Pro-Growth Fiscal Policies Will Help Main Street But Hurt Wall Street

by: J. Lawrence Manley, Jr., CFA

Donald Trump's election accelerated the worldwide shift from globalism to nationalism.

Pro-growth fiscal policies will end the Fed's policy of Financial Repression, ushering in a period of free markets, improved productivity and increased market volatility.

The economic cycle will bottom this summer and growth will accelerate to an above-average rate.

Equities are priced for perfection and offer a poor long-term risk-reward.

Fourth Quarter Review

The stock market corrected 5% in October and then rallied sharply after the November election. Risk assets performed well during the fourth quarter (the S&P 500 appreciated 3.83%, and the Russell 2000 increased by 8.83%) despite the increased uncertainty due to the proposed shift in policy from globalism to nationalism. Safe-assets performed poorly in the quarter (U.S. 30-year Treasury bonds declined 12.1%, and gold declined 13.3%) as investors increased their economic growth expectations.

As conservative value investors, we are disappointed with our performance in 2016. We began the year believing that the stock market was extremely overvalued and offered a poor risk-reward. Additionally, the economic cycle had peaked in late 2014; growth rates were slowing, and corporate profits were in a recession. Given the market's poor risk-reward and the slowing economy, our 2016 asset allocation was defensive (underweight equities and overweight safe assets). Our goal was to preserve capital, reduce volatility and provide a positive return during any market correction or bear market, (e.g., provide a U.S. Treasury bond risk-reward with a put on the equity market).

While the economy and corporate profits were weaker than the consensus expected and there were several significant surprises that increased economic uncertainty (China growth scare, Brexit, Trump election, Italian referendum), an equity market correction never developed and volatility remained low.

We believe that despite many viable catalysts for a market correction, the unprecedented actions of the central banks suppressed volatility and prevented the markets from declining. Market corrections, bear markets, and recessions are all essential elements of capitalism that eliminate mal-investment and maximize the efficient allocation of resources. Any attempt to manipulate markets and suppress volatility only increases future systematic risk. Unfortunately, the central banks continue to inflate financial assets and obstruct the market's natural price discovery mechanism. Despite already owning approximately $18 trillion of financial assets, which is 24% of global GDP, the global central banks continue to print money to buy more than $235 billion of government and corporate bonds each month.

In hindsight, while our view of the economy and corporate profits was correct, we underestimated how aggressive the central banks would be in intervening in financial markets.

Historically, stocks perform poorly when markets are overvalued, and the fundamentals disappoint. Recently, central bank interventions led to an investment environment where bad news is good news and stocks rally. This environment was difficult and frustrating for fundamental value investors. As we discuss below, there has been a dramatic global shift in political and economic ideology that will significantly impact the economy and investing. As long-term value investors, we believe that we are very well positioned to perform well in this "new" investment environment where fundamentals, not central bankers matter most.

Investment Outlook Summary:

