The US Presidential Election - A New Order FOR PROFESSIONAL INVESTORS - November 9, 2016

Steven Friedman Senior Investment Strategist BNP Paribas Investment Partners [email protected]

Daniel Morris, CFA Senior Investment Strategist BNP Paribas Investment Partners [email protected]

The election of Donald Trump as the next president of the United States has come as a shock to financial markets, as polls had been predicting a narrow victory for Hillary Clinton. Initial reactions have been negative for risk assets, for a number of reasons. First, Trump’s professed policy priorities suggest a radical break from the establishment consensus. In addition, many of the initiatives president-elect Trump proposed during the campaign — such as trade restrictions and deportation of illegal immigrants — are clearly negative for US economic growth. Third, representing a break from the establishment, his policies carry a higher risk of unforeseen consequences, including reactions of foreign countries to trade, immigration and foreign policy shifts. Finally, many of Trump’s policy pronouncements have been vague or fluid, and have engendered uncertainty among investors and with much of the public. Indeed, uncertainty may remain elevated for quite some time, not just until Trump’s policy priorities become clear, but as the public attempts to understand the impact of policies that could differ meaningfully from prior Democratic and Republican administrations. As such, we anticipate a higher political risk premium to be discounted in asset prices for the foreseeable future. Trade and immigration policy constitute significant areas of concern as we contemplate a Trump presidency. This is because a US president has considerable latitude in both these areas. And we are hesitant to dismiss Trump’s pronouncements on trade and immigration as mere campaign posturing. At some point, one has to accept the words of a candidate for higher office as an expression of policy intent. Still, we acknowledge our own uncertainty over which Trump will govern. Will it be the populist candidate elected on promises to bring jobs back home even if it means a trade war, and to deport over ten million people, many of whom are critical members of the labor force? Or the pragmatist who stakes out tough positions as a negotiating tool and would ultimately not pursue policies that would clearly have a negative impact on growth. In reality, we are likely to see both sides of Trump in the coming years. But this continuing dichotomy will itself engender uncertainty, and does not increase our confidence in the economic outlook.

The US Presidential Election - A New Order - November 9, 2016 - 2 Regarding trade, presidents have significant freedom to increase tariffs on specific countries without Congressional approval, and Trump may be very willing to use this lever to extract trade and other policy concessions from China and Mexico. We see the impact of tariffs as unequivocally negative. Tariffs on imports would increase consumer prices and reduce real disposable income. In addition, both Mexico and China would be very likely to retaliate with tariffs of their own on imports from the US. Meanwhile, we do not anticipate that tariffs would result in a meaningful shift in manufacturing production away from China and Mexico to the US. Some US companies may feel political pressure to make a token gesture of on-shoring jobs and production, or reduce planned off-shoring. But uncertainty over how long protective tariffs would remain in place will limit the incentive for US companies to reorient jobs and production to the US. Within the bounds of the law, there are also few constraints on an administration that seeks to increase the intensity of resources committed to deportations. The administration could simply hire more immigration enforcement officers and direct US Immigration and Customs Enforcement (ICE) to redouble its efforts to identify, detain and eventually deport undocumented immigrants. This of course requires money, but an administration could attempt to shift funds to ICE from other government operations. The overall impact of increased deportations, even on a scale less than what Trump has suggested, would be to reduce the size of the labor force and constrain domestic consumption. The shift in labor supply could lead to higher wages for lower-paying jobs, which could feed through to inflation. Of course, we cannot ignore the possibility that a Republican-controlled Congress may act to constrain the Trump administration’s actions in trade and immigration through its power over the purse strings. But how hard would Republicans push back on Trump? It would be highly unusual for a president to face significant opposition from within his own party on major policy priorities. For many Republican representatives and senators, particularly those in red-leaning states, the most likely path to re-election runs through support of Trump’s policies. Outside of trade and immigration, many of Trump’s other policy initiatives are more closely aligned with mainstream Republican thinking. With Republicans in control of both the House and the Senate, they will be able to pass the legislation required to implement these policies. Consequently, if it eventually becomes clear that the more damaging trade and immigration policies will not be pursued but instead the more traditional pro-business Republican initiatives will, we would expect equity markets to rebound, similar to the way they did post the UK’s Brexit vote. The election result is without a doubt disruptive, but this is why it may open up significant new investment opportunities. History supports the contention that the combination of a Republican president and a Republican-controlled Congress (made up of the House and the Senate) results in above-average returns for US equities. Since 1954, this configuration has coincided with inflation-adjusted returns for the S&P 500 of over 13% (see Figure 1). Ironically, the only combination with superior returns was that of a Democrat president and a Congress controlled either by the Republicans or split between the two parties, the likely arrangement had Clinton won the election. Figure 1: Average Annual Real S&P 500 Return Depending on Party Controlling Presidency and Congress Return (%) 15

10

5

0

Dem + Dem Dem + Rep/S Rep + Dem/S

Rep + Rep

Data through 31 October 2016. Note: First label (Dem=Democrat or Rep=Republican) indicates the party of the president since 1953-1954, while the second part of the label indicates the party controlling Congress or “S” if control was split between the two parties. Sources: Standard & Poor’s, BLS, BNP Paribas Investment Partners.

