We have received a number of questions around our views on Donald Trump’s surprise victory in the recent US general election. While many are sick and tired of hearing about Trump, there are important aspects to consider from a portfolio management perspective. We outline our framing of the situation below and illustrate how our views have changed in a post-Trump world.
We caveat that we have no idea how Trump’s presidency will play out – and neither does anyone else. But the process of thinking through possible scenarios is valuable, in our view; and can lead to some important insights around how the shape of the probability distribution of possible outcomes has changed. We again recall the insightful words of Dwight Eisenhower that: “Plans are useless, but planning is indispensable.”
First, we frame the outcome of the general election in some context. The simplified map below illustrates how we evaluated the probability distribution of possible outcomes. In summary:
- We believe a Clinton victory with a Republican-controlled House was the highest probability outcome.
- We believe a Clinton victory with a Democratic-controlled Congress was very low probability outcome.
- We believe a Trump victory was a low probability event; and a combined Trump victory and Republican-controlled Congress an even lower probability outcome. (Of course this latter scenario is the one that played out).
We also considered an additional probability around the propensity for candidates to stick to the policies outlined during their campaigns. This is particularly relevant for Trump: we placed only a 50% probability on Trump sticking to many of his draconian policies (e.g. trade barriers, Mexican wall, banning Muslins, etc) post-victory. Based on recent behaviour since the election, we believe this probability has only reduced further.
What is particularly important here for investors is not that this was yet another occurrence of a low probability event; it is that this was the occurrence of one of only two possible (but very low probability) scenarios that have the potential to boost the US economy. And it stems entirely from the control the Republicans now have of the White House, the House and the Senate. Given the complete dysfunctionality of US lawmakers over the last six years, the Republicans will surely pass as much legislation as physically possible over the next two years (just as Democrats would do if they found themselves in such a position).
As equity investors, we now consider the possible scenarios for global equity markets on a 12-24 month view. For simplicity, consider just three possible outcomes over the next 12-24 months:
- Bull case – global equities return double-digits percent per annum;
- Slug case – global equities return +/- low-single-digits percent per annum; and
- Bear case – global equities fall double-digits percent per annum.
We then use the “premortem” technique to place ourselves in the future and look back at the reasons why we found ourselves in each possible scenario. This technique is designed to break cognitive groupthink. We outline each of the possible scenarios below.
It is important to reiterate that we have no idea in which scenario we will find ourselves in 12-24 months time. We cannot predict the market – and neither can anyone else, in our view. But interestingly, there is a definitive statement that we think we can make about the probability distribution of possible scenarios in a post-Trump world.
We believe the probability of the Bull scenario has increased meaningfully, while the probability of the Slug scenario has decreased meaningfully, since the results of the US general election. We illustrate this concept below. Again, this is not to say we will end up in the Bull scenario definitively, it is simply that the probability of this scenario has unequivocally increased, in our view.
As an aside, we believe all three scenarios are US dollar positive. Investors will know that we have biased our global portfolios towards owning high-quality US dollar-denominated earnings streams; and we do not expect this to change any time soon.
Based on the analysis above, we have repositioned our global portfolios in two key ways:
- We have modestly increased the net market exposure to take advantage of any potential Bull scenario playing out; and
- We have systematically scaled back many of our US-exposed short positions. On the margin, we would prefer to be adding European or Asian short positions in the near term.
Finally, there is the obvious question around the sustainability of any Bull scenario that might potentially play out over the next 12-24 months. After all, if it were that easy to fix the US economy, why did President Obama not simply effect similar changes years ago?
We believe the crux of the answer lies in the fiscal position in which the US government currently finds itself. There are two key charts published by the Congressional Budget Office that summarize the situation and are worth revisiting, in our view.
The first, illustrated below, shows the current annual fiscal position of the US government based on government revenues and government expenditures. The chart then shows how the annual budget looks in 30 years into the future based on current law (i.e. pre-Trump). There are a number of key observations to note:
- Currently, expenditures outpace revenues to the tune of about 3% of GDP per annum.
- The largest component of expenditures is what have become known as “entitlements” which includes spending on healthcare and social security (effectively a pension for certain retirees). These collectively amount to 10.4% of GDP per annum at present.
- In 30 years’ time, under current (pre-Trump) law, entitlements will be running at 15.2% of GDP per annum; and the annual deficit (expenditures, less revenues) will be approximately 9% of GDP.
Naturally, as expenditures outpace revenues, the difference has to be funded with borrowings. The CBO can then estimate how much cumulative government debt will build up over the next 30 years. As illustrated below, the debt build-up is projected to be significant – the highest in the nation’s history – over this projection period. And this has been the primary concern of Republican Congress members for at least the last eight years.
The point is that the fiscal position of the US government is already very stretched. And this position is not conducive to cutting taxes and raising government expenditures – as Trump promised during his campaign. And the reason why Democrats were not able to effect any meaningful fiscal stimulus over the last six years was because they refused to cut entitlements to fund the incremental expenditures. Trump and Republicans may be far more willing to cut entitlements.
Even Fed Chair, Janet Yellen, recently cautioned against neglecting the stretched fiscal position of the US government in setting fiscal policy. As the Wall Street Journal wrote:
- “In considering the costs and benefits of fiscal policies, Ms. Yellen urged lawmakers to keep longer-term fiscal challenges in mind, including the country’s rising debt-to-GDP ratio, and to remember that the economy might need stimulus if its runs into trouble. She also urged them to choose fiscal policies that would improve long-term productivity and economic growth.”
Based on this analysis, we believe it is sensible to estimate the following:
- While Trump will surely push for fiscal stimulus – likely prioritizing tax cuts over direct government spending – he will be hamstrung by the Republican Congress that are laser-focused on the annual deficit and cumulative public borrowings.
- This implies, Trump’s determination to effect fiscal stimulus will be a direct function of his willingness to cut entitlement spending.
We do not know how this will play out. We believe the probability of fiscal stimulus and the positive economic benefits that may stem has increased significantly post the result of the recent US general election. We believe that in a world in which fiscal stimulus is pursued, this will either exacerbate the indebtedness of the US government; or, more likely, will be funded via significant cuts to healthcare and social security.
 (WSJ) Fed Rate Rise Could Come ‘Relatively Soon’ as Data Point to Stronger Economy, November 2016