  • The election of Donald Trump accelerated the worldwide shift from globalism to nationalism. While investors embraced this ideological shift and pushed stocks to an all-time high, it remains unclear if the Trump administration's economic policies will resemble: the successful nationalist policies of the 1980s (a reduced role of government in the economy and free trade) or the unsuccessful nationalist policies of the 1930s (an increased role of government in the economy and protectionism). Also, we believe that the "Trump mandate" to help Main Street will negatively impact Wall Street.
  • Pro-growth fiscal policies will end the Federal Reserve's policy of financial repression, ushering in a period of free markets, improved productivity and increased market volatility. We believe that the Fed was not prepared for the sudden shift to a pro-growth fiscal policy. The Fed expected a continued environment of sub-par economic growth and low inflation, which would allow them to normalize interest rates gradually. In our view, the Fed will be forced to become more hawkish and remove monetary accommodation at an accelerating rate, which will increase market volatility and lead to larger drawdowns. Optimistically, we believe that the end of financial repression (negative real rates and printing money to buy bonds) and a return to free markets will create a very favorable investing environment for active value investors.
  • The economic cycle will bottom this summer and growth will accelerate to an above-average rate. While the economic cycle peaked more than two years ago, and corporate profits, industrial production, and domestic investment remains in recession, we expect that the proposed pro-growth fiscal policies will lead to an above-average growth beginning in the second half of 2017. Unfortunately, the recent increase in interest rates and the strength in the dollar will lead to a disappointing first half of 2017. Also, while we are optimistic that the proposed fiscal policies (lower taxes and reduced regulations) will turn the economic cycle positive sometime this summer, we are concerned that protectionist trade policies ("a border tax adjustment"), if enacted, could lead to a trade war and a global recession.
  • Equities continue to offer a poor long-term risk-reward. Despite the proposed pro-growth economic policies and our expectation that the economic cycle will bottom this summer, stocks remain overvalued and offer a very poor risk-reward. After eight years of central banks printing money to buy financial assets - global central banks own nearly $18 trillion of financial assets, which is 24% of world GDP - most financial assets are poised to provide poor prospective returns. Based on long-term valuation models, we expect that the S&P 500 will return only 2% per annum over the next ten years (0% per annum real return). In our estimation, stocks and the 10-year U.S. Treasury bond have similar expected returns despite significantly different risk profiles. Additionally, given the market's extreme valuation, stocks will be especially vulnerable to any policy mistake (Fed policy, protectionism or disappointing fiscal package).
  • In the short term, the financial markets are overbought, and optimism is at an extreme despite significant uncertainty. After the election, stocks appear to be discounting a best-case scenario and remain priced for perfection. Despite significant geopolitical and economic policy uncertainty, the VIX, a gauge of expected volatility, is near a 10-year low. We expect that over the next several months, stocks will correct and bonds rally as the economy slows and the specifics on policy are debated.

Asset Allocation: As value investors, the market's long-term risk-reward and the rate-of-change in economic growth drive our strategic asset allocation ("SAA"). Currently, our SAA remains underweight equities and bonds, while overweight the dollar, gold, and commodities. We are positioned to perform well in a period of slow economic growth, increasing inflation and rising market volatility.

Current Asset Allocation:

Large Cap Equity


Long-term U.S. Gov. Bonds


Small Cap Equity


Int-term U.S. Gov. Bonds


International Equity


Municipal Bonds


Emerging Markets




Equity Hedge(small-cap and volatility)







Economic Outlook: We are optimistic that the proposed supply-side fiscal policies (lower tax burden and reduced regulations) will properly incentivize corporations and entrepreneurs to invest, hire and grow their businesses. After eight years of disappointing growth and anemic capital investment, we believe that the correct fiscal policies have the potential to lead to a capital investment boom and above-average economic growth. While accelerating economic growth will benefit Main Street (better jobs and higher wages), we believe that Wall Street may struggle because the Federal Reserve is "behind the curve" and corporate profitability is poised to regress to a normal level. Additionally, while we expect the economic cycle to turn and accelerate in the second half of 2017, we are very concerned that proposed protectionist policies could lead to a trade war and global recession.

Since the Great Financial Crisis, a tight fiscal policy (high taxes and increased regulation), and an unprecedented loose monetary policy (zero interest rates, negative real rates, printing money to buy bonds and jawboning financial markets) drove our economy. The net effect was economic uncertainty, a stagnant economy (slow growth and declining real wages) and inflated asset values. Main Street struggled, while Wall Street prospered. In our view, this policy of financial repression led to wealth inequality and a distrust of globalism, which contributed to the recent surprising election results (Brexit, Trump and Italian Referendum).

Because of the election, economic policy is poised to change dramatically. We believe Main Street will prosper, while Wall Street may struggle. We are confident that the proposed supply-side fiscal policies will lead to substantial domestic capital investment and increased hiring, which will grow the economy at an above-average rate and dramatically help ailing Main Street. These pro-growth policies will create a problem for the Fed and monetary policy.

Since 2010, tight fiscal policy and financial repression (negative real rates and printing money to buy bonds) led to a disappointing real economic growth rate of 2.1% per annum. This anemic growth is 34% below the historical real growth rate of 3.2%. In their most recent forecast, the omniscient Federal Reserve continues to forecast weak economic growth and low inflation for the foreseeable future:

(Fed's December Median Forecast)





Longer Run

Change in Real Growth






PCE Inflation






Fed Funds Rate






Source: Federal Reserve

Even if the proposed pro-growth fiscal policies coupled with the pent-up demand for capital investment lead to only average economic growth, the Federal Reserve is "behind the curve" and their potential policy errors are a concern. If they raise interest rates too fast, given the economy's excessive debt burden, they may cause a recession, and if they raise rates too slowly, inflation could accelerate and create substantial economic problems.

