The S&P 500 (NYSEARCA:SPY) soared as much as 12.5% during the months following the presidential election, in what has been dubbed the "Trump rally." The Russell 2000 small-cap index (NYSEARCA:IWM), which is more representative of the domestic economy, rallied nearly 18%. This enthusiasm for risk assets was underpinned by the fact that one party controlled Congress and the White House, making candidate Trump's campaign promises to overhaul healthcare, reform the tax code and spend massively on infrastructure seem like relatively easy bars to hurdle.
Economists raised their expectations for the rate of economic growth, consumer and business confidence surged, and strategists increased their estimates for corporate earnings and their price targets for the stock market indices.
The problem is that while the stock market has already priced in the potential economic upside of Trump's campaign promises, nothing has been accomplished! Furthermore, despite the daily barrage of hyperbole we hear from the Trump administration about how much has been, and soon will be, accomplished, it is looking increasingly likely that nothing in Trump's agenda will be achieved in 2017.
This is what stalled the Trump rally at the beginning of March. This is also when the consensus of economists began to ratchet down their estimates for the rate of economic growth, as can be seen below. It is also important to note than many economists, including those at the New York Fed, incorporate soft data, such as consumer and business confidence, into their estimates.
Yet the hard data on consumer and business spending has continued to weaken as confidence levels remain near decade highs. If President Trump does not fulfill his campaign promises soon, you can be sure that consumer and business confidence will fall in line with the current levels of spending, which will undoubtedly further slow the rate of spending growth, if not result in it turning down.
Unlike the New York Fed, the Atlanta Fed does not incorporate confidence surveys into its estimates for the rate of economic growth. You can see the plunge in its estimate for the first quarter of this year, which took place at the beginning of March, to what is now a paltry 0.5%. The relevance of the rate of economic growth is that it is highly correlated with the rate of corporate revenue growth, which the consensus now believes will be better than 5% in 2017, an unrealistic forecast given the low growth rate.
The bond market is considered far more intuitive than the stock market when it comes to developments in the real economy. It is no coincidence that long-term bond yields, as measured by the 10-year Treasury, resumed their downtrend in early March, despite the consensus expecting to see rates test 3.0%. Declining long-term interest rates imply slower rates of economic growth.
Another useful bond market tool is the spread between short term and long-term interest rates. When the spread narrows, it also implies that a deceleration in the rate of economic growth is forthcoming. Short-term Treasury yields are rising because the Fed is gradually increasing the Fed Funds rate, which tightens financial conditions in the economy.
The stock market also started to drift lower at the beginning of March, along with long-term interest rates and expectations for the rate of economic growth. The 10- and 20-day moving averages for the S&P 500 have fallen below the 50-day, as has the index itself, in what looks like could be the beginning of a correction.
Yet the market mounted a resounding comeback yesterday, with the Dow Jones Industrials (NYSEARCA:DIA) soaring as many as 200 points, the Nasdaq Composite (NASDAQ:QQQ) closing in on its all-time high, and the S&P 500 finishing less than one point beneath its 50-day moving average. What renewed the enthusiasm for risk assets?
I think it was Treasury Secretary Steve Mnuchin's assertion that the White House is very close to bringing forward "major tax reform," which will be "sweeping" and "create a lot of economic growth." I find this hard to believe considering that Mnuchin stated on Monday that having a bill on the President's desk by the August recess would be "highly aggressive to not realistic at this point." What was the reason for the flip-flop?
President Trump stated the following on Tuesday:
"So we're in very good shape on tax reform. We have the concept of the plan. We're going to be announcing it very soon. But healthcare, we have to get the healthcare taken care of, and as soon as healthcare is taken care of we are going to march very quickly. You're going to watch. We're going to surprise you. Right, Steve Mnuchin? Right?" It sounds like Mnuchin was commanded to flip-flop by the commander of flip-flop himself.
The reason that healthcare reform is so critical to Trump's agenda is that the savings obtained from repealing the Affordable Care Act are required to fund the tax cuts. This is the only way to appease the deficit hawks in the Republican Party. Yet voting to repeal the law would clearly be political suicide for many incumbent Republicans facing mid-term elections. Therefore, I don't think the law will be repealed. There is a brick wall in front of the Trump agenda, and I see no way that it can be surmounted. It comes in the form of what are now rising budget deficits that are the result of both increases in spending and declining tax revenue.
The chart above raises serious concerns about the health of the economy and the ability of the Trump agenda to move forward. The primary reason that we are now seeing a year-over-year decline in federal government revenues is that corporate tax revenue has fallen significantly. How can corporate earnings be rising when tax receipts are falling?
The reason is that corporations are paying taxes on earnings figures based upon generally accepted accounting principles (GAAP), while the earnings Wall Street and investors are using to validate what are already nose-bleed stock valuations are "adjusted" for a variety of expenses to inflate the (pro-forma) earnings number. The differential between what are real and fake earnings is alarmingly wide, calling into question the quality of earnings and the true health of the economy.
If the Trump administration is successful in cutting the corporate tax rate, then federal tax receipts will decline even further. Meanwhile, individual income tax revenue is flat with year-ago levels. This shows why it is critical for the Trump administration to generate savings from the repeal of the Affordable Care Act, which seems politically untenable. Healthcare reform is a no-win situation.
Even if Trump were successful in repealing the Affordable Care Act, he would face an entirely different problem, which is depicted below. While candidate Trump promised that he would replace the ACA with a superior market-based alternative covering all Americans at a lower cost and with better care, no such plan exists.
The President is relying on House Republicans to produce an alternative plan, but the one proposed would leave millions uninsured. I believe that the uncertainty over healthcare reform, which is a linchpin to the Trump agenda, is a contributing factor to the slowdown in consumer spending. If you do not have employer-sponsored healthcare, do you know what your coverage is going to cost next year? I have no idea about mine.
If the Trump administration attempts to move forward with tax reform without addressing healthcare, it will undoubtedly rely on the questionable practice of "dynamic scoring" to sell its proposal to Congress. This involves projecting a significant increase in the rate of economic growth and tax revenue in the future that would likely result from reducing tax rates today. Of course, if the growth and revenue does not materialize, then we will be far worse off from a fiscal standpoint than we are today.
The financial markets appear to be slowly awakening to the fact that the Trump agenda is far more bark than it is bite. I think the next shoe to drop will be a reversal in the meteoric rise in consumer and business confidence levels. Perception will fall in line with reality.
My outlook for the markets remains unaltered from the beginning of the year. I continue to think that long-term interest rates will decline, the rate of economic growth will slow and that gold will outperform stocks and bonds as uncertainty reaches a fever pitch. The best strategy in such an environment is a defensive one. While always looking for stocks to buy, I'm focused on growth at a more reasonable price than what the broad-market indices offer, and with the benefit of a parachute in the form of an attractive dividend yield.
I am still waiting for what looks like the inevitable bottom in long-term interest rates to further shorten the duration of my existing fixed-income holdings. I am also continuing to increase my exposure to precious metals, namely gold (NYSEARCA:IAU) and gold miners (NYSEARCA:GDX) to what is my maximum allowable allocation. At this stage in the business and market cycle, I much prefer controlled aggression over unbridled enthusiasm.
Disclosure: I am/we are long IAU, GDX.
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: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.