Tags: Trump Administration | tweet | donald trump | economy

Trump's Tweets Merely Opening Salvo to Negotiations

Trump's Tweets Merely Opening Salvo to Negotiations

(Getty/Andrew Burton)

By    |   Wednesday, 25 January 2017 08:52 AM

New policies may be hiding in plain sight

So are Trump’s tweets merely an opening salvo to negotiations? In some ways yes, as we see Trump more like a third party President. Trump may well need to reach across the isle if he wants to have a substantial infrastructure spending program, as there are more than a few budget hawks amongst Republicans that scoff at a trillion dollar infrastructure spending program. Although divided over a ten-year horizon as stipulated, $100 billion a year ain’t what it used to be. More than a few people are scratching their heads about how Trump wants to succeed in replacing Obamacare, as any new rules will require a sixty person majority in the Senate.

What is striking to us is the juxtaposition between what at times appears to be off-the-hip shooting by Trump on Twitter and the clear policy path his cabinet nominees have presented in their hearings. Be careful, by the way, not to confuse "clear path" with agreement or disagreement: as an investor, understanding the proposed policy takes priority over one’s own conviction as to what the better policy ought to be. To me, it means Trump delegates. I don’t think he could have built his sprawling empire if he micro-managed. Whereas former President Jimmy Carter at some point managed the schedule for the White House tennis court, Trump is at the other extreme. So much so that he has time to tweet, so much so that he doesn’t listen to each and every security briefing.

A common theme in the nomination hearings I listened to has been the importance of clear policies; the importance of consistent policies; and the importance of adhering to agreements. If you aren’t scratching your head on how to reconcile this with Trump’s comments, you aren’t paying attention.

In our 2017 outlook Webinar (please watch a replay by clicking here), we dived into various potential policies a Trump administration might bring. Here, let me touch on fiscal policy, taxes, trade, defense and regulation:

  • Fiscal policy. Trump’s inaugural address built on his campaign and suggested a major infrastructure investment program. If implemented on the backdrop of low unemployment, we see this primarily as inflationary. That said, we wouldn’t be surprised if Congress won’t go along with Trump’s spending priorities; regardless of that, though, expect to see Tweets about great infrastructure projects under way (some of which will likely have been initiated already under the Obama administration).
  • Taxes. As a simple majority is sufficient in Congress to change the tax code, we encourage anyone to study the Ryan tax plan, as he has the opening salvo in the legislative process. And please disregard any analysis that focuses on the reduction in the number of tax brackets - the number of tax brackets are, in my view, completely irrelevant, as to the impact for investors. What is relevant is whether businesses will, as proposed, indeed be able to deduct 100% of their investments in the first year rather than having to amortize them (this may encourage investments); and how that border adjustment tax proposal is going to look when all is said and done. What to look out for here is whether the U.S. tax system is shifting to a territorial one, i.e. where businesses are taxed no longer on their global income, but based on their U.S. income. If so, it may remove the incentive for businesses to move their headquarters abroad. And while many quibble over whether any money that’s going to be repatriated will be used to create jobs, that discussion, in my humble opinion, misses the point: more important is whether artificial barriers to allocate capital are removed, allowing a more efficient allocation of capital. Another detail may have big implications: the Ryan tax plan would no longer allow the deduction of net interest expense; if implemented, it provides a disincentive for leverage (in our assessment, that’s good for financial stability, but a headwind for growth).
  • Trade. Both Trump and his nominees know that imposing 30% trade barriers is counter-productive. That said, a variant of Ryan’s border adjustment tax may well penalize imports and encourage exports. The proposal would no longer allow the deduction of expenses related to imports. If a variant can be devised that withstands scrutiny by the World Trade Organization (WTO), Trump may well claim victory on trade, even if no tariffs are imposed.
  • Defense. While Congress might be reluctant to fully embrace Trump’s appetite for spending on infrastructure, a Republican controlled Congress may be more willing to invest in defense. Importantly, China’s building of artificial islands in the South China Sea was compared to Putin’s annexation of Crimea during the nomination hearings. I mention this because there too the tone is set. I wouldn’t be surprised if those islands will be a priority for the new administration; the argument may well be to contain China before they become too strong. If so, I believe the risk for a trade war resulting from that dispute to be higher than from a more traditional trade negotiation over, say, the NAFTA, agreement (e.g. China retaliating by making life difficult for US tech firms; or by banning grain imports under the disguise of health concerns).
  • Regulation. Finally a world on regulation: one reason why Trump can dismantle many of Obama’s policies is because he governed by re-interpreting regulations without a change in laws. The executive branch has quite a lot of leeway here, and if Trump doesn’t get what he wants in Congress, he may well pursue a similar strategy. We have already seen this with a directive not to enforce aspects of the Affordable Care Act. The problem with governing this way is that it provides uncertainty to businesses: the one thing worse for business than regulation is uncertainty over regulation. A key reason why expectations on real growth rose after the election was, in our assessment, a perception that a unified Congress could pass laws to not only reduce regulation, but to provide clarity that might outlive the administration. To the extent that such optimism is unwarranted, we may well see real growth disappoint expectations.

