View From The Top: Beyond the Trump bump  

View from the very top: keep it simple and focus on the bigger picture. America has a decisive mandate for change, and this should be very good for equity investors, at least in the near-term. There is a fortuitous current confluence of strong US economic growth combined with relative weakness in the rest of the world. Add in a deeply transactional President that will seek to use all the leverage at his disposal to improve America’s positioning. This combination should spur higher nominal US GDP growth. Further, the Federal Reserve is operating from a position of strength. Interest rate cuts that coincide with economic growth tend to be supportive for equities. In this world view, bond yields and the US Dollar likely trend higher too, with clear asset allocation implications. We see no cause for complacency in a likely more uneven and volatile world but believe that the case for high-conviction diversification remains firmly intact. Use any pullbacks as opportunities. 

Asset Allocation:

• Equities: The S&P 500 Index has outperformed all other major stock market benchmarks since its October 2023 low. US equities may be trading in at least their 95th percentile versus 40-year average levels on every meaningful valuation metric (per Goldman Sachs), but we see good reasons why this outperformance can continue. Other regions (especially Europe and Emerging Markets) look set to be relative losers from the ongoing strength of the Trump-charged US economy. Our US optimism is, however, nuanced. Look beyond the mega-cap tech complex. Just 39% of S&P 500 Index stocks have outperformed year-to-date (the second lowest level since 2000, per Bloomberg), while the Russell 2000 Index of smaller businesses trades at a meaningful discount to the S&P 500 Index. This is a time for active stock picking.
• Fixed Income/Credit: It is hard to make a strong case for US Government debt in the context of the strength of the domestic economy and the likely rate of change of interest rates. Sovereign debt in the Eurozone, of course, is a potentially different matter, given the continent’s more challenging economic outlook. Higher yields do represent an alternative source (beyond equities) for investors’ capital, but crucially, inflation expectations remain well anchored for now. We note the narrowness of corporate spreads (both Investment Grade and High Yield), which we believe point to investor optimism regarding the outlook.    
• Currencies: Long Dollar may be a highly consensual trade (the US Dollar Index is at a two-year high) but for very good reason, in our view. Even if the incoming President is said to favour a weaker Dollar, the relative strength of the US economy should provide sufficient momentum to keep the currency elevated for now. The Fed is under limited pressure to cut rates, in contrast to its peers elsewhere. Expect ongoing relative weakness in both the Euro and EM currencies.
• Gold: The precious metal may have lost ground in November, but it remains up ~30% year-to-date. We continue to see it playing a crucial diversifying role in investors’ portfolios. Gold acts as a clear hedge against geopolitical uncertainties (as well as the risks attached to a growing fiscal deficit). Central Banks are also continuing to buy gold.
• Alternative Assets: Owning assets with collateral-based cashflows brings diversification to portfolios. Many benefit from an illiquidity premium too. We advocate being highly selective across this broad and diverse area, favouring differentiated and uncorrelated strategies.

The result on 5^th November was decisive and was followed by a similarly emphatic reaction in financial markets. Wall Street clearly voted for Donald Trump. He certainly has a mandate for change, but crucially, it will occur in the context of an already robust and resilient economy. Normally after the sugar-rush comes the reality, but we see dangers in the temptation to over-analyse. For us, the path of least resistance in the near-term is one of higher equity markets, higher bond yields and a stronger US Dollar. Sure, the road forward is unlikely to be linear, but any pullbacks may bring opportunities.

The US election followed a very similar path to that witnessed in other developed democracies. A high turnout of voters opted for change – and perhaps with good reason. While readers of this piece are schooled to appreciate the importance of the rate of change, the electorate cares more about absolutes.Higher prices and the impact of inflation is neither popular nor good news for incumbents. Not only did the Republicans complete a sweep of all the principal branches of the legislature, but every state in the US witnessed a shift towards the right. Useful lessons can be learned.

After the pain of the recent past, the Trump administration has been gifted the inheritance of a very strong economy. The odds of near-term recession look low. After reported 2.8% GDP growth in Q3, output is tracking towards 1.8% for the fourth quarter, leaving the US economy set to record 2.7% economic growth in 2024 (per Bloomberg). Consequently, America is the only major developed economy where output is now back to above pre-pandemic levels. At the same time, 4% unemployment is well below levels witnessed in the last three decades. Crucially, inflation also appears to be returning to a more normalised trend. From a peak of 9