The Great Rotation

The Great Rotation?

After almost a decade of underemployment, low rates and sub-optimal growth across the globe, it appears as if investors have formed the view that Trumpenomics will be the dawn of a new era. Growth will be driven by increased infrastructure spending that will then lead to higher interest rates combined with increasing inflation.

Investors have been exceptionally quick to reposition investment portfolios towards asset classes they believe will benefit from Trumpenomics, but is this the start of the Great Rotation or just a blip on a well-trodden path? The consensus view among investors that ‘growth and rates would be lower for longer’, has invariably led to investors structuring their investment portfolios in similar ways. When investors then decide to run for the door and rotate out of assets that provide a yield to those that are growth oriented, the baby can often be thrown out with the bath water.

How Trump won the Presidential electionClinton claimed 47.9 per cent of the popular vote and Trump claimed a marginally lower 47.2 per cent (New York Times 2016, as at 15 Nov 2016) but the popular vote does not determine the winner of the election. In order to win the election, a candidate must receive a majority of the 538 Electoral College votes, which is 270. Each state has a number of Electoral College votes which is roughly determined by the number of people who live in that state. When people voted for a Presidential candidate in November, they actually voted for electors in their respective states who support that particular candidate.Most of the states operate on a first past the post, winner takes all system. As an example, Trump won the State of Florida by a small margin and could subsequently claim all 29 electoral votes in that state. Low Democrat voter turnout also assisted Trump. Many traditional Democrat voters did not vote because they didn’t like Hillary Clinton. Voters in areas that have been negatively affected by globalisation tended to support Trump.

Central banks have not been effective in boosting growth and inflation

Monetary policy, in the form of low interest rates and quantitative easing, has provided support to investment markets and the financial system. Unfortunately, almost a decade after the Global Financial Crisis (GFC), the long period of low interest rates has inflated asset values rather than stimulating the economy by encouraging investment in ‘real’ businesses. Central Banks have said that now is the time for fiscal policy to take the baton. A shift to fiscal policy will drive productivity and stimulate growth, however, governments generally are heavily in debt so most politicians are reluctant to increase spending even if they accept that this is the solution required.

Instead, politicians have generally been doing the opposite of increasing spending by introducing austerity measures and aiming for budget surpluses. Voters have been rejecting austerity and are expressing their dissatisfaction with the condition of their economies and leaders at the ballot box. The anti-establishment swing to the right wing, across Europe and the US is clear.

Is anti-globalisation and protectionist rhetoric taking hold?

Dissatisfaction, protectionism and anti-globalisation have been in the ascendancy, with the British voting to leave the European Union and Trump being voted in as President of the US. In more normal times, Trump’s inflammatory rhetoric – such as plans to build a wall on the Mexican border, labelling China a currency manipulator and applying trade tariffs on China and Mexico – would have likely sabotaged his political success.

The Trump Presidency increases political risk around the world. Politicians will have taken note of how popular protectionist rhetoric has been among voters and may well tailor their messages accordingly. Countries including France, Germany and the Netherlands are holding general elections in 2017. If patterns from the US election are replicated then right-wing, nationalistic political parties are likely to perform well.

Will Trump’s policies boost global growth?

At face value, Trump’s proposed fiscal policies would provide a boost to Gross Domestic Product (GDP). Plans to spend at least $550bn on infrastructure would be inflationary, leading to higher expected interest rates and potentially a stronger US dollar.

Trump’s fiscal plans will need to be approved by Congress, meaning they could still be thwarted. The Republicans retained control of Congress, which comprises the Senate and House of Representatives as well as winning the White House. This increases the probability that Trump’s plans will be passed, but because Republicans have historically been fiscally conservative, Trump’s policies are likely to be watered down and there will be less scope for Trump to push through major fiscal budget changes.

His proposed tax cuts for example, that are worth around $6 trillion, would be largely unfunded if his infrastructure and defence spending is approved, running the risk that Trump’s policies would likely see debt to GDP skyrocket to 110 per cent, up from its current level of around 76 per cent. It is unlikely that Congress would allow this to occur.

Additionally, the budget deficit is expected to grow rapidly regardless of any new policy initiatives, indicating Trump is unlikely to have as much flexibility as he would like.

Trump has more bark than bite

Trump’s victory speech surprised markets because in it he indicated that he will strive for unity within the US as well as common ground and partnership with the global community. These sentiments were different to those expressed when campaigning.

China and Mexico contribute 35 per cent of all US imports and Trump’s protectionist stance is a risk to them. Trump’s comments on imposing a 45 per cent tariff on foreign goods is probably more of a threat, rather than an actual policy that will be implemented. A trade war is not expected and the impact on Australian exporters is negligible because Australian only contributes 0.5 per cent to all US imports, thus any impact to Australia-US trade would have a minimal impact on the Australian economy. Australia is currently protected by the 2005 free trade agreement which eliminated most tariffs for exported products from Australia to the United States.

There is some concern that any impact on China will flow through to Australian exports but it is important to note that Chinese exports to the United States are less than 3 per cent of China’s GDP. China also has the ability to weaken its currency in order to support their export industry. We do not expect that any tariffs imposed by the US on China will have a significant impact on China’s economic stability.

Ultimately, in terms of Australia-US trade, a Trump victory is more about lost opportunity from the Trans-Pacific Partnership, which Trump has threatened to revoke, rather than any negative effects on current trading arrangements.

Interest rates – where to from here?

In the last few months, cyclical factors have been re-asserting themselves. This has been reflected in higher commodity prices, growing expectations that the US Federal Reserve will increase interest rates, concern over the effectiveness of monetary policy and a greater emphasis on fiscal policy. In response, investors have reduced their bond holdings, which has led to a sudden and sharp rise in long term bond yields. This rise in bond yields has also been triggered by expectations of significant fiscal stimulus in the US as Trump plans to spend more on infrastructure and defence, thereby lifting inflationary expectations.

The rise in inflationary expectations coupled with more encouraging economic news on the outlook for US growth, has increased the probability of the US Federal Reserve increasing the cash rate in December. Investors are now pricing in a far sharper rise in rates in the future as well as a stronger USD. We are now likely to be past the low point in interest rates, but we expect interest rates to gradually increase at a slightly lower trajectory than is currently being priced into the market.

Trump and investments – winners and losers

The direct beneficiaries

Trumpenomics includes increased infrastructure spending and fiscal stimulus, as well as potentially reversing

‘Obamacare’ and promoting less stringent financial regulations. Additionally, a view to ‘Make America Great Again’ is supportive of a protectionist policy, which is potentially negative for trade and globalisation, and perhaps inflationary. If investors are correct and Trumpenomics leads to an increase in demand for infrastructure spending, and hence commodities demand, other than the direct benefit for commodity companies, banks may be able to reverse their bad-loan provisions made for mining related services and commodity companies.

Any increase in commodity demand will help Australia’s budget as well as the trade deficit, putting less stress on the economic environment and potentially reducing the likelihood of a downgrade of Australia’s sovereign credit rating by the rating agencies.

What about bond proxies?

One of the effects of increases in bond yield is to depress the price of property and utility shares. Increasing yields makes it more expensive for property companies to finance acquisitions and increasing debt costs directly impact the bottom line but this is also true for the valuation of all shares. Utility companies are generally heavily indebted and so will be negatively affected, but these companies prices are regulated by government, which limits the potential downside as higher costs in terms of debt will ultimately be passed through to customers.

How will a stronger US dollar affect Australian shares?

Higher inflation and increased interest rates in the US will lead to a stronger US dollar and this will benefit those companies that generate strong sales in the US. Typical of these types of company are CSL, Resmed and Ansell. They will not only benefit from a stronger dollar, but also potentially from any change to US Healthcare legislation, should Trump overturn ‘Obamacare’. Companies that will benefit from a weaker Australian dollar are those in the tourism and education sectors.

What to expect next

The global economy should benefit from Trumpenomics if Congress is agreeable. Increased infrastructure spending should lead to stronger global growth, a firmer US dollar, an uptick in inflation and higher bond yields. This will lead to a continued shift out of yield investments and into growth. However, this transition may not be as fast and as sharp as investment markets have currently priced in.

Central banks will be wary of raising interest rates too quickly to avoid financial distress. This is because they are acutely aware of the high levels of indebtedness of households. Rising bond yields will continue to be a theme but will need to be accompanied by genuine economic growth. Investors should ensure they have good downside protection, which will remain vital as we move into 2017, a year filled with multiple geo-political risks, including the enacting of Brexit and the results from major European elections.

Research Analyst – Elan Miller, Paul Saliba, David Pobucky, Alex Harris

Approved By – Matthew Drennan

_{Research Analyst Disclosures:
I, Elan Miller, Paul Saliba, David Pobucky and Alex Harris, hereby certify that all the views expressed in this report accurately reflect my personal views about the subject investment theme and/or company securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
I, Paul Saliba and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: Perpetual Share-Plus Long Short Fund, BHP
I, David Pobucky and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: HGG, IPL
I, Alex Harris and/or entities in which I have a pecuniary interest, have an exposure to the following securities and/or managed products mentioned in this report: Antipodes Global fund, Magellan Global Fund, Bentham Global Income, Invesco Global targeted returns}

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