Financial Insights

Some Deeper Thoughts for Policy Under Trump

The equity market rallied and the bond market declined, both sharply, in anticipation of the kind of policy changes now considered possible or likely under a Trump Administration. It remains our judgment that equities remain very attractive and bonds highly unattractive, despite their sharp gains and losses, respectively. We think both markets have further to go. Republican majorities in the House and Senate provide considerable potential for new policy directions in many arenas, although forging a coalition of support may be difficult at times. Trump’s programs are more populist than Republican or conservative, so getting full support from Republicans may require compromises or some wheeling and dealing.

Tax Policy

Trump is likely to push for reduced personal and corporate income taxes, some sort of tax holiday for U.S. companies repatriating foreign profits currently locked overseas, repeal of the estate tax, and possibly some additional tax policy changes on imports and exports to encourage domestic production. Many of these initiatives will require some compromise with Democrats, especially in the Senate, to gain the votes needed for passage. The Republicans do not have the majority needed to overcome a filibuster. But, Republicans may balk at enlarged budget deficits. Most everyone has agreed for quite some time that a major overhaul of the tax code is highly desirable, but any effort to do so bogged down very quickly under the radically different visions Democrats and Republicans have for taxes. That hasn’t changed. Without any doubt, this will be one of Trump’s first initiatives and it will serve as a serious test of his new Administration.

One very specific Trump tax proposal that bears extra attention is his desire to lower the corporate tax rate to 15% to make domestic companies more competitive versus foreign ones, discourage mergers to relocate domestic companies to lower tax foreign havens, and to entice companies to bring back to the U.S. profits trapped offshore. All of these reasons help increase the value of U.S. stocks. But a reduction in the corporate tax rate is extremely important for equities, far more than is realized. Even if the tax rate is reduced just to 25% from 35%, instead of the 15% tax rate preferred by Trump, companies will experience an increase in after tax profits of about 15%. This also means the market’s current price earnings multiple on 2017 earnings of around 16.6 would decline to 14.1. Suddenly, stocks look reasonably cheap, even before the benefits of increased government spending and stronger economic growth.

Trump’s tax and spending ideas, as proposed in the election campaign, would sharply increase the budget deficit, so opposition is likely even from traditional Republicans who favor balanced budgets. Tax policy may serve as the ultimate test of Trump’s ability to negotiate any deal, yet it is likely to be a focal point fairly quickly.

Some progress may occur since some of the less contentious pieces can be addressed individually, such as a reduced tax rate to bring back foreign held cash. Efforts to separate such legislation efforts in the past were stymied by use of this item as a bargaining chip in much more complicated tax discussions that never went anywhere. A simpler and lower tax structure on corporate profits to make American companies more competitive in the global market and to reduce incentives to relocate to lower tax havens might also move to the front of the queue. But even that gets complicated by the intersection of corporate and personal taxes for partnerships and family businesses. It’s not easy to address corporate taxes without involving taxes on household income. Still, the need for a modification of the corporate tax structure has been obvious for a long time, so change here seems fairly likely, despite it also being a political football.

Beneficiaries of these policy changes are likely to include companies that support infrastructure construction. But the benefits are likely to be very widely shared, if tax rates do come down for households, since increased disposable income would lead to a higher level of consumer spending, which will affect most companies and add to hiring needs. This would be one of the most pro-growth initiatives of the new Administration.

Regulatory Policy

Deregulation, a hallmark desire of traditional Republicans and also of Trump, is likely to quickly become a second focal point of policy change. Dodd-Frank, an awful piece of legislation, is more likely to be modified than repealed, however. Repeal would be difficult, since Democrats would very likely filibuster any such effort. However, Dodd-Frank can be changed quite easily by simply modifying the rules that implement it. One of the greatest weaknesses of Dodd-Frank was that it provided some overall objectives for regulations, but depended largely on the regulatory rules of government agencies to implement the law. In many cases, setting up those rules proved to be exceedingly difficult, so the process was long, tedious, and as filled with errors as progress. And many rules seemed needlessly complicated and of dubious value. Reversing some of these rules can be implemented quite easily, if new guidelines for how financial firms are to operate can be determined. The simplest way to preserve the spirit of Dodd-Frank and to make the law far less burdensome is to raise capital requirements, while eliminating many of the rules governing lending and business practices. If the banks hold enough capital, they can absorb the losses that come from their mistakes.

On the environment, the Obama Administration pushed much of its initiative via agency rulings, which makes them quite easy to reverse. For example, the obstructions placed on the Dakota Access Pipeline, the XL Pipeline, and other such private investments are likely to be removed fairly quickly. Capriciously, the government overrode court decisions and the careful adherence to the procedures required under the law to remove approval for the Dakota pipeline. This threatened to cast a pall on all energy investment, since firms couldn’t know if the government might withdraw approval on projects even after investment had begun. I expect this withdrawal of approval to be reversed very soon. Also, the approval process for energy exploration is likely to become considerably less burdensome across the board. But will a Trump Administration also remove some of the burden on coal mines and the burning of coal for power, or eliminate the incentives to employ renewables like solar and wind so quickly? That’s less clear. Trump’s campaign rhetoric can’t be dismissed, although it seems doubtful he would totally reverse all of these clean energy initiatives. Regardless, we remain rather cautious about the prospects for coal and very positive about the outlook for natural gas.

There has been plenty of speculation that the Department of Labor ruling on fiduciary behavior will also be terminated. In our judgment, it might be delayed a bit or modified, but if so, only slightly. A major overhaul of this ruling seem unlikely to us. Moving brokers and investment advisors into a unified regulatory framework has been a policy objective for many years. So, we think that process will continue, even if the ruling is modified.

The effects of deregulation are likely to be subtle, broad ranging and profound. Regulations stymie investment and entrepreneurial initiatives. Adding more regulations doesn’t accomplish much, especially when the regulation isn’t written carefully, except for looking good optically. Moreover, the benefits of deregulation are longer lasting, unlike the shorter term benefits of a change in tax regime. So, this could prove to be a powerful longer-term stimulant to economic growth and it won’t even cost anything in government spending. (Take heed of this lesson, Japan, Italy, France, and plenty of others.)

Monetary Policy

Trump’s public statements on monetary policy provide only limited clarity on his objectives. He spoke in favor of low interest rates, hardly surprising for someone who made his living off real estate, yet he also suggested that interest rates are artificially low for political reasons. These views were simply inconsistent. His thinking might also change from his new perch in the White House. I doubt Janet Yellen will resign because of the election, although I also doubt she will be reappointed when her term expires in February 2018. Trump is likely to take the opportunity to select a new chair who better reflects his views to replace the liberal, Democrat Yellen. There are plenty of well regarded, high caliber, conservative economists who could fill that role. In the meantime, the Fed will have to think about the possibility that increased spending or lowered taxes might stimulate a stronger economy and require a somewhat faster pace for rate increases. Any such moves will be driven by data, notably inflation, not by politics. The spending and tax policy initiatives of the Trump Administration are likely to reinforce the trends that will require earlier Fed action.

Health Care

Senior people surrounding Trump have already expressed the idea that ACA, otherwise known as Obamacare, is likely to be subject to repeal. However, such a major piece of legislation cannot simply be repealed without some sort of acceptable alternative structure. Moreover, there will be a firestorm of opposition to any effort to repeal. Over the weekend, Trump even acknowledged there were parts of the Obamacare legislation he liked. But, change is likely. So, what kind of modification is coming? The thrust of the Obamacare can be totally undermined by regulatory change, even without repeal, but this could be very disruptive without some sort of new structure to replace it or, at a minimum, offered side by side. Since this is a high priority for Republicans, their strategy in addressing this program should unfold fairly soon.

Manufacturers of pharmaceuticals are likely to benefit, since regulatory restraints against new drugs are likely to become less onerous. Hospitals were huge beneficiaries of Obamacare, since they experienced a radically reduced level of payment defaults. They could be losers under a new structure, although that is largely speculative, as yet.

Trade Policy

This has been such a major issue in the election campaign, it is hard to envision how Trump might be able to tone down his positions, even though he is sure to get considerable pushback from Democrats and Republicans alike. Oddly, Trump may get more support from Democrats than Republicans on some of his ideas, such as a harder line on imports and free trade agreements. TPP is almost surely dead, since only objective economists support it and they don’t hold power. Will NAFTA negotiations be reopened? Or, might Trump allow NAFTA to remain in place as a bargaining chip to get something else he wants more, like his cherished tax reductions? Frankly, it is hard to anticipate how this one plays out.

National Defense

It is odd that defense contractors performed so well in the aftermath of the election, since both candidates were thought to recognize the need for renewed defense outlays, but certainly Clinton more so than Trump. Since it will take time to recalibrate our defense programs, no large immediate effects are likely. But defense companies should benefit over time from the need to rebuild our defense capabilities.

Supreme Court

One seat is vacant and others may open fairly soon. Who Trump nominates may go far to open up rifts with Democrats or to heal them.

Immigration Reform

Any action Trump might take to restrict immigration, which he described as another major priority, would exacerbate the growing scarcity of labor and increase inflation prospects. It would also require more rate hikes from the Fed sooner than expected.

Public comments since the election suggest that Trump, Republicans and Democrats may seek ways to collaborate (Harry Reid, who is retiring, excepted). Both sides recognize they will need to live with each other for the next four years and there are so many significant policy issues that it is hard to imagine they can all be addressed within a year or two. Indeed, the rhetoric has changed quite radically already. House Speaker Ryan has been busy mending fences with Trump. Trump has been far more gracious as a winner than would have been expected based on his campaign statements. Even President Obama has been outspoken in his desire to smooth the transition, despite calling Trump unfit less than one week ago. Well, we are still in the honeymoon period and the long knives are merely stashed away, at least until actual legislation is proposed. But, we can certainly say this election has been different, so it may be that more surprises lurk down the road.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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