Trumped-Up Economics: How Deregulation Plans May Likely Derail The Economy (Part 3 Of 3)

| About: iShares U.S. (IYJ)

Summary

In this final piece of my three-article series, I asses the current market rally across Industrials and Basic Materials.

I also take a brief snapshot of history and the political economy to show how history sometimes repeats itself.

Lastly, I make a point that the US economy may be in a late business cycle, and any expansionary fiscal policy may already be too little, too late.

This is the final article of a three-part series in which I have been dichotomizing the post-election financial market rally, and assessing the potential effects of deregulation on the US economy. In this final piece, I will analyze the recent performance of the materials and industrials sectors.

In parts one and two of this three-part series, I analyzed year-to-date returns for all major sectors. I found that early in the second half of the year, half of the sectors underperformed while the other half performed well. The sectors averaged out to a flat overall performance for the S&P 500. However, the election outcome caused a dramatic shift in the trends of all sectors. In the days following the election, all major U.S. indices rallied for several days and remain at record highs, in nominal and real terms. To see this pattern in close detail, please have a look at the chart below (Sector data sourced via Bloomberg):

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The chart above shows year-to-date market returns by sector with data retrieved from August 16th, 2016, through November 22nd, 2016. The sectors traded within the same range for most of the second half of the year, but have converged since the election outcome became known. The healthcare, financials, info tech, materials, and industrials sectors had the highest post-election returns. These were sectors most likely to benefit from a Trump victory over a Clinton victory. Conversely, sectors with a move to the downside included consumer staples, telecom, and utilities. The consumer discretionary and energy sectors had returns tilting to the upside, but not by a meaningful amount. The materials and industrials sectors have become market-leading sectors, trailing only behind energy. These two sectors are the focus of this article, as they are arguably poised to benefit from any sort of Trump deregulation or fiscal stimulus policy.

Ideally, a wave of corporate tax savings, public investment in infrastructure, deregulation, and repatriation of corporate earnings held offshore are likely to spur an economic expansion, right? At least this is what the consensus seems to believe, and I on the other hand caution against this "herd mentality." A graph of one-month returns for the same sectors is found below (see here):

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From the chart above you can identify the top three performing sectors; financials, industrials, and materials sectors. As you can see, in the earlier part of the year, these sectors did not perform as strongly throughout the year. After the election, these sectors began to strengthen at the prospect of the new president-elect. In the next few paragraphs, I want to discuss a little more about the political economy, and debate how the surge in these sectors may be unfounded.

Initially one has the tendency to go with the herd mentality as the sound of an accommodative and business-friendly Federal Government sounds promising. However, upon careful analysis, there is some reason to believe that any expansionary fiscal policy may be coming too little, too late. Here is why.

After years of monetary easing from the Federal Reserve and fiscal austerity (remember the fiscal cliff?) acting as a headwind to the economic cycle, the current economic cycle may be showing signs of peaking. The chart below presents the civilian unemployment rate as sourced from the St. Louis Federal Reserve's Economic Database:

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The chart above represents the historical civilian unemployment rate. As you can see, the most recent trend appears to be at a trough. With the unemployment rate currently at 5%, there may be very little room for a large economic expansion in the US, from this perspective. The average historical unemployment rate is 5.8% and the economy has been trending below this average for most part of the year. There are some adverse effects to stimulating an economy which is already at its peak.

Expansionary fiscal policy in a late business cycle has been attempted before, in the mid-to-late 1960s. President Lyndon B. Johnson's Great Society ordered fiscal stimulus while the Federal Reserve kept target interest rates low as a widening budget deficit ensued. It is coincidental how Johnson's "Great Society" so closely resembles the "Make America Great Again" movement. Even the Truman promises of modern transportation, modern infrastructure, and crime control parallel those of Trump. The consequences of these actions lead to severe inflation by the middle of the following decade. Richard Nixon inherited an overheating economy burdened with costs tied to the Vietnam War. He later implemented temporary wage and price controls, and hosted the meetings which eventually led to the free-floating US dollar. Then, the recession of '71 arose, which was deemed the worst since the Great Depression. This was followed by a small period of growth and the double-dip recession again in '74. Of course, the Federal Reserve was just starting to work out the kinks of monetary policy, and Ben Bernanke was still completing his doctoral studies at MIT. The solution to the problem was a man named Paul Volcker who helped tame inflation but held back economic growth (Most of the information presented in this paragraph can be found in these lectures here, as well as here, and here).

The Federal Reserve has managed to keep inflation expectations well-anchored for the last two decades following Volcker's term as Fed Chairman. This is likely to be the case moving forward, so runaway inflation may be less of a problem in the future, albeit, at the expense of a much higher cost of borrowing which constrains economic expansions.

My Assumption of What Happens Next

So, the idea is that "Trumped-Up Economics" is going to stimulate growth in the US economy. With GDP growing at less than 2% per year, Trump wants to grow at 4% to 5% per year. Among Trump's plans are indications of corporate tax cuts, repatriation of foreign earnings, and deregulation. How does all this affect the sectors covered in this article?

