U.S. equities reached new highs in the weeks following Donald Trump's election as president. The "Trump bump" was strongest in segments of the market projected to benefit the most from policy changes under his administration.
Small company, financial services and energy stocks were among the winners, while health care stocks, bonds and bond proxies were among the losers. Investors have embraced economic expectations for 2017 that are generally positive for equity markets, with key assumptions, including:
Increased government spending. Trump promises to boost spending, particularly for infrastructure. Although there is bipartisan support for infrastructure spending, President Trump may face the same shortage of "shovel-ready" projects that President Barack Obama faced in his first term.
Tax reform.Corporate tax reform is expected to be a first-term priority for Trump, providing a boost to small company stocks that tend to have fewer deductions and higher effective tax rates than large companies. A cut in effective tax rates would provide an immediate boost to after-tax profits. Small companies would also benefit from a less restrictive regulatory climate. Trump's plan for personal tax cuts and simplification, though likely to fall short of campaign promises, would provide a boost to consumer spending.
Energy policy. Trump's advisors include Exxon Mobil Corp. (ticker: XOM) CEO Rex Tillerson, former Texas Gov. Rick Perry and Oklahoma Attorney General Scott Pruitt. Trump is expected to favor oil, gas and coal over the renewable power sources favored by the Obama administration. Trump's selection of fossil-fuel friendly advisors and the recent OPEC agreement to limit oil production has boosted energy stocks.
RELATED: Here's the NYSE looked like before the election:
Financial services regulation. Low interest rates, a flat yield curve and a post-crisis regulatory regime have bedeviled bank stocks in recent years. Trump is expected to be a friendlier to banks than the prior administration, with the selection of Goldman Sachs Group's (GS) Gary Cohn as director of the National Economic Council and of former Goldman executive Steve Mnuchin as Treasury secretary an indication that Wall Street will have an easier time. Banks have rebounded given expectations of a lighter regulatory touch and a steeper yield curve.
Interest rates and inflation. Prior to the election, the Fed was poised to raise interest rates in December given a tightening labor market, rising wage inflation and an easing of deflation concerns. Trump's policies brought inflation concerns to the forefront of market expectations and reinforce the anticipated direction of Fed policy. The "lower for longer" mantra for the market has been replaced by expectations of reflation, and investors have adjusted their expectations for rate hikes through the end of 2017. Consequently, interest rates moved up dramatically after the election, with longer-term government bonds, municipal bonds and emerging markets debt losing ground. Bond-proxies that benefited from the quest for yield earlier in 2016, such as utilities and real estate investment trusts, also lost ground post-election.
Some parts of the market have diverged from pre-election expectations. Health care and defense stocks were expected to be winners in a Trump administration. Health care was expected to benefit from an aging population, lower pricing pressures and the anticipated repeal or restructuring of the Affordable Care Act. However, Twitter commentary signals that high drug prices may be a target of the president-elect, so the pharmaceutical industry may face unanticipated pressure. Defense was also expected to be a major beneficiary in a Trump presidency, but Twitter attacks on Boeing Co. (BA) and Lockheed Martin Corp. (LMT) indicate Trump may intervene in government contracting decisions. Both segments of the market will be volatile until a stable pattern emerges.
The 30-plus year bull market in bonds, at long last, appears to be over as rates have moved up dramatically post-election. Bonds may not offer a good value today, but may become more attractive in the latter part of 2017 as rates continue on a path toward normalization.
Outside the U.S., despite improving economic momentum European stocks face challenges in the aftermath of the Brexit vote, continuing populist unrest and unresolved issues in the banking system. Japan faces daunting debt levels and demographic challenges, though Japanese equities have rebounded with help of a falling yen and government equity purchases. Emerging markets have a mixed outlook, as rebalancing toward consumer-oriented economies will help some emerging markets, but high level of U.S. dollar debt and potential de-globalization initiatives will hurt others.
The euphoria of the recent rally may fade as Trump faces the limitations of presidential power, and uncertainty builds about the specifics of his governing priorities and ability to implement policy. Changes to the market outlook are likely to be driven by a few key economic and geopolitical considerations.
Here are five economic and geopolitical considerations:
Trade policy. Trump's administration is likely to formally label China a currency manipulator, the start of a lengthy process full of sound and fury but little substance. Trump is also likely to impose tariffs or restrictions on Chinese steel. However, the 45 percent tariffs threatened during the campaign will likely serve as bargaining chips rather than serious policy moves and the trade wars feared during the campaign may not materialize. If Trump moves more aggressively on trade than currently expected, equity markets will likely take a turn for the worse.
Immigration. Immigration was one of the highest profile issues in the campaign, but many investors are hoping that Trump's priorities will be directed toward illegal immigrants in trouble with the law and on refugees from "ungoverned" states such as Syria and Somalia. If Trump restricts immigration more broadly and substantially limits the entry of highly skilled workers, technology, pharmaceutical and biotechnology companies will be among the losers.
Populist movements. 2016 was the year of the populist movement, with Brexit and Trump's election upending the political establishment in the western world. The European "project" is increasingly fragile, with French, Dutch and German elections, the formation of an interim government in Italy and negotiations for Brexit all holding the potential to turn the European status quo upside down. Geopolitical stability in Europe would provide a boost to equities, particularly hard-hit financial services stocks.
The dollar. Rising U.S. interest rates may boost the dollar, helping domestically-focused companies while hurting exporters. A rapid dollar appreciation would be more disruptive than a gradual appreciation, and a rapid move upward in the dollar would cause the Fed to re-think their plans to hike rates in 2017. Emerging market countries that have substantial dollar-denominated debt are particularly vulnerable to a robust rally in the dollar.
Limitations of government policy. Certain trends will be difficult to stop, regardless of how many tweets come out of the Oval Office. Pressure to maintain manufacturing jobs in the U.S. may have unintended consequences, as companies may replace people with robots if forced to keep plants open in the U.S., or consumers may rebel if iPhone or other consumer goods prices double in response to protectionist measures. Tariffs aimed at single countries may also have unintended consequences, as presidents from Johnson to Obama have discovered. The U.S. may "punish" China or Mexico by imposing tariffs, but U.S. consumers may substitute imports from other low-cost countries rather than pay up for higher-priced products that are "Made in America."
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