Executive Summary
The Trump administration in the US is embarking on what The Economist describes as ‘an extraordinary economic gamble’. Like any gamble, the Trump agenda has a range of potential economic outcomes both positive and negative. The impact on the US stock market could be severe and the risk/return trade-off is highly unfavourable for broad based US equity exposure.
Will Trump over-stimulate the US economy?
Trump was elected on a platform of accelerating US economic growth and he is following up on his commitments to reduce taxes and increase spending in areas such as infrastructure and the military. According to figures reported by The Economist, this will result in the US budget deficit increasing from just under 3% of GDP in 2018 to just over 5% of GDP in 2021. This will add about one trillion dollars a year to a Federal US debt that already exceeds twenty trillion dollars.
The fear for investors is that stimulating an already strong economy will drive up inflation and that increased government borrowing to fund the budget deficits will increase competition for capital. The combined effect will be to drive up interest rates which could slow economic growth. Under a bear case scenario, the rise in interest rates could trigger a recession which would have the compounding effect of worsening the budget deficit due to falling tax revenues. Under an extreme bear case scenario, the US could find itself in a position where lenders are no longer willing to buy government bonds without the US imposing the type of austerity measures some European countries were forced to adopt in the post-GFC period.
The bull case scenarios for the success of the US economic agenda rely on a few key assumptions:
- Accelerated economic growth can be achieved without driving up wages and inflation. This assumption is based on the argument that technological developments such as robotics have increased the substitutability of labour to a point where bargaining power has been permanently constrained.
- Fiscal stimulatory measures will be self-funding over the longer-term as a result of increasing economic growth.
- Investors will continue to buy US government bonds, even as supply almost doubles from current levels over the next few years.
While we cannot rule out any of these assumptions, there is limited evidence to indicate that they will hold true and all, in some way, run counter to orthodox economic theory. Despite the multitude of commentators willing to provide confident and persuasive arguments as to why this time will be different, the fact is that no-one knows what will happen. That’s why the Trump economic agenda should be understood as ‘an extraordinary economic gamble’ with a highly uncertain outcome.
What are the implications for the US equity markets?
As investors, when faced with an uncertain future, we frame our decisions in terms of scenarios and probabilities.
We can structure our thinking about the range of potential outcomes for the US economy into four scenarios:
- The bull case - US economic growth accelerates, company earnings increase and there is only a mild increase in wages, inflation and interest rates.
- The moderate bull case - Accelerating US economic growth is accompanied by increases in both earnings and wages. Under this scenario, US companies are able to absorb increases in labour costs without raising prices by simultaneously growing earnings through productivity improving investments and increased demand.
- The moderate bear case - Accelerating US economic growth drives increased employment and wages, with companies unable to pass on price increases due to competitive pressures. Under this scenario, US company earnings decline as the corporate profit share of GDP returns to historical norms.
- The bear case - Accelerating US economic growth is accompanied by a substantial rise in wages and inflation. Interest rates rise rapidly to contain inflation, triggering an increase in unemployment and substantial decline in corporate earnings.
The potential impact of these scenarios on the US equity market is illustrated in the table below.
| Scenario | Earnings (USD) | Multiple | Return | Assigned Probability |
|---|---|---|---|---|
| Bull Case | 155 | 22.0 | 22.7% | 25% |
| Moderate Bull Case | 152 | 19.5 | 6.6% | 25% |
| Moderate Bear Case | 130 | 15.0 | -29.9% | 25% |
| Bear Case | 110 | 13.0 | -48.6% | 25% |
| Expected return | -12.3% |
Based on the assumption that each scenario carries an equal probability of holding true, the expected return for the S&P 500 is -12%. By way of comparison, leading US fund manager GMO forecasts a -4.4% return for the US market over a seven-year time frame.
Under these scenarios, an investor would have to assume a 75% probability of success for Trump’s political agenda in order to achieve a break-even expected return. Given the history of the economic cycle, the premature death of which has been mistakenly called on multiple occasions in the past, we think the probability of success is much lower.
It is no surprise, therefore, that the fund managers we recommend to clients are finding investment opportunities with more attractive risk/return trade-offs in other regions of the world. Fortunately for our clients, these managers have been able to achieve significant outperformance over recent years despite the continued strength of the US markets.
Although we are only applying this framework as a hypothetical exercise (we do not make asset allocation decisions using this approach), it does help to illuminate the risks for investors, particularly those with broad based exposure to the US equity market. As always, the key is to be selective as to where you invest and make sure you only buy assets at sensible valuations.
DISCLAIMER
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.