While we are optimistic that the proposed supply-side fiscal policies will grow the economy by more than 3% per annum and lead to improving living standards, we are concerned that the proposed protectionist measures will result in significant economic problems. Trump's proposed 15% tariff on imports or the Republican's "Border Adjustment Tax," if enacted, could lead to a major economic dislocation, trade wars and ultimately a global recession. The proposed tariff or border tax would result in inflation, a very strong dollar and potential retaliatory measures by our trade partners. Also, a 15% tariff on all imported Chinese goods would push the world's growth engine into recession (China accounts for approximately one-third of global growth).

While unfair trade practices have cost the U.S. many jobs and economic growth, the process of leveling the playing field is complicated, and given the weak global economy and over-indebtedness, any miscalculation could have significant economic consequences.

In summary, the election brought the promise of important and overdue economic change. We are optimistic that if politicians follow the successful policies of the 1980s - lower tax burden, less regulation and a stable currency - the economy and Main Street are poised to prosper. We are hopeful that politicians resist the populist urge to implement protectionist trade policies and instead work with our trading partners to find reasonable solutions.

Chart 1: Nominal GDP Peaked Two Years Ago

Nominal GDP peaked for this cycle at 4.9% in the third quarter of 2014. This cycle's peak growth rate was significantly below normal growth rates that averaged 6.5% since 1948. The proposed supply-side fiscal policies are poised to turn the economic cycle in the second half and deliver strong economic growth.

Source: FRED

Chart 2: Gross Private Investment as a Percent of GDP

Gross private investment is critical to improving productivity and growing the economy. Investment peaked in the first quarter of 2015, significantly below previous peaks. The lack of investment this cycle led to disappointing economic growth. Pro-growth policies will incentivize corporations and entrepreneurs to invest capital, which will increase productivity and lead to strong economic growth.

Source: FRED

Chart 3: Investment Spending is in Recession

Investment spending turned negative in the first quarter of 2016. Typically, when investment spending is negative, the economy is in recession. Pro-growth fiscal policies will lead to an increase in capital investment, an improvement in productivity and a stronger economy.

Source: FRED

Equity Market Outlook: Because fundamentals (growth rates and profitability) regress to the mean over the long run, the primary driver of an asset's long-term return is valuation - or what you pay for an investment. Despite the recent increase in growth expectations due to the proposed pro-growth policies, equities remain poised to deliver disappointing returns and offer a poor risk-reward.

While we believe that the economic cycle will turn positive this summer, that may not be good news for the stock market. Stocks have benefited greatly from the Fed's financial repression strategy (negative real rates and printing money to buy financial assets). Since the "Great Recession," corporate profit margins have been elevated because interest rates were artificially low, wages were depressed, and many companies favored buying (stock buybacks and acquisitions) at the expense of building (capital investment and hiring). We believe that robust economic growth will end this period of financial engineering and corporate profitability will regress to normal historical levels, as corporations invest and grow organically.

Also, as economic growth accelerates, interest rates are poised to go back to a normal level. The 10-year U.S. Treasury bond should provide a real return of at least 2.0% (i.e., inflation plus 2.0%). Today, the inflation rate is expected to average 2.0% per annum over the next ten years, so the 10-year should yield approximately 4.0%, instead of the current 2.4%. As growth improves and interest rates normalize, stocks will struggle as valuations decrease to a normal level.

Additionally, while equities offer limited upside potential, we are concerned that there is significant downside risk if a policy error occurs (i.e., a monetary mistake by the Fed or a protectionist policy is implemented by Congress).

In summary, after eight years of financial repression, markets remain dislocated (stocks are too high, and interest rates are too low) and poised to return to normal. While stocks currently offer a poor-risk reward, despite the improved long-term economic outlook, we believe that markets will be volatile and provide opportunities for value investors as the new administration's policies are debated, and the Fed attempts to "catch-up."

