A Tortoise on Steroids

President-Elect Trump’s Policy Agenda Triggers “Animal Spirits” But Brings Plenty of Risks Too

Louis P. Abel, CFA, CAIA
Chief Investment Officer, Chair of the Investment Committee – First Foundation Advisors

2016: A Year of Surprises and Market Tumult

Every year brings surprises for investors. Typically these are events, actions, or policy changes that occur but are limited in frequency and often limited in impact. But 2016 was filled with an unusual number of surprises ­– surprises that were not only big but also impactful. With those surprises came market volatility. The year began with investors worrying about a host of issues, including a continued collapse in oil prices, an economic slowdown and currency devaluation in China, the possibility of a hawkish Federal Reserve, the impact of negative interest rates in Europe and Japan, and an increased likelihood of a global recession. Within just five trading days into 2016, the Dow Jones Industrial Average had fallen 1,000 points – its worst-ever start to a year. By mid-February, the S&P 500 had declined 10% from the beginning of the year, and 16% from its peak. With the possibility of a recession on the horizon, many investors feared we were about to enter a bear market. We thought otherwise. While we acknowledged that these concerns were real, we believed the global economy would nevertheless remain sound and financial markets would ultimately recover. That’s exactly what happened. After the stock market bottomed on February 11, it rebounded strongly – and by March 17, the Dow had returned to positive territory. However, we weren’t entirely out of the woods just yet. The Brexit vote in June caught investors by surprise. Global stock markets sold off again, only to subsequently recover yet again. This time the rebound was fairly quick. By July 12, the Dow hit its first record close since May 2015. Then, in November, we had yet another big surprise: the election of Donald Trump.

Sell!...No Wait…Buy!

As the election returns rolled in on the evening of November 8 and it became clear that Donald Trump was headed for victory, investors were completely caught off guard. The initial interpretation was that Trump means uncertainty. Investors hate uncertainty. Uncertainty means volatility. Investors grabbed the standard playbook for volatility, which says, “Sell risk assets and buy safe-haven assets.” That’s exactly what they did. As Trump continued to rack up more and more Electoral College votes throughout the evening, the Dow futures plunged 870 points. The Mexican peso plummeted 11%. On the other hand, the dollar climbed higher, U.S. Treasury bonds rallied, and gold rose to above $1,200 per ounce. The initial reaction was decidedly “risk off.”

But then, as the reality of a Trump victory began to settle in, investors started to re-evaluate things. By midnight Eastern time, with a greater than 95% likelihood that Trump had won, and with market circuit breakers having stopped the market plunge, the Dow futures turned on a dime and began to recover. Mr. Trump’s victory speech at 3:00 a.m. seemed to further fuel the recovery. Investors began to consider that maybe there were actually two Trumps – what we might call “Campaign Trail Trump” (bombastic, extreme, and unpredictable) and “Victory Speech Trump” (calm, conciliatory, unifying…and, most importantly, pro-growth and business-friendly). Investors realized that the “volatility playbook” they had executed initially was the wrong playbook! They realized that a Trump presidency called for an entirely different playbook – the “pro-growth, business-friendly playbook.” And that playbook, it turns out, is almost the exact opposite of the volatility playbook. Instead of “Sell risk assets and buy safe-haven assets,” it says, “Sell safe-haven assets and buy risk assets.” Suddenly, we went from “risk off” to “risk on” in just a few hours. The Dow futures recovered fully and the index opened higher the next morning and ended the day up 1.1%. U.S. Treasury bonds, on the other hand, declined, causing yields to reverse course and rise. Gold gave back its gains. About the only thing that didn’t turn around was the Mexican peso.

Trump Supercharges the Rally

Since the tumultuous reaction on election night, investors have settled into the idea that, whatever else a Trump presidency means, it’s likely to result in faster economic growth driven by fiscal stimulus, lower taxes, and less regulation. Even prior to the election, investors were already encouraged by accelerating economic growth, improving corporate profits, and a recovery in oil prices, and had driven the stock market higher as a result. The election of Donald Trump served to supercharge the existing market rally.  The Dow Industrials hit a record level of 19,000 on November 22. The index gained 7.8% between the election and year-end, closing at 19,762. Including dividends, the Dow ended up 17% for the year, while the S&P 500 gained 12% and the Nasdaq Composite rose 7.5%. That’s quite a comeback for the stock market after what was the worst-ever start to a year.

