for important offices, we do see the potential for more contentious relationships as well.  For example, Brendan Carr, Trump’s nominee for Chairman of the Federal Communication Commission has overtly talked about instituting free speech safeguards and other regulation for search engines, social media, and other traditional media.  Robert F. Kennedy Jr., Trump’s appointee for Health and Human Services has discussed restricting or banning a group of food additives, changing vaccination testing protocols, and altering drinking water standards.  This won’t be a one-way street, but in aggregate, it should be a positive for the market.

Regarding tariffs, we believe there is a common misperception that their introduction during Trump’s first administration leveled the corporate competitive playing field amongst nations, made America more self-sufficient, and helped bring back jobs to the United States.  By contrast, we strongly contend that tariffs delivered no such benefit.  We believe the distortions caused by tariffs were simply wallpapered over by the benefits of tax relief and the reshoring of American jobs.  It’s important to note that tariffs didn’t reduce the number of imports into the U.S.  In fact, imports were up in 2017, 2018, and 2019, only to fall in 2020 when the pandemic arrested economic activity.  Post the conclusion of that event, they resumed their sharply upward trajectory.

What frightens us about this episode is the unknown.  Does Trump truly intend to levy these tariffs or will he use them as a starting point for negotiation?  To the extent that we get better reciprocity from our trading partners, it could be a boon for U.S. exports.  That said, it could also backfire if other countries respond with retaliatory tariffs and we devolve into a broad trade war.  In Trump’s first administration, tariffs were generally episodic and good specific.  The across-the-board tariffs were only applied to China and they were easily maneuvered.  Chinese goods were shipped to neighboring countries for final assembly and/or exported to other nations for reimportation into the United States.  So, while China’s share of imports into the U.S. fell, imports from other Southeast Asian countries into the U.S. exploded as did trade with Mexico.  Over this same period, China saw its global export volumes grow, suggesting enterprising people figured out how to circumvent the law.  What concerns us with the current Trump tariff proposal is that the magnitude is large, and the application is very broad.  Some of the tariff proposals that have been espoused include a 10% levy on all imported goods regardless of trading partner, 60% tariffs on Chinese goods, and a potential dismantling of the USMCA agreement (US, Mexico, Canada trade agreement) with 25% tariffs conditionally applied to all Mexican and Canadian goods based on illegal drug and immigration enforcement.  To be clear, we would be lying if we told you we have a clue of what will happen on this front.  That said, our message to investors is that the market does not appear to be modeling much/if any negative impact.  Unlike the first Trump administration, if we were to see an across the board 10% tariff implemented, it would be hard to circumvent.  U.S. consumers would feel it this time.  Budget Lab at Yale University estimates it would raise prices for the average household by 1.4% to 5.1% and reduce GDP by 0.5% to 1.4%.  Both outcomes are obviously negative.

Finally, regarding immigration policy, while we fully agree that we need careful vetting of the individuals that enter our country and a much more organized process for asylum seekers, we worry that investors underestimate how vital immigration is to sustained economic growth in a mature nation.  Gross Domestic Product (GDP) is easily derived.  It is a function of net population growth (more people = more spending), labor force participation (more workers = more output, income, and spending), and productivity (more output per employee = higher growth).  In the U.S., our birth rate has been declining for the past 40 years while our population has been aging.  Half of our labor force growth has been driven by immigration.  Without it, we would have fewer people available to enter the workforce and population growth would stagnate.  Additionally, immigration is key to certain industries like restaurants, hospitality, agriculture, and construction.  Bottom line, a poorly executed strategy could be detrimental to US growth.  This is a risk factor that does not appear to be properly embedded in the consideration set.

 

Now, let us examine where we reside on markets.  Trump inherited a market in 2016 that had been stagnant for the two prior years.  The twelve-month forward price to earnings ratio was slightly below the historical average of 16x.  That is not the case today.  Today, Trump inherits a market priced at 22x forward earnings, significantly above historical averages.  In other words, the stakes are higher.

Subsequent market returns from these valuation levels have been rather anemic as you can see in the illustration below.  Our simple observation is that we need to see better earnings growth to justify these high multiples.  Should tax relief and less regulation fail to deliver upside, these multiples look stretched relative to historical context.

Additionally, Trump inherits a job market, that, while healthy, is slowing.  Employment growth drives output, discretionary income, and spending growth.  To date, most of the weakening in the labor market has been in lost job openings, as opposed to actual job losses.  That said, the monthly non-farm payroll additions have been receding for some time (as you can see in the previous Labor supply illustration).  While jobless claims have been relatively steady, in a range of roughly 215k per week, the continuing claims data has been escalating, and now resides at 3-year highs.  Said differently, it is getting more difficult to find employment.  This is not to say that we are going to have a recession.  Our point here is that the job market appears to be at a pivot point.  If tariffs or immigration reform work out poorly, we have the potential for a negative surprise.  By contrast, if tax reform and less regulation unleashes higher income, we would have a virtuous conclusion.  Once again, the impact of policy initiatives could be profound.

Finally, on the monetary side of the equation, Trump enters with an accommodative Federal Reserve, a major positive.  The Federal Reserve has been lowering short-term interest rates (a total of 75 basis points thus far) since September 2024.  Bank loans, most credit card interest rates, and many other forms of corporate credit are benchmarked to short term interest rates.  That will reduce pressure on consumers and corporations alike.  However, this is not a purely virtuous story.  While short-term interest rates are coming down, fears of loose fiscal policy and less corporate tax revenues are driving long-term interest rates up.  In other words, the work that the Federal Reserve is doing to accelerate economic conditions is being undermined by fears of rising federal debt.  Buying a home, a car, or other big ticket durable goods is getting more expensive, not cheaper.

Getting more granular, consumer finances, while still healthy in aggregate, are stressed at the margin.  Debt payments are rising as a proportion of disposable income and delinquencies on auto and credit card debt have each eclipsed 8%.  Offsetting this has been big gains in stock portfolios and home values which has increased the wealth effect.  That has kept consumer spending strong.  That said, at this point, a lot is riding on how interest rates settle out.  Many of these same policy initiatives will be the determinant of that direction.

Our bottom line is that the starting point for this new Trump administration is different from the prior.  Thinking that we are simply going to see a sequel of the first episode is naïve in our opinion.  We would caution investors not to assume that the “Trump Trade” is the only possible outcome.  There is still much to be learned on how these policy initiatives will be implemented, how others will react and behave in response, and thus, what the final outcome will be.  How are we leaning?  We will publish a 2025 outlook at the end of December, but at this point here are our thoughts.  While we see no immediate catalyst for correction, our overwhelming bullishness on large cap, US equities is fading given high expectations and rich valuations.  We will likely redeploy some of the shock absorbers into US markets that we abandoned early in 2023 to insulate our portfolios against volatility.  We think a worst-case outcome in now embedded in emerging and international markets regarding tariffs.  As such we see limited downside, and indeed outperformance, should the tariff outcome prove more moderate.  Our sense is some of the sector specific trades like long legacy energy and short healthcare will prove transitory as the investing “tourists” fail to see confirmatory evidence show up in fundamentals.  In fixed income, we see more ways for growth to disappoint than accelerate with early policy initiative implementation.  Thus, we believe the risk/reward for bonds is quite favorable.  Our preferred category in fixed income is asset backed securities which offer higher yields than corporate bonds with similar credit quality characteristics and embedded inflation protection.  In real assets, we continue to favor public REITs and homebuilders as well as private infrastructure.  Finally, within alternatives, we see the most compelling returns in distressed debt where we project a super-cycle.

As always, we welcome your questions.

 

 

 

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