Chart 4: Market Capitalization to GDP - Stocks Remain Very Expensive

In a 2001 Fortune Magazine article, Warren Buffett stated that market capitalization relative to GDP "is probably the best single measure of where valuations stand at any given moment." Currently, stock market capitalization is 128% of GDP; this is significantly above the 50-year average of 65%. Based on this valuation measure, stocks would need to decline by 49% to be considered fairly valued.

Source: FRED

Chart 5: Private Sector Net Worth Relative to GDP Has Never Been Higher

The central bank's easy money policies have driven most asset classes to historical levels of overvaluation. Since 1950, private sector net worth (real estate and financial assets) has averaged 377% of GDP. Currently, private sector net worth is 482% of GDP, which is 2.7 standard deviations above the mean.

Chart 6: S&P 500 and GAAP Earnings

Since Q4 2014, the S&P 500 appreciated 10.0%, while GAAP earnings have declined 18%. In our view, stocks are detached from the fundamentals due to central bank activism and complacent investors. In the short term, excess liquidity and ebullient investor sentiment can drive stocks from their intrinsic value. In the long term, stocks are driven by the fundamentals. When the liquidity growth ebbs and sentiment sours, stocks will regress to the mean.


Chart 7: Corporate Profits to GDP - Despite an 18% Profit Decline, Margins Remain Elevated and Poised for Mean Reversion

Profitability has peaked for this cycle. Currently, corporate profits are 9.0% of GDP, which remains significantly above the historical average of 6.5%. We expect earnings growth will continue to disappoint investors as profitability returns to a normal level.

Source: FRED

Short-Term View (three months): The post-election rally led to an overbought market and excessive investor optimism. Despite significant geopolitical and domestic policy uncertainty, investors are ebullient and expected volatility is near a 10-year low. We believe that stocks are poised to correct as specifics on policy are debated, and the Federal Reserve is forced to take a more hawkish stance. Additionally, since the Fed is behind the curve, they are less likely to intervene when market volatility increases.

Chart 8: The VIX is Near a Ten-Year Low

The VIX, a measure of implied market volatility, is near a ten-year low, despite significant geopolitical and economic uncertainty. Volatility at such a low level indicates extreme complacency and that the market is poised to disappointment.

Source: Stockcharts


  • The proposed supply-side fiscal policies have the potential to return economic growth to a normal 3.2% per annum growth rate and help Main Street -- more jobs, better wages, and improved living standards - if populist protectionist policies are avoided.
  • While Main Street is poised to recover, Wall Street will struggle as profit margins regress lower and interest rates normalize. Equities remain overvalued and offer a poor risk-reward despite the prospects of a stronger economy. We estimate that stocks will provide a return of less than 2.0% per annum for the next ten years (versus a 10.0% historic real growth rate), roughly the same as a 10-year U.S. Treasury bond.
  • The Federal Reserve expected to normalize interest rates gradually, due to low inflation and sub-par growth. The Fed was not prepared for an accelerating economy, and the risk of a monetary policy error is substantial. Optimistically, the period of financial repression is over. We expect that the markets and interest rates will return to normal levels, as the central banks become less engaged in manipulating financial markets. We expect volatility and market drawdowns to increase.
  • In the short run, investors are ebullient; stocks are priced for perfection, and implied volatility is near a 10-year low, despite significant geopolitical and economic policy uncertainty. While we expect the economic cycle to turn positive this summer, we believe that the recent increase in interest rates and the strong dollar will lead to a disappointing first half of 2017. In our view, as the economy slows and the specifics on policy are debated, stocks will correct and bonds will rally.

While much has changed since the last quarter, we are optimistic that the economy and living standards are finally poised to improve. We are confident that active value investors will be well positioned to prosper in this "new" investment environment, which will be driven by fundamentals and not profligate central bankers.

All information disclosed in this statement is accurate and complete to the best of our knowledge. Past performance is no guarantee of future results, and there is no assurance that the firm or client's investment objectives will be achieved.

This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.

Disclosure: I am/we are long SPY, TLT, NEA, SGOL,UUP, DBC, DBA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.