2016 U.S. Election Impact
Once again a vote in a developed nation resulted in a populist outcome that polls had inaccurately forecasted. Unlike the Brexit decision, however, we know the timing of the event, but the actions to be taken are less clear. Over the coming weeks, investors should anticipate the possibility of heightened volatility as personnel assignments and policy frameworks for the new administration take shape.
Over the medium term, we expect that bond investors will require higher U.S. yields, likely with a steeper curve. There is greater uncertainty regarding how credit markets will respond, but watching equity performance in the coming months may provide some insight. Much of the platform should be supportive to credit and equity, although expect sector rotation of out/under performers. Given the expected changes to the Affordable Care Act, financial regulations, energy policies, foreign cash repatriation, and trade agreements, not all industries will benefit equally.
Which industries might be affected and how?
A reduction in the corporate income tax would, of course, be beneficial to a wide range of companies. Large corporations with substantial international operations would benefit from Trump’s proposal of a small one-time tax on repatriation of overseas earnings. Trump’s stance on trade deals could be far more problematic, however, with a number of export industries–and those companies sourcing products overseas–negatively affected. Aerospace and technology are good examples. A rollback of Dodd-Frank and other financial regulation may be a positive for bank profitability, but may encourage greater risk-taking and weaken bank balance sheets. In healthcare, hospital chains will feel the negative impact of changes to the Affordable Care Act, while insurers and pharmaceutical manufacturers will benefit.
Why should U.S. bond yields rise?
Several of Trump's key policies are inflationary and/or could result in a dramatic increase in the fiscal deficit. Both themes should push rates higher. Given Republican control of Congress, it is unclear what sort of limitations will be put on Trump’s policy platform, so the impact cannot be accurately assessed yet. We would place a higher probability on tax reform in the coming year.
Mr. Trump promised to "tear up" existing trade agreements and opposes the Trans-Pacific Partnership (TPP). He has also threatened to impose punitive tariffs on goods from foreign countries. All of these are inflationary and will push up the prices of goods, while impeding growth. [Note that historically Republicans have supported trade deals.]
Mr. Trump has also promised the biggest tax overhaul since the Reagan Administration, pledging to cut taxes across the board, with a maximum tax on American businesses of 15% (this compares with the current maximum of 35%). Additionally, the highest personal tax rates would fall from 39.6% to 33% while reducing the number of tax brackets from seven to three. The lowest bracket would rise from 10% to 12%. The plan also proposes eliminating the alternative minimum tax and federal estate taxes. The plan was revamped in August to reduce the potential deficit impact from $9 trillion over a decade to $6 trillion.
How likely is the Fed to raise rates in December?
Should the equity and credit markets remain stable and current economic trends continue (e.g., employment and inflation), there is a strong probability of the Fed moving. With pro-growth policy priorities of lower taxes and repatriation of foreign cash, the arguments for a December move are at least as valid today. We expect that upcoming inflation and employment data (the Fed’s mandates) will continue to support a near-term rate hike, particularly if the dollar remains lower. The market pricing reduced the probability post-election from 80% to 50%.
Should volatility decrease now that the election is over?
Markets dislike uncertainty, so having any decision is a positive. The Brexit lesson for equity and credit buyers was to buy quickly on sell-offs. That lesson was put to work last night. However, with no previous governing experience, a lack of transparency on key appointees, major policy promises with limited details, and questions surrounding how the Republican establishment will work with Mr. Trump, volatility may remain elevated in the near-term as specifics take shape.
What does this mean for investment positioning?
LIM fixed income portfolios were well positioned to benefit from the market’s initial response. If volatility spikes again and credit underperforms, the portfolios could take advantage, having slightly reduced risk over recent months. We continue to have a defensive duration posture and will monitor opportunities to move toward neutral.
The arbitrage portfolios also should be well positioned in the event of heightened volatility. Immediate reaction in our investment universe was fairly muted, aside from deals spanning managed care and those specifically cited by the President-elect on the campaign trail (Time Warner / AT&T). We believe that the portfolios continue to represent a compelling value proposition with a focus on absolute returns and low volatility.
The opinions contained herein are those of Longfellow Investment Management Co. LLC (LIM) at time of publication and may vary as market conditions change. They are based on information obtained by LIM from sources deemed to be accurate and reliable. However, accuracy is not guaranteed. It is in the sole discretion of the reader whether to rely upon the opinions contained herein. The information provided does not constitute investment advice, is not a recommendation, offer or solicitation to buy or sell any securities, or to adopt any investment strategy and should not be relied upon as such. It does not take into account an individual investor’s particular investment objectives, strategies, tax status or investment horizon. There is no guarantee that any forecasts contained herein will come to pass. Past performance is not an indication of future results. Investment involves the possible loss of principal.