2016 is certainly ending with a bang as investors have begun thinking about the potential impact the Trump administration and a Republican Congress could have on the U.S. economy and markets. The Dow, S&P 500 and Nasdaq are all trading at a record highs. In the latest "Reading The Markets With Mike and Jane" video, we talk about some of these likely changes and when the impacts of these changes might begin to cycle through the equity markets. Please watch the video below to get a full rundown.
Impact on Equity Markets
The S&P 500 has rallied nearly 200 points since the beginning of November. That is a return of nearly 10% in a short period of time. Tax reform will likely create some of the biggest impacts on equity markets, as a reduced corporate tax rate could help drive profit margins and help companies to reinvest back into their enterprises. Although a 15% tax would be significant, it might not fall that low. However, even a corporate tax at 20%-25% would be a marked improvement from today's 35%. Additionally, repatriation of the dollars held offshore by companies could help to spur additional reinvestment and job creation.
Additionally, deregulation could be a major driver for economic growth as businesses could be able to cut through red tape at a much quicker pace. The final piece could be infrastructure spending. Upgrading many structures such as bridges, roads, and airports could lead to more job opportunities and increased demand for materials, hardware, and the equipment used for construction. GDP growth has been anemic for nearly 10 years now. Most people do not realize that GDP has not grown by more than 3% year over year since 2005.
You can see in the chart above that the highest rate of GDP growth year over year was in 2010 and 2013 at 2.7%. When we look at this on quarterly basis, GDP growth has only crossed 3% three times since 2006: 3.1% in Q3 2010, 3.3% in Q1 2015, and 3.0% in Q2 2015. That is all. You can see why the equity market might finally be getting excited.
Impact on Yield and FX
Part of the reason why 10-Year Treasury yields have run from around 1.7% in November to 2.5% today is because of a return of inflation expectation due to growth. As a result, we have seen the dollar surge against the euro and yen.
The other piece of this is because the spending bills and tax reform are likely to create deficits, meaning more debt creation. Deficit spending has been the norm for most of my lifetime, nearly 40 years, and the national debt has ballooned to nearly $20 trillion today. However, people often forget that the U.S. has the most widely used currency and is a reserve currency. In a way, this debt might only become problematic if investors begin to choose not to buy our debt anymore. The U.S. has the benefit of being able to print its way out of virtually any problems.
At this point, it does not seem to bother investors as the dollar has surged against the euro from nearly 1.12 vs. the dollar to today's 1.04 vs. the dollar, since early November. Meanwhile, the yen has also weakened vs. the dollar, falling from approximately 102 to 117 vs. the dollar during the same time. One would think that if deficit spending was a major concern, along with dollar printing, investors would be selling dollars not buying them.
A strong dollar could be bearish for some commodities not directly linked or impacted by these new fiscal policies, such as gold. Additionally, the higher demand might not be enough to soak up excessive, high oil supplies.
Timing of Impact
Clearly, the timing of new policy will be crucial. Markets in the U.S. have been shifting in anticipation of these new policies. However, it might take some time before the plans get put to paper, agreed on, voted in and then implemented. Also, the other big if will center around whether the new policies fall short, meet, or beat expectations. Markets are currently pricing in policy changes without even knowing what they are, and would not take kindly to falling short or meeting expectations. Due to this, I'd expect some volatility in the markets as this all begins to get rolled out.
The new administration has indeed made many investors optimistic. Markets have been repricing because of this. However, volatility will likely return as the process begins to fall into place. My belief is that most of the economic benefit will start to emerge in the second half of 2017. It might make the markets choppy in the meantime, but should make for a fun and exciting second half of 2017.
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