The Tortoise Economy

Not only had fears of a recession abated during the year, but investors were emboldened even before the Trump victory by signs of increasingly robust economic growth. GDP growth accelerated to 3.5% in the third quarter, a strong showing after three consecutive quarters of less than 2% growth. Corporate profits rose after several quarters of declines. The unemployment rate declined to 4.6%, indicating a further recovery in the labor market. Still, although the economy has picked up lately, the recovery remains weak by historical standards. In fact, this is the weakest economic expansion of the 11 expansions we’ve experienced since World War II. Economist Robert Reich popularized the term “tortoise economy” to describe the U.S. economy in the wake of the financial crisis in 2007, and many believe it is an apt description of what we are currently experiencing. While we’ve come a long way since then – in fact, at 90 months, this is the third-longest expansion on record since 1900 – and the recovery appears to be solid and sustainable, it nevertheless remains a tepid recovery. It’s definitely more “tortoise” than “hare.”

While the recovery has been languid, and its benefits have certainly not been spread evenly – which is one of the reasons for the rise of the populist movement that helped catapult Donald Trump to the White House – many economists believe that the economy is approaching full capacity. Consider the statistics: The unemployment rate has dropped from 10% at its peak in October 2009 to 4.6% in November of last year, before rising just slightly to 4.7% in December. At these levels, many economists believe we are at full employment. The labor market has experienced a dramatic gain in jobs. After losing 8.8 million jobs during the recession, we have now gained back 15.6 million jobs, many more than we lost. Of course, not all of the same jobs that were lost were gained back and many people remain underemployed or have had to take part-time jobs, but the recovery in the labor market has been substantial nonetheless. Job gains have been averaging about 200,000 per month for several months, although they have since slowed somewhat to 156,000 in December. While the labor market has experienced a strong recovery, one important element that was missing was wage growth. But now, even wage growth has finally turned a corner. Wages have risen from a paltry 1% at the trough to 2.9% in December. The cyclical sectors of the economy have also experienced a recovery. For example, vehicle sales reached a record level of 17.7 million units in November, well above the average level of 15.5 million per month over the past 10 years and the trough of 9 million per month during the recession. Signaling its confidence in the recovery, the Fed raised interest rates in December, only the second time in 25 months.

Tortoise or Hare?

The question for investors is what the impact of further policy support, in the form of fiscal stimulus and tax cuts, would be at this stage of the economic cycle. Would it help sustain and extend a tepid recovery or, if we’re already at full capacity or close to it, would it lead to an overheated economy and runaway inflation? Will the slow tortoise morph into a swift hare?

While the stock market is excited about the possibility of the tortoise morphing into a hare, the idea has the bond market downright scared. U.S. government bonds declined in price in 2016. The yield on the 10-year U.S. Treasury note closed the year at 2.45%, up from 1.6% at the end of the third quarter. The yield on 30-year Treasury bonds rose from 2.32% at the end of the third quarter to over 3% by year-end. All of this is an indication of the bond market’s concern over the president-elect’s pro-growth policy agenda. The concern is not just that fiscal stimulus and tax cuts might trigger runaway inflation, but that they could significantly increase the budget deficit and the national debt as well.

The U.S. Congressional Budget Office (CBO) forecast for total government spending in 2017 is $3.9 trillion, of which $590 billion, representing 15%, comes from borrowing. And while the federal budget deficit has declined significantly with the economic recovery, from -9% of GDP in 2009 to -3.2% in 2016, it has increased recently. The CBO forecasts that it will rise further over the next 10 years – and that’s before factoring in any fiscal stimulus or tax cuts under a Trump administration. The federal debt, representing accumulated deficits, has already ballooned from a low of 21% of GDP in the mid-1970s to 77% today. The CBO forecasts that it will grow further to 86% of GDP over the next 10 years – again without any fiscal stimulus or tax cuts.