So what does it all mean for investors?

To gauge what it all means for investors, keep in mind the backdrop: stocks have appreciated for years, including a post-election rally. Bond yields not long ago reached historic lows. And the dollar index was up four calendar years in a row. So if you are bullish on stocks, keep in mind that stocks might be expensive. If you are bearish on stocks, will bonds provide the refuge even if inflation ticks up? And that dollar, will the greenback really soar?

With regards to stocks, we don’t have a crystal ball, but are concerned about high valuations. Without giving a specific investment recommendation, we would not be surprised if small caps (as expressed in the Russell 2000) outperform large caps (as expressed in the Nasdaq). The reasons include:

  • Just as larger firms tend to relatively benefit from more regulation as they have more economies of scale, a reduction in regulation may well benefit smaller firms disproportionally.
  • The Nasdaq companies tend to be more internationally active and, as such, be more vulnerable to retaliation on any policies by other governments.
  • Historically, in the stock market declines we have studied, the Russell 2000 has outperformed the Nasdaq. The reason may be that the Nasdaq has the more popular (and thus pricier) firms. While I believe this may well apply, a caution to this theory: in 2016, the Russell outperformed the Nasdaq already.

To protect against a general decline in stocks, one may need to look further. In that context, cash is an option that is often not mentioned. As investors ponder ways to diversify - or even just a rebalancing of portfolios as equities have outperformed other asset classes - keep in mind that equities tend to be more volatile than some alternatives; as such, to be protected in a downturn, one might need to load up quite substantially on alternatives. As an extreme example: to protect a 100% stock portfolio against a broad market downturn, it would really need to go to almost 100% cash if one wanted to avoid the risk of losing any money. As most investors don’t want to do that, investors are looking for diversification, i.e. for investments that have a low correlation. To the extent that one finds such investments, a similar test should be performed though: how much does one need to add to attain the desired diversification?

Bonds should prove interesting in 2017. My personal opinion is that we saw historic lows in 2016. However, if stocks were to tumble, wouldn’t bonds rally? Possibly. What I’m concerned about is that bonds will fall for different reasons than in 2016: in late 2016, more real growth was priced in; I happen to believe that some of those higher real growth expectations will be replaced with higher inflation expectations.

If that happens, bonds can lose money even if stocks fall. More so, the dollar might not be so shiny after all, if higher inflation is priced in. Fed Chair Yellen recently (at Stanford on January 19) gave a speech in which I interpreted her argument as to suggesting "this time is different" as rising inflationary pressures e.g. in wages are really not as strong as some say.

That’s not to say other currencies can’t suffer in a trade war - the Mexican Peso has been particularly vulnerable as the Mexican economy is particularly dependent on exports to the U.S.; China’s currency may also be vulnerable as speculators could increase their attack on the currency should China be pushed into a corner. That said, I am more optimistic on how major currencies will perform versus the greenback, as we may have seen the low in interest rates in much of the world. Last week, European Central Bank President Draghi fought against that perception, but it was a fight in words only which I characterized as "huffing and puffing" to pressure the currency lower - a strategy that worked for a few hours that day.

What about gold? As we have indicated in the past, gold may be the "easiest" diversifier. Easy because it’s easier to understand than other investments that might be able to perform well when both stocks and bonds are vulnerable (e.g. a long/short equity or long/short currency strategy). We believe gold is a good diversifier over the medium to long-term, as its long-term correlation to equities, in our analysis, is near zero; that said, the price of gold can have an elevated correlation to either stocks or bonds over shorter periods. If I am right that inflationary pressures will increase, then gold may benefit. If, however, Trump’s policies will foremost boost real growth, gold might suffer. One reason why I am optimistic on gold is that I haven’t seen any proposal to get long term entitlement spending under control which is, in my view, key to long-term fiscal sustainability. The link to gold is that a lack of long-term fiscal sustainability may lead to negative long-term real rates which, in turn, would be a positive for gold which has a cost of holding and doesn’t pay interest.

To expand on the discussion, please register for our upcoming Webinar entitled ‘Trump or Dump Gold?’ on Thursday, February 16, to continue the discussion. Also make sure you subscribe to our free Merk Insights, if you haven’t already done so, and follow me at twitter.com/AxelMerk. If you believe this analysis might be of value to your friends, please share it with them.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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So are Trump’s tweets merely an opening salvo to negotiations?
tweet, donald trump, economy
Wednesday, 25 January 2017 08:52 AM
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