First, lower taxes should in theory provide American corporations with a much-needed incentive to expand business. As businesses expand, new jobs are created, people will make and spend more and this creates economic growth. With an expansion comes the need for new roads, housing, more consumer goods and so on, right?

What If "the Herd" is Wrong?

Or better yet, how could the herd be wrong? Is there a way that this expansion will not happen? Let me describe two alternate scenarios which could potentially counter the herd mentality.

Scenario 1: Let's say that corporate-level managers do not forecast meaningful growth in aggregate demand. The managers decide instead to use these corporate tax savings to boost earnings, dividends, mergers and acquisitions (more industry consolidation), or perhaps pay off debt which has been piling up for years. All this may appear to be just what corporations have been doing for the past five or six years. So, let us now look at a different scenario.

Scenario 2: One of the probable effects of the invisible hand behind "Trumped-up Economics," is that US revenues from corporate taxes will in the short-run unavoidably drop if the corporate tax rate is reduced. This will likely lead to an undeniably widened budget gap. So, the Federal Government must elect to either cut back on spending or issue additional debt, especially if moving forward with any promised infrastructure spending. Recall that the Reagan Administration combined tax cuts with additional military spending, which widened the budget deficit during this period.

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The scenarios arising from either a cutback in fiscal spending (more austerity) or adding more to the federal debt are likely to cause a stir among the American people. One of the leading discussions during the presidential debates was the outstanding balance on Federal debt. Rational people may react a lot like they are doing now; hoarding savings, spending less or living at their means rather than above them. This would yield low inflation expectations again, little or no job growth, and perhaps even another recession. These are the two maybes driving uncertainty, which add to my view that there is far too much uncertainty to sustain a market rally right now. It simply is not clear and the future data has not yet been revealed. This leads me to my outlook on the two sectors of interest in this article: materials and industrials. In the next two sections, I caution against having too much confidence in this recent rally, as the industrials and materials sectors may revert to a downward trend.

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Views on the Materials Sector

I want to go into a few details on the materials sector, and it is important that I show how it has performed in the past. A few elements have been constraining growth in this sector this year. Among these elements are a slower-than-expected global economic output and global trade. The iShares Dow Jones US Basic Materials ETF (NYSEARCA:IYM) closely tracks the performance of the materials sector. From the chart below, you can see that the materials sector has benefited from the post-election market rally. Goldman Sachs has also recently upgraded its outlook on commodities, metals, and mining which are major components of this sector.

The sector also includes the chemicals, construction materials, containers and packaging, and paper and forest products industries. Again, as I mentioned earlier, these industries are set to benefit from an expansion in global growth and trade, or so the argument goes. If the economy in the US expands, it could set the stage for demand in these industries to rise as well. More recently, the president-elect has proposed a list of items he will attempt to implement within the first 100 days of his presidency. The list lacked the essential items such as the promised across-the-board corporate tax cuts and expansion of public spending on infrastructure. The two top items, which, according to Trump, would help propel the economy to his desired 4% to 5% GDP growth rate, or conversely, as I proposed above, the policies may derail the stability of the US economy (See here and here).

Views on the Industrials Sector

In this section, I present my discussion on the industrials sector, debating that the rally across this sector may also not be as healthy as it appears. In the image below, I present the iShares US Industrial ETF (NYSEARCA:IYJ), which closely tracks the industrial sector.

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Again, as I demonstrated above, this sector has been a top performer. As the chart shows, the IYJ ETF rallied rather strongly after the US presidential election, in line with the sector performance. This sector is a little more interesting to me than the materials sector because it includes a larger range of industries. Also, the materials sector may be a little more tied to global growth, where on the other hand, industrials is more anchored to the US economy. In the table below, I list the industries found in this and the materials sector:

Sector Industries

Aerospace & Defense companies have some of the highest valuations out of this sector. In addition, the freight and logistics service companies such as Saia, Inc., (NASDAQ:SAIA) and ArcBest Corp. (NASDAQ:ARCB) have also led this sector higher. If you look back to the summer, shipping rates and tonnage held back this industry for most of the year. Holiday sales aside, the situation with shipping tonnage has not changed, also the upcoming first quarter is typically one of the slowest seasons for demand in this industry and particularly less-than-truckload (LTL). Any unexpected changes or a harsh winter weather could also add to this imbalance. The list goes on for struggling industries which have somehow outperformed in the current market environment (See here, here, and here),

Conclusion

To conclude, my discussions in this article series reviewed the post-election reaction by financial market participants, presented information about the current sector rotation, and argued that the post-election market rally may be unfounded. I also discussed some of the controversial and even conflicting views from the US president-elect to identify the scale of uncertainty underlying this market rally. In this article, I focused on the materials and industrials sectors of the economy. I argued that the post-election rally in these two sectors is unfounded.

For any investor interested in trading this argument, I would recommend shorting the rally taking place in the two sectors I mentioned above. My ideal time frame for the market to fully digest the tumultuous number of events and information revealed this month is 9 to 12 months' time. I think that by this time next year, the market might have a better perspective of the current economic situation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Past performance is not an indicator of future performance. This post is illustrative and educational and is not a specific offer of products or services. Information in this article is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented is believed to be factual and up-to-date, but I do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change.