No Wonder Bond Investors Are Alarmed

A report prepared by Moody’s in June of 2016 forecasts that, under a Trump administration, assuming all of Trump’s proposals are enacted – a scenario it calls “Mr. Trump at Face Value” (which is admittedly unrealistic) – the federal deficit would increase by approximately $1 trillion by 2020, the final year of Trump’s term. By 2026, the end of the budget horizon, Moody’s forecasts that the deficit will be $1.6 trillion greater. And the Moody’s report was prepared before Trump had even proposed an infrastructure spending program, which he indicated at one point could be as large as $1 trillion. Even under a more realistic scenario, where Trump’s policy proposals are scaled back – what Moody’s calls “Mr. Trump Lite” – the deficit rises to 7.7% of GDP and the debt expands to 90% of GDP. And again, with an infrastructure program factored in, even one that’s substantially less than $1 trillion – say $500 billion or even $250 billion – the fiscal picture would be decidedly worse.

And what about inflation? Under the “Mr. Trump at Face Value” scenario, Moody’s forecasts the CPI will reach 5.4%, up from 1.7% currently! Even under the “Mr. Trump Lite” scenario, Moody’s expects inflation to increase to 3.8%. With a ballooning deficit and debt and substantially higher inflation, no wonder the bond market is worried. After all, bond investors read Moody’s; stock investors usually don’t.

Our best guess is that – even with a Republican-controlled Congress, which includes the Tea Party movement and a number of deficit hawks – we’re likely to see a significantly scaled-down version of what Mr. Trump suggested on the campaign trail. With concerns over the deficit and debt, we could see pushback on big personal tax cuts. An infrastructure spending program would boost growth, but the effects won’t be felt right away. What we learned from President Obama’s infrastructure program is that there are no shovel-ready projects. Corporate tax cuts should also boost growth, through greater investment spending, but corporate taxes at 8% of overall spending are not that significant.

A Trade War Would Hurt American Consumers

What about trade policy? We don’t expect to see dramatic moves. There will likely be a lot of talk about tariffs, but it’s very difficult to impose tariffs without hurting American consumers who buy foreign goods – the very same people who voted Mr. Trump into office. And, moreover, imposing tariffs on foreign goods is likely to trigger retaliation from our trading partners. China, Mexico, and our other trading partners are not likely to stand idly by while we impose tariffs. We suspect that Trump’s economic advisors know that a trade war would be bad for economic growth. We see the threat of tariffs as simply Trump’s way of negotiating better trade deals. But, suffice it to say, we’ll be watching this issue very carefully.

Immigration Is Necessary for Growth

Mr. Trump’s campaign focused significantly on the idea of cracking down on illegal immigrants. As a result, he will likely follow through on his promise to build a wall. Though we expect immigration to be curtailed somewhat, we don’t expect to see mass deportations. Such a move could have a negative effect on the economy. Based on census statistics, 85% of the growth in the workforce population over the next 10 years is expected to come from immigrants. That’s because our native-born population is aging. Without immigration, or a significant boost to productivity – which isn’t likely given that productivity has been declining – the economy can’t grow very fast.

Regulatory Relief Likely But Little Impact on Growth

President-elect Trump’s cabinet selections suggest we’ll likely see deregulation. The most affected sectors will likely be financial services and energy. The president has broad powers when it comes to the regulatory environment. But regulatory relief, while welcomed by many industries and additive to growth at the margin, is unlikely to fundamentally change the economic growth equation. It’s hard to push productivity growth up much with regulatory relief alone.

Affordable Care Act: Repeal and Replace

There seems little doubt that the Trump administration will follow through on its promise to repeal and replace the Affordable Care Act. Indeed, the Republican-controlled Congress has already begun to set the stage for its repeal. Whether they repeal and replace or repeal then replace has important implications for the 20 million Americans who currently have insurance through the ACA and healthcare providers and insurance companies. But whichever approach Congress takes, repealing and replacing ACA is not likely to significantly impact overall economic growth.