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The amount of legislation passed from here is likely to be sharply higher given the general alignment in interests and policies between the president and the Congress. The Republicans, of course, will not be able to implement every agenda item they wish, just as President Obama was not able to when he was initially elected in 2008 and the Democrats controlled Congress. Despite the Republican control of the Senate, their majority is not “filibuster proof”, meaning that Democrats are still able to thwart some legislation. How often the Democrats decide to do this will depend on what they believe is the best policy to improve their own chances in the mid-term elections in two years. As for policy priorities that are likely to be advanced with a Republican-controlled legislative branch, these include corporate tax reform (including ending the taxation of US corporate profits earned outside the US), renegotiation of trade agreements, reconsideration of regulations imposed under the Wall Street Reform and Consumer Protection Act (aka Dodd-Frank), investing in infrastructure, reform or repeal of the Affordable Care Act, and reductions in income taxes. Given the difference in policies between the incoming president compared to the last eight years, there are many sectors of the US equity market that may be significantly affected. The most obvious would be health care, where both parties agree there needs to be legislative changes to the Affordable Care Act (ObamaCare), even if there is far less agreement on what should be changed. While the Republican campaign rhetoric has always been to repeal it, the reality is that many of the measures already in place, particularly the provision of insurance for a greater share of the US population, could hardly be reversed. What will have to be addressed is how that additional costs of the expanded insurance coverage are funded. Republicans generally prefer local, market-oriented solutions as opposed to expanding Federal mandates such as the Medicaid program for those with low-incomes. The energy sector, particularly companies in the coal and oil industries, will likely see less regulation while companies in the renewable energy sector would receive less government support. The fall in oil prices had anyway increased the amount of subsidies necessary to make many renewable energy sources economically viable so the scope for further expansion was already probably limited. Any infrastructure spending package will likely benefit companies in the capital goods and construction materials industries, and it is possible that the programmed cuts in military spending (sequestration) mandated by the Budget Control Act from 2011 could be reduced, to the advantage of the aerospace and defense industries. For all the focus on the party of the president and of Congress, returns for US equities will depend as much on Federal Reserve policy, the strength of the US and global economy, trade, and market valuations, as on new legislation. From this point of view, there are still reasons to be cautious. On the economic front, US growth remains modestly strong and steady and we do not anticipate a recession in the near term. Ideally legislation which cuts taxes and regulation could boost productivity and growth. A government infrastructure package will support aggregate demand, for a few quarters at least. If there is an agreement to repatriate US corporate profits held offshore, this would allow the infrastructure package to be funded without the need to raise corporate or individual taxes. Still, Trump’s more populist views, for example on trade and immigration, would likely lead to lower growth and higher inflation. We cannot at this point dismiss the possibility of a deterioration in US trade and a significant increase in deportations. This is because Trump’s pronouncements on immigration resonated deeply with many of his voters and it could prove difficult for him to move away from stated positions on the topic. And his public comments over many years evidence support for policies that risk a trade war with major trading partners. Pursuit of these policies once elected would lead us to mark up the probabilities we assign to a recession accompanied by inflation above the Federal Reserve two percent objective. US inflation and interest rates are nonetheless expected to rise, which clearly poses risks to both equities and fixed income assets. While inflation is generally positive for equities (revenue growth in the most recently reported quarter was less than 4% (excluding energy) so more inflation would certainly help), if it prompts a response from the Fed, any benefit will be short-lived. The key risk of rising bonds yields for the equity market is to the “bond proxies”: REITs, utilities, telecommunication services, and consumer staples. These four sectors accounted for nearly 70% of the return for the S&P 500 in the first half of the year, and though they have fallen recently, valuations still appear elevated. The question for the market overall is whether returns in previously ignored parts of the market such as financials and industrials, or sectors with positive growth fundamentals such as information technology, can offset the declines in the bond proxies. It will be a fine balance.

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The outlook for global trade agreements such as Transatlantic Trade and Investment Partnership (TTIP) with Europe, or the Trans-Pacific Partnership (TPP) Agreement with Asia looks decidedly grim. Even if president-elect Trump would be open to renegotiating them, that may take years and enthusiasm for trade globally is at low levels in any event. Consequently, US small cap equities may gain at the expense of large cap equities. Any infrastructure package would also disproportionately aid small and mid-cap companies, and they are currently trading at a slight discount to the S&P 500 compared to long-run averages. US Treasuries yields are likely to continue to rise because the Federal Reserve will be hiking rates and because of expectations for higher inflation. We do not anticipate a significant selloff, however, as foreign demand and loose monetary policy elsewhere should keep serve to cap any rise in yields. But fiscal policy may pose a new risk to the outlook for fixed income. Trump and Congressional Republicans are in alignment on tax cuts, but they appear to be far apart on spending, with Trump insisting that he will not support cuts to entitlement programs. In an outcome where lower tax revenues are not broadly balanced with lower spending, wider deficits and the associated increase in debt issuance would lead us to revise higher our outlook for Treasury yields. How well investment grade and high yield credit perform in this environment will depend on the evolution of credit spreads. Credit conditions in the US are deteriorating mildly while spreads are currently low (or were as of 10 November; see figure 2). The extra spread in high yield means that they should eventually outperform Treasuries, though there may be a better entry point in the near future. Figure 2: US Corporate Credit Spreads

Inv. grade (left) High yield* (right) Average

bps

bps 800

220

700

190

600

160

500

130 100

400 2010

2012

2014

2016

300

Data as at 31 October 2016. *Excludes energy sector. Note: Average applies to both investment grade and high yield separately. Chart is scaled such that the average for each is appropriate depending on the axis (left or right). Sources: Barclays, BNP Paribas Investment Partners.

The rebound in oil prices from the low post-Brexit levels has helped boost inflation expectations, though strong payroll data and Janet Yellen’s comment that she would consider allowing the US economy to “run hot” for a time has also increased investors’ forecasts for future levels of inflation. Inflation expectations have consequently been rising, but they are still low relative to history. Compared to the range of five-year forwards rates since 2004, current levels are around the 10th percentile. While lower economic growth and lower inflation globally means we do not anticipate inflation will revert to historic norms, market expectations seem too low to us and Treasury Inflation Protected Securities (TIPS) appear to be good value relative to Treasuries. How might a Trump presidency affect global markets? Once the current risk-off reaction passes and markets rebound, we would expect rising Treasury yields next year to put upward pressure on core European bond yields even as the ECB continues its Quantitative Easing program. If tax cuts and less regulation boost US GDP growth, this should help global demand by increasing US imports. The biggest risk is that uncertainty about a Trump presidency will increase volatility and damage sentiment. While volatility is indeed likely to be higher under Trump, that’s where the opportunity lies.

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BIOGRAPHIES

Steven Friedman Senior Investment Strategist BNP Paribas Investment Partners

Steven is a Senior Investment Strategist at BNP Paribas Investment Partners. In this role, he is responsible for developing thematic views on the market, economic and policy outlook in the US and other major economies. Steven joined our company in 2013 and is based in New York. Prior to his current role, Steven was a Director for the Central Banks and Official Institutions team at FFTW, a subsidiary of BNP Paribas Investment Partners. Steven also held various positions at the Federal Reserve Bank of New York, most recently as Director of Market Analysis, where he worked on both market and policy analysis and relationship management for the Bank’s Investment Advisory Committee on financial markets. Prior to that, Steven worked in other roles within the Markets Group, including, Director of Foreign Exchange and Investments, where he had oversight for the Fed’s and Treasury’s foreign exchange portfolios. During the financial crisis, he worked on the design and implementation of a number of liquidity facilities, such as swap lines with other central banks. Steven also spent two years at the Bank for International Settlements as a member of the Basel Committee Secretariat. Steven has over 18 years of investment experience. He holds a BA in Government and Russian studies (with honors) from Wesleyan University, an MA in International Relations from The Paul H. Nitze School of Advanced International Studies at The Johns Hopkins University, and an MBA (executive program) from Columbia Business School.



Daniel Morris, CFA Senior Investment Strategist BNP Paribas Investment Partners

Daniel is a Senior Investment Strategist at BNP Paribas Investment Partners. In this role, he has responsibility for promoting collaboration between investment teams and formulating alpha-generating investment views across asset classes. Daniel’s wideranging experience encompasses advising clients and providing investment recommendations, as well as offering a strategic perspective to senior management and portfolio managers. He joined our company in 2015 and is based in London. Prior to joining us, Daniel was Managing Director, Global Investment Strategist at TIAA-CREF, where he was responsible for advising clients and portfolio managers on investment strategy and asset allocation. Prior to that, Daniel was Global Market Strategist at JPMorgan Asset Management, Senior Equity Strategist at Lombard Street Research, and US Equity Strategist at Bank of America Securities. Daniel has 20 years of investment experience. He holds a BA in Mathematics from Pomona College, an MA in International Economics and Latin American Studies from Johns Hopkins University, as well as an MBA from The Wharton School of the University of Pennsylvania. Daniel is a CFA Charterholder.

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