Trump, Trade & the Markets

President Trump’s first weeks in office have certainly been busy. The challenge for financial markets is that very little of that business has been about moving the economy forward. Arguably much of what has been floated or discussed could be negative for the global economy, especially around the trade issue, which provides promise and peril for both President Trump and the markets.

President Trump’s early focus on action by executive order has resulted in something akin to a continuation of his campaign. It is a clear-cut case of making good on his campaign pledges to the extent possible by executive order alone (many will be litigated in the courts or reshaped in the legislative process). Clearly though his political “base” is pleased to see action being taken on campaign promises.

So good politics, at least good “base” politics but what about the costs of such an approach? Well the costs are not insignificant. They include the elimination of the traditional Presidential honeymoon where the first 100 days are meant to be about not only setting the policy stage but also exploring ways to work with the other side, the members of the losing party. There has been very little of this in the Trump administration from the Inauguration onward.

Kicking off the first 100 days with the obligatory repeal of Obama care and the naming of a Supreme Court nominee suggests playing to the base may take precedence over building up the economy. These issues almost ensure a long, drawn out and divisive legislative period, even before one brings into the mix tax reform, the budget deficit, fiscal stimulus, trade or infrastructure.

Yet financial markets have responded positively to date, seemingly unflustered by all the political volatility. How long can this continue is one of the big questions for investors to consider, as is the capacity for the Trump administration to move from politics to policy. Such a shift requires a fully fleshed out team, a strategy and a process to develop, shepherd and implement legislation, none of which is readily apparent.

So far patience has been a virtue; EM equity, thought to be squarely in the cross hairs of a protectionist, strong dollar US policy mix, leads global equities up 6% year to date.  Ten year UST yields, thought to be at risk to bond vigilante attack, are hovering around 2.40%, down sharply from post election highs while the USD itself is off close to 4% from its recent high. Markets would seem to be fading the Trump jobs promise.

Economic policy needs to be brought forward fairly soon however. Equities have risen post election not on the media created “Trump trade” but on the expectation that a Govt controlled by one party, namely the Republicans, would be able to get things done.  This meant in particular bringing fiscal policy to bear alongside monetary policy to boost the economy and create jobs. Failure to do so would suggest a fully valued stock market with forecast 2017 EPS growth of 15% is well ahead of itself, especially considering 2016 EPS growth is likely to come in around 5%. US equities are not priced for status quo ante but something much better.

TRADE POLICY – PROMISE & PERIL

There is no question (at least not from this armchair) that global trade policy needs refreshing. With finance (the tip of the globalization spear) in pullback mode since 2009 and global trade growth below that of (subpar) global GDP growth President Trump may find himself pushing on an open (trade) door. 

Regular readers know I have a dog in this fight, namely my Tri Polar World (TPW) global growth model which argues that the three main regions: Asia, Europe and the Americas can catalyze global growth by regional deepening. This regional integration is driven by three new and mutually reinforcing factors: each region’s ability to self finance through growing wealth pools, self produce through advanced manufacturing and self consume through urbanization and the rise of e commerce. (See Tri Polar World 2.0, published March 2015)

In each of the three main regions this perspective puts one at odds with current consensus. Currently, consensus thinking seems to hold that the US has all the cards in (possible) trade disputes with Mexico, Europe and China. There is a case to be made, however, that in fact the opposite is true, particularly for investors. Lets explore each region in turn beginning with the Americas where President Trump has made a point of questioning the future of NAFTA, the North American Free Trade Agreement.

NAFTA – A LEADERSHIP OPPORTUNITY?

Clearly there is room to update and enhance NAFTA. Both Mexico and Canada have signaled they are open to such an exercise. President Trump could lead an effort to not only enhance NAFTA but expand it further southward to include South and Central America. Laying out a vision of the Americas within a Tri Polar World would demonstrate presidential leadership, offer a way forward for the global economy and enhance regional deepening at a time when South America is more open to such an idea than at any point in the past several decades.

Eliminating NAFTA makes no sense at all given how intertwined the various regional supply chains have become over the past twenty years. Political integration within North Americas has stalled but corporate supply chain integration has expanded dramatically. As noted in my 2017 Outlook (See America First?, published December 2016) the idea that the US can go it alone is as outmoded as the idea that the way forward is to extend supply chains 3,000 miles. The future of globalization is regional integration.

There are growing signs that corporates recognize the need to consolidate and shrink supply chains. The corporate agenda has shifted from outsourcing in the 1990s to reshoring over the past half decade to a growing focus on reshaping supply chains. Today's corporate challenge is to satisfy a consumer who expects to see something they fancy, order it off their phone and have it delivered by the end of the day. Satisfying that demand mitigates against the global supply chain and instead supports a thesis of regional supply chain integration. President Trump is an accelerator of such corporate strategy.

EUROPE – PAST PEAK BEARISHNESS

Conventional wisdom towards Europe suggests all is lost and it’s only a matter of time before the EU disintegrates. I disagree and believe that the combination of Brexit and Trumpian rhetoric could lead the EU to greater integration. Think of what occurs when one stares into the abyss and contemplates a future never expected; it concentrates the mind. Europe, in staring into a non US abyss, could conclude that what it has is worth fighting for. In other words, rather than simply giving in to the forces of disintegration, Europe could well embrace what it has and seek deeper regional integration.

Europe’s corporate structure also seems ahead of its political class. There are reports on almost a daily basis of media companies seeking to build out “pan European” brands and structures while fintech companies seek to obliterate domestic boundaries. The Internet of Things (IoT) could prove to be Europe’s tech Renaissance. Should Europe be able to implement the Digital Single Market or the Capital Market Union the repricing to be had would be wild!

This perspective suggests markets are PAST peak EU and Euro bearishness. Yes there are important upcoming elections in France, Holland and Germany and yes the Fillon affair has thrown French politics into a tizzy & bond spreads have widened as a result. However, there is also the reality of better growth than the US, the lowest unemployment rate since the crisis, easier & growing credit, a cheap currency, manufacturing PMIs at a 6 year high & continued ECB monetary accommodation to consider.

ASIA – IS IT WISE TO EXPECT CHINA TO MAKE THE SAME MISTAKE TWICE?

President Trump’s decision to pull the US out of the Trans Pacific Partnership (TPP) would seem to clear the way for China to lead Asian regional integration. One can expect China to try and further stitch up the region via trade pacts following in the footsteps of its One Belt & Suspenders regional infrastructure push.

However, there also seems to be a growing risk of a trade fight between China and the US with most commentators feeling as if the US holds the trump cards (no pun intended). Given that China is one of the biggest creditors to the US, one wonders why this point of view is so widely held. Perhaps it’s the old cliché about if one owes the bank a $100 its one’s problem but if one owes the bank a million dollars it’s the bank’s problem, just writ large to national scale.

China however is unlikely to make the same strategic mistake it made in 2008-9 when instead of blaming the West and the Great Financial Crisis (GFC) for its need to rebalance its economy, it doubled down on stimulus with the result that today it has a significant (and very well known) debt problem.

Instead it would seem quite possible that should the US label China a currency manipulator that China could use this pressure to first, blame the US for the need to reset its growth profile, second, let its currency float to a much lower level, say 8 to the dollar and third, decide to sell a chunk of its UST position.  The combined effects of which would likely include a stronger USD and higher US rates leading to a weaker US stock market and softening US economy. 

The idea that the US holds all the cards in potential trade conflicts with its erstwhile partners is an area where the gap between reality and fiction seems to be at its widest.

PORTFOLIO IMPLICATIONS

What does all this mean for one’s investment portfolio? It suggests that the better risk adjusted opportunities lie outside the US, especially in the equity space. Dollar strength is overdone, especially against the Euro while EM equity is at risk to policy movement in the US.

The best area of opportunity remains the Developed Markets (DM) ex US, namely in Europe and Japan. Global growth is picking up, led by the DM economies. European banks remain very much of interest given faster economic growth, expanding credit and loan growth and rising rates. The sector remains cheap, underowned and underappreciated. More broadly, Europe’s Q4 earnings season has been the best in several years and earnings revisions are moving higher.  EU equity funds had record outflows last year; 2017 could see the reverse. Yes, political risk exists in Europe as it does elsewhere but it seems in the price, absent a Le Pen victory in France. Pullbacks should be bought.

Japan remains of interest given the view that 2017 will bring the return of inflation. Corporate restructuring, improved governance, rising EPS forecasts and the potential for a weaker yen are all supportive, especially on a currency-hedged basis.

In the EM space, Mexico remains a preferred option with an attractive risk reward profile. The very solid response by both the peso and equities to President Pena Nieto’s decision to cancel his meeting with President Trump suggests an awful lot is priced in. In fact the peso is trading stronger than the immediate post election price.

Chinese equities are worth a look as well. Stability is the focus in the run up to the Fall Party Congress while a growing crackdown on capital flight suggests that money will stay in country. Given the property run up and commodity price boom of the past 18 months or so, equities, still 50% or so off the 2015 high, would seem to be of interest. A trade conflict with the US that included devaluation as a choice could send Chinese stocks soaring.

Beyond trade, the 2017 outlook noted above outlined three possible policy paths for the US: Full Bore Trump, Unmoored Trump and a narrow policy path to success. Full Bore Trump which implies aggressive fiscal stimulus and Buy American infrastructure efforts that would spark inflation & the return of the bond vigilantes seems increasingly unlikely. Odds of an Unmoored Trump path, where the first 100 days passes with limited activity on the economic front leading to markets recalibrating their economic and earnings growth expectations, seems like a rising possibility. The narrow policy path to success, which implies a well-developed process to guide legislation and drive its implementation, seems less likely today than a month ago. All of which suggests the gap between political volatility and stock market volatility is likely to be closed at some point. Stay focused my friends!