How Does All This Translate Into Economic Growth in the U.S. Going Forward?

Year-over-year growth in the third quarter of 2016 was 1.7%. On a quarter-over-quarter basis, it improved to a robust 3.5%. But the expansion overall is averaging just a little over 2%, which is well below the average of 2.8% since 1970. Basically, what we have is a “healthy tortoise,” but a tortoise nonetheless. If we assume that we get half the stimulus from spending and tax cuts that the president-elect has proposed, which won’t kick in until the second half of the year, we expect growth to accelerate to maybe 2.5% this year and next. That’s a material boost for sure, but not a dramatic one. It’s still short of the average recovery. Basically, we’re talking a “tortoise on steroids.” We’re not likely to see the tortoise morph into a snappy hare. Rather, it’s a bit like dangling a leaf of lettuce a few inches in front of the tortoise’s nose to get him to move slightly faster.

The Fed and Interest Rates

We think the Fed provides a healthy counterbalance to the fiscal stimulus under a Trump administration. Janet Yellen doesn’t think the economy needs fiscal stimulus given that it’s already at, or at least close to, full employment. As a result, we think the Fed will raise interest rates sufficiently to keep the economy from overheating and inflation from getting out of control. At the moment, the Fed is forecasting three rate hikes of 0.25% each for 2017. The market is expecting only two. The market has forecast fewer rate hikes than the Fed for some time and it’s been correct. The Fed has consistently had to readjust its forecast downward to match market expectations over time. For example, in 2016, the Fed expected four rate hikes and yet we ended up with only one. But in 2017, the Fed may have to move more aggressively to stave off an overheating economy in the face of fiscal stimulus. Thus, this time, we might see market expectations rise over time to match the Fed’s more aggressive assumptions.

What About the Rest of the World?

In terms of economic growth, the rest of the world is in fairly good shape. When we look at the Purchasing Managers Index (PMI), an indicator of economic expansion or contraction (with a figure of greater than 50 indicating expansion and less than 50 indicating contraction), for various countries around the world, we see a shift towards improvement.

Last summer, figures indicated either weak growth (with readings in the low 50s) or, in some cases, even contraction (with PMI of less than 50). Now figures indicate solid expansion (with PMI in the mid-50s). This is a notable improvement. Basically, in just six months, the PMI figures have gone from being almost entirely in the low 50s, or less than 50, to readings in the mid-50s.

Europe, which had been growing very slowly and was even flirting with recession fairly recently, is finally showing signs of a recovery with the PMI improving from below 50 to 53.9 as of December. Unemployment has declined from a peak of 12.1% to 9.8%, and credit demand has swung from contraction to growth. Even Japan, which seems perpetually in a funk, is showing signs of growth, albeit modest, with the latest GDP figure of 1% and unemployment declining from a peak of 5.5% to 3.1%. China’s economy continues to slow, but so far the Chinese authorities have managed to avoid a hard landing. Through continued investment spending and accommodative monetary policy, China has engineered a decent growth rate of 6.7%.

A Review of How We Fared Last Year

Last year was a good year overall for our balanced asset allocation strategies. While we certainly didn’t predict all of the big surprises last year, such as the Brexit vote or the election of Donald Trump, we got a number of calls right. For example, when much of the world feared a recession, we were confident that we would avoid one. This enabled us to stay invested in stocks. Even in the face of a sharp pullback, sticking with stocks allowed us to benefit from the subsequent recovery, driven by an accelerating economy and supercharged by the Trump election victory. It also enabled us to continue to hold high-yield bonds, which proved to be the best-performing fixed income asset class, posting a gain of 17% for the year.

Our decision not to sell international stocks in the wake of the surprise Brexit vote proved to be the correct one. While international stocks posted a lackluster return of only 1.5% for the year, our international investments handily outperformed the index, contributing nicely to our overall portfolio gains.

Our exposure to a select group of REITs was a particular bright spot in the portfolio. They posted strong returns for the year overall. As always, please remember that not all of our investment decisions have been or will be profitable.

While our tax-exempt municipal bonds suffered somewhat due to rising rates, our taxable fixed income nicely outperformed the broader bond market index. Much of this was due to our shorter duration, our avoidance of U.S. government bonds, and our focus on credit-oriented strategies, such as mortgage-backed securities, high yield, floating rate notes, and opportunistic credit.

How Are We Positioned Going Forward?

With the election of Donald Trump shaking things up, you would think we would be making lots of changes. But, actually, we have made very few changes. That’s not because we predicted the Trump victory, but rather, it’s because we were well-positioned for such an environment even before the election. We were benefiting from the rally in stocks before the election and continued to do so after the election. Our general belief is that stocks can continue to post further gains over time as corporate profits continue to grow, especially with a faster-growing economy. We hold this belief even though we remain somewhat cautious due to above-average valuations in large cap stocks. Small cap stocks have experienced a strong run lately, one that we have not participated in given a number of factors, but we’re not likely to chase them. We feel we are well-positioned in the right categories within fixed income. We have invested in credit-oriented bonds and floating rate notes in an effort to deal with an environment of gradually rising rates. Recently, we have taken profits in high-yield fixed income given the strong run that it had in 2016. We will continue to assess the outlook for rising rates and look for additional ways to protect capital while seeking opportunities at the same time. We continue to believe the REITs we own represent good value and, although they have experienced some weaknesses lately due to concerns over rising rates, we are sticking with them given that REITs tend to hold up over time – even in a rising rate environment. Moreover, we believe these REITs, in particular, remain attractively valued.

Plenty of Risks to Consider

As usual, there are plenty of things to worry about, including:

- The outcome and impact of the Brexit negotiations;

- Upcoming elections in the Netherlands, France, and Germany and the potential rise of populist movements in Europe and the possibility of a breakup of the eurozone or the European Union;

- An Italian banking crisis that leads to a broader financial crisis in Europe;

- The migrant crisis in Europe;

- A possible hard landing, currency devaluation, and debt and property bubbles bursting in China;

- Geopolitical risks (e.g., Russia, Syria, Iran, North Korea);

- Global terrorism;

- Fiscal stimulus leading to an overheating of the U.S. economy and runaway inflation;

- Interest rates rising faster than expected;

- Ballooning budget deficits and national debt;

- A policy mistake by the Federal Reserve or other global central banks;

- An eventual recession, given that the recovery has been underway now for more than seven years; and

- A shift by investors back to concerns over the unpredictability of Donald Trump.

No doubt there are many other items that we could have put on the list. Rest assured that we will remain vigilant about the various risks out there. We will also be looking for opportunities that present themselves over time. It’s hard to imagine that 2017 will be filled with as many surprises as 2016, but we always prepare for the unexpected.

The election of Donald Trump has clearly changed things quite dramatically. This is a new regime – both politically and economically. We will be watching very carefully to see how things unfold, and adjusting accordingly. For now, we think a tortoise on steroids is not such a bad thing. If the U.S. economy can boost growth modestly – while keeping inflation in check, interest rates from rising too rapidly, and the deficit and debt from spiraling out of control – the next few years will prove to be good ones. But we’re well aware of what could go wrong. Just like a healthy tortoise, we won’t be retreating into our shell.

As always, we appreciate your confidence and trust in us. Should you have any questions, please don’t hesitate to reach out to your advisor.


Important Disclosures

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by First Foundation Advisors), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from First Foundation Advisors. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. First Foundation Advisors is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a First Foundation Advisors client, please remember to contact First Foundation Advisors, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the First Foundation Advisors’ current written disclosure statement discussing our advisory services and fees is available upon request. First Foundation Inc. provides two separate and distinct services: (1) investment advisory services through First Foundation Advisors, as an SEC registered investment adviser, and (2) banking, trust services and philanthropic and family consulting through First Foundation Bank and insurance services through the bank’s subsidiary, First Foundation Insurance Services. Clients may engage First Foundation for either or all services. However, no investment advisory client is required to engage First Foundation Bank for banking services, and no banking client is required to engage First Foundation Advisors for investment advisory services.

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