New U.S. president and Republican-controlled Congress will test investors’ faith in their ability to enact transformative policies in taxation, trade and infrastructure.
When Donald Trump won the U.S. presidential election, markets were thrilled by the victory and its clearing of a path to fiscal stimulus, alongside transformative tax, trade and infrastructure policies.
The inauguration of President Trump on Jan 20th raised the stakes. As he took the oath of office, the glow of victory transitioned to the harsh reality of governing, putting a spotlight on lingering disagreements between the new president and key Republican policymakers, who, seeing a governing opportunity, embraced Trump, despite their criticism of his conduct and lack of conservative orthodoxy.
A return to gridlock and negative unintended consequences are meaningful risks.
Our base case remains that Republicans can execute a tax-reform-driven fiscal stimulus on or around the third quarter; however, we concede that execution risks are rising. Investors following this high-risk, high-reward path may find it increasingly difficult to believe that their faith in U.S. policy will be rewarded, as the year progresses.
Consider the debate over tax reform, specifically, “border adjustability.” The untested, controversial provision could meaningfully disrupt corporate finance, rotate wealth from certain sectors of the U.S. economy to others, and create tighter financial conditions through a stronger dollar. We have taken the proposal seriously, as it aims to achieve two key ends for Republicans:
- Address the president’s desire to incentivize domestic production by eliminating companies’ ability to deduct the cost of imported goods; and
- Raise revenue to offset losses from lowering the corporate tax rate.
The latter is of particular importance, given Speaker of the House Paul Ryan’s desire to push tax reform through the budget reconciliation process, which requires revenue neutrality. This approach is made easier when fresh revenue is available, limiting the need for fiscally conservative Republicans to consider voting for higher deficits.
However, when the president stated his displeasure with the provision in a recent interview, calling it “too complicated,” we imagine the speaker may have not only felt that the goalposts were moved, but airlifted to another playing field. While Trump later moderated his view, reticence on this topic is further reflected in dissent from at least one senator, Tom Cotton (Republican, AR), making the difficulty of executing tax reform self-evident.
The takeaway is twofold:
- Tax reform could include some disruptive elements that blunt its economic positives; and
- Tax reform is not a given.
As if the politics of tax reform weren’t complicated enough, there’s rising risk that it becomes collateral damage of the debate over how to repeal the Affordable Care Act, a.k.a. “Obamacare.” Rising displeasure among Republicans about the risk of increasing the number of uninsured Americans if they repeal the ACA without immediately replacing it, risks delaying this legislative process—and tax reform as a consequence.
We still see Republicans delivering tax-reform-driven stimulus, supporting U.S. economic growth at 2.0% in 2017 and 2018, vs. the consensus 2.3% and 2.4%, respectively, compared to the slowdown we envisioned before the election. Specifically, we believe that Republicans can cloak themselves in the language of “Trump Keynesians”—prioritizing growth over fiscal conservatism as political cover to accept higher near-term deficits, paired with the promise of future spending cuts. This allows for the softening of key provisions, phase-ins and other maneuvers to enhance its political viability. The recent approval of higher deficits in the 2017 budget resolution, in the name of enabling ACA repeal, put this concept into practice.
Yet, it would be naive to assert that this outcome is definitively positive for markets. Rather, we think it prudent to recognize that investors may see this evidence and come to a less-than-optimistic conclusion—a return to gridlock and negative unintended consequences are meaningful risks. If that happens, then the collaborative market strategy views of our Morgan Stanley colleagues may look prescient: a lower earnings multiple for U.S. equities (18x bull, 16.2x base, 15x bear price-to-earnings ratio); a deterioration in the goldilocks conditions for U.S. credit; and a low ceiling on Treasury yields in 2017 (2.5% 10-year Treasury year-end target).