30 October 2016
Themes For October
As we forecast in last month’s report, financial markets experienced a rocky ride during October as storm clouds gathered over the financial landscape. The major concern centered on uncertainty over the outcome of the US Presidential election held in early November. In addition to this, economic data confirmed the growing likelihood that the US Fed will increase cash rates for the first time in a year by hiking rates by 0.25% in December. In the UK, the reality of the Brexit vote to leave the EU began to strike home as Prime Minister Theresa May commenced the process to extricate the UK from the European Union. Equity markets were generally weaker over the month with Australian market down 2.2% despite a firmer Resources sector, buoyed by firmer commodity prices. A back up in bond yields saw the interest rate sensitive sectors of our market such as REIT’s fall sharply. In overseas markets, The US was down 1.8%, while the UK was up 1% and Germany up 1.5%. The standout performer was Japan which rose by 5.3% as the BOJ announced it would continue its expansionary monetary policy settings. It was significant to observe that bond yields backed up both in the US and Australia as the market began to factor in the likelihood that the process of normalising interest rates in the US was close at hand. In Australia, the RBA decided to keep rates on hold in their meeting on Melbourne Cup day, leaving a finely balanced equation as to whether we have seen the bottom of the interest rate cycle here.

US Presidential Election Outcome

The election of Donald Trump as the 45th President of the US will go down as the most stunning political upset in US history, confounding virtually every pre-election opinion poll. In addition to capturing the White House for the first time in 8 years, Republicans also maintained control of both the House of Representatives and the Senate, meaning that all branches of Government in the US are now under Republican control for the first time since 1928. This replicates the position the Democrats found themselves in following the election of President Obama in 2008.

The initial market reaction to the shock election outcome was negative with US equity futures declining 5% and safe havens such as gold and bonds rallying as it became clear Trump would prevail.  During the following day’s US trading session, sentiment sharply reversed given the conciliatory tone of Trump’s acceptance speech and a realisation that many of Trump’s policies would be positive for stocks. It is also worth pointing out that no US President has unfettered executive power and there are prudent checks and balances embedded in the Constitution through the Congress and the Supreme Court that limit the ability to implement any radical proposals.

Financial market implications of the Trump Victory

President elect Trump will certainly claim a legitimate mandate to implement his economic agenda and will expect the support of the Republican congress to pass his key proposals. There will be some motivation for Trump to move quickly in the first 2 years of his term as the mid-term elections in 2018, where 1/3rd of the Senate will be up for election, will pose a challenge for Republicans to hold the Senate given the number of seats they will be defending at the time.

The key elements of his economic platform are:

  1. A reduction in the corporate tax rate from 39% to 15% and the top marginal personal tax rate from 39% to 33%.
  2. Fiscal stimulus via increased spending on infrastructure projects.
  3. Approving the development of US energy projects such as the Keystone pipeline, vetoed by President Obama.
  4. The renegotiation of free trade deals such as NAFTA and TPP and the imposition of tariffs on goods imported from China and Mexico in particular.

The first 3 items will no doubt be stimulatory for the US economy, however will also pose some short term risks to the US Budget before the revenue benefits of stronger growth reach the Treasury coffers. This is likely to put upward pressure on US bond rates and accelerate the timetable for interest rate increases already forecast to commence in early December. The proposed import tariffs will also put upward pressure on consumer inflation adding to the Fed’s case for higher rates sooner than would have otherwise occurred.

A higher growth trajectory for the US economy in concert with the lower corporate tax rate and regulatory relief will ultimately be positive for corporate profits and therefore share prices, offset partially by the negative impact of higher interest rates. The prospect of tariffs on imported goods from China and Mexico will have a negative impact on the tradable goods sectors of those economies. Given our trade dependency with China, a slowdown in the growth prospects for that economy will have a negative impact on their demand for our commodities such as iron ore and coal.

Investment Outlook

Last month we reduced the equity risk in diversified portfolios by selling down holdings in both Australian and international shares. The rationale for this recognised emerging risks in equity markets and a desire to protect capital and establish a buying reserve should a substantial correction occur. With the passing of the uncertainty surrounding the US election, we still believe there are sound reasons to exercise caution. First and foremost, the market is fully valued and still hasn’t fully factored in the prospect of a rate rise in the US which in our opinion is all but certain. Elsewhere, there remains grave concerns about growth prospects in the UK post their exit from the EU and activity remains subdued in Europe and Japan. Central Banks (excluding the US) continue to operate expansionary monetary policy programs in an effort to stimulate growth and re-ignite inflation. We believe that the government bond market is grossly overvalued being artificially supported by the extraordinary level of buying from Central Banks since the GFC. Over the coming years it is inevitable that bond yields will rise producing negative returns as stimulus measures are wound down in response to improving growth and rising inflation.