Perspectives

Tough Transition

  • The so-called “Trump Trade” began to lose steam toward the end of Q1 as it became clear that single-party control in Washington wouldn’t necessarily translate into quick results
  • Events abroad in Afghanistan, Syria and North Korea also took the President’s attention away from his aggressive domestic agenda
  • The Fed continued to hike rates during the quarter and shifted its tone from one of patience to one that is markedly more aggressive
  • Comparisons between our current economy and political situation to those of the early 1980s are not supported by the data

 

In Q1, President Trump began an unusually difficult transition from campaigning to governing and, in the process, wiped out much of the enthusiasm behind the so-called “Trump trade” (the bet that his pro-growth policies would lead to reflation and stronger equity markets). The expectation that single-party control of the executive and legislative branches of government would make for easy tax reform, deregulation and fiscal stimulus was dashed during the failed bid to reform the Affordable Care Act (ACA) in mid-March. By early April, international events in Afghanistan, Syria and North Korea also became credible distractions from the President’s aggressive domestic agenda.  And, despite a number of soft economic data points during the quarter, the Fed continued hiking rates, further frustrating Trump’s growth agenda with tighter monetary policy and a stronger dollar. While it may be too early to be pessimistic about Trump’s ability to make quick progress, even members of his own administration have been urging caution about the speed of his agenda going forward. That leaves us with a highly- valued US equity market that, as we discussed in our last communication, desperately needs validation from corporate earnings or significant improvements in hard economic data to maintain its current footing.

Aside from being a prominent campaign promise, health care reform was an important precursor to tax reform.  The thinking was that a replacement plan for the ACA would reduce the federal deficit, making fiscal and political room for tax cuts.  With single-party control by the party that has advocated for a repeal of the ACA for nearly 8 years, markets assumed healthcare reform and, hence, tax reform were foregone conclusions.  Ultimately, however, mainstream Republicans were unable to sway Freedom Caucus conservatives (let alone Democrats) to change the law. This made immediate progress on taxes less likely and, more broadly, drew into question the value of one-party control when that party may be too fractured to form meaningful coalitions.

The administration’s decisions to use military force abroad were further distractions from Trump’s domestic agenda.  Within a few short weeks it seemed, the candidate who promised limited military engagements abroad was involved in military action in three different arenas - Afghanistan, Syria and North Korea – the latter two having significant potential for escalation. While the engagements seemed to have legitimate catalysts, they came to dominate the President’s agenda and may have served to further alienate anti-interventionist members of his own party. By mid-April, US Treasury Secretary Steven Mnuchin – who was busy readying economic sanctions against Syria – admitted that the original timeline for tax reform was too aggressive. Whether the President can refocus on domestic issues and unite his party from here is anyone’s guess. 

The Federal Reserve and dollar, meanwhile, have shifted into high gear.  The Fed hiked rates for a third time in March, and indicated it was moving from policy that was intended to be stimulative to one that was intended to sustain the current expansion.  In the muted tones of Fed speak, that indicates the central bank is concerned about the economy overheating. The most recent employment number made the Fed’s concerns abundantly clear; it took the addition of just 88,000 jobs to drive the unemployment rate down to 4.5% without any concurrent drop in the labor force participation rate.  This scarcity of labor has driven wage inflation to 2.8% over the past year and, without an unexpected increase in labor productivity, the higher wages are likely to translate into higher consumer price inflation in short order.  Despite warnings from various Fed officials that bond holders are likely to be hurt, bond markets seem to be shrugging off the more aggressive Fed stance.  Currency markets on the other hand have been more reactive and the dollar has remained strong against major trading partner currencies.  Trump, for his part, has attempted to ‘talk down’ the dollar, hoping keep American exports more competitive, but such jawboning has generally had limited lasting impact in the past.

The improving global economy, Republican resurgence in politics and ensuing surge in business and consumer confidence has led some to draw comparisons between our current time and the early 1980’s when Ronald Reagan came to power.  The obvious inference being that those conditions led to one of the greatest bull markets in history.  At the risk of sounding too dour, the conditions we currently face couldn’t be more different.  At the time, the S&P traded at 8 times earnings; currently, we are close to 22 times earnings, well above historical averages.  At the time, the Federal Reserve was successfully battling inflation and set in motion a three-decade decline in interest rates; now the Fed is hiking rates and will embark on reducing its huge balance sheet that has been the basis of historically large monetary accommodation.  At the time, the economy was coming out of a recession; we are currently going on 8 years of expansion and are in the mature stages of the credit cycle.  This is not to say that doomsday is around the corner, but it is a reminder that we face an unusually wide possibility of policy outcomes and high market valuations (both equities and bonds) that justify greater prudence than otherwise might be taken from such a comparison.

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