A New Sheriff in Town

The stock market has performed quite nicely since Donald Trump was elected president.  However, the rising tide has not lifted all boats.  The biggest beneficiaries of the rally have been companies that benefit from infrastructure spending, higher interest rates, higher commodity prices, and less regulation.  On the other hand, companies that might be negatively affected by higher interest rates or protectionist policies have not done nearly as well.  At the risk of oversimplifying, the market, to date, appears to be giving credit to Trump and the Republican Congress for a sizeable infrastructure spending bill, tax cuts for individuals and corporations, an overhaul of the regulatory backdrop and no changes to entitlements.  At the same time, it does not appear as though investors are adequately discounting the potential negative ramifications of Trump’s policies.  Don’t get me wrong.  We have all enjoyed this rally.  We obviously hope that it continues well into the New Year.  However, Trump’s direct interference into the private sector and Fed monetary policy strike me as potentially troublesome.

Donald Trump’s recent interference in the private sector – including statements (or tweets) regarding United Technologies’ outsourcing of jobs to Mexico; the high cost of Boeing’s Air Force One contract and Lockheed Martin’s F-35 fighter jet contract; and the exorbitant price increases for some prescription drugs – strike me as anti-laissez faire (anti- free markets).  As such, they seem to run counter to Republican orthodoxy.  Traditionally, Republicans have sought to minimize the government’s involvement or influence in the business sector and capital markets.  Trump, however, seems to believe that the country’s best interests are served by strong-arming our companies into: 1) keeping jobs in the US; 2) minimizing the cost to taxpayers for government contracts; and 3) protecting citizens from companies (especially drug companies) with a history of price gouging.  The markets be damned!  There’s a new sheriff in town, and his Republican brethren best get with the program or else incur his wrath.

Many people will agree with the President-elect’s decision to play a more visible role in the private markets.  However, I think there is a very real danger of a slippery slope.  It’s one thing to make sure that the government is getting its money’s worth when it is a party to a contract.  In such cases, the government is the customer and therefore should have the ability to demand accountability for cost overruns and other issues.  However, direct interference in a company’s decision to move production offshore could be more problematic.  Trump’s actions, in this case, represent an intrusion on a private company’s ability to make business decisions based on the profit motive, which is the very basis of capitalism.  Some may argue that because about 10% of United Technologies’ revenue comes from the US government, the latter should have the ability to influence the company’s actions.  But if this is the case, where does the government draw the line?  Should the government have the ability, for example, to influence pharmaceutical companies’ decisions regarding drug pricing?  How about the cost of food and energy?  Should the government limit the amount of rent that landlords can charge?  It seems to me that this kind of market interference could inhibit capital formation and damage the US reputation for free markets.

Trump’s words and actions are affecting the markets.  On the day after the presidential election, shares in a biotech exchange-traded fund (ETF) rose 9% on the expectation that Trump would be far less inclined to interfere with drug pricing as compared to Hillary.  However, the market has since given back those gains as investors have interpreted Trump’s recent comments regarding drug pricing, as well as its interference in other sectors, as being negative for drug makers.  In a December 7th interview in Time magazine, Trump specifically addressed his plans to control drug pricing.  I think it is safe to assume that this kind of “headline” risk is going to be an ongoing issue for drug companies and their shareholders during Trump’s tenure.

Similarly, the defense contractors got a bounce after the election, with one aerospace and defense ETF rising as much as 12% since the election.  That ETF, which incidentally has Boeing, United Technologies and Lockheed Martin as its three largest holdings, has since dropped a bit to reflect Trump’s comments related to the Air Force One and F-35 contracts.  In fact, Lockheed Martin’s stock was down about 3% earlier in the week in response to Trump’s comments.  Will Trump continue to unilaterally and arbitrarily make decisions regarding individual government contracts?  Is he in the best position to evaluate these contracts?  As an investor, how do I incorporate this new risk in my investment decisions?

Another interesting observation is that the S&P 500 Index, up 5% since the election, is trailing the Russell 2000’s increase of 15% since the election.  We suspect that investors are worried that Trump’s protectionist trade rhetoric could hurt the earnings prospects of US multinationals.  The Russell 2000, on the other hand, is composed of smaller companies that derive the vast majority of revenues (>80%) from the United States compared to a little over 50% for the S&P 500.  Will Trump follow through with trade restrictions that could affect nearly 50% of S&P 500 revenues?  As an investor, how do I handicap that risk?

There are other troubling aspects to the President-elect’s recent behavior.  Despite declaring himself a “low-interest-rate guy”, Trump has voiced his disapproval of the Federal Reserve’s ultra-loose monetary policy while also foreshadowing his intent to replace Fed Chair Yellen.  At a minimum, these statements threaten the Fed’s independence, and some believe that Yellen has now become a lame duck with her head on the chopping block.  At worst, Trump seems to believe that he is better equipped to make monetary-policy decisions than the (supposedly) politically agnostic Fed.  Why is this important?  Because if Trump believes that the Fed’s actions (interest-rate increases) could water down or even neutralize the positive effects of his fiscal stimulus, then he might try to influence the Fed’s makeup or actions.  Under this scenario, the Fed’s statements regarding monetary policy would lose their credibility, and therefore the Fed would lose much of its power to pursue its Congressional mandates of maximizing employment and maintaining price stability.  There is a reason that the Fed is expected to act independent of political influences, and Trump is putting this independence at risk.

Investing in the Trump era has introduced a number of new variables that, for now, are being largely ignored.  Will Trump’s proposed fiscal stimulus be supportive of economic growth?  The answer is probably yes.  But there are many additional issues to consider.  Can he get the measures through a Republican Congress worried about deficits?  Will the stimulus initiatives be powerful enough to offset the removal of eight years of free money?   How long will the initiatives take to work?  And perhaps most importantly, what will be the side effects of Trump’s proposed policies?  There are likely to be some powerful offsets to the proposed fiscal stimulus, which may include higher budget deficits, higher inflation and interest rates, a stronger dollar, larger trade deficits, and a rise in energy prices.  As a result of the multitude of unknowns, our advice at this time is to not get too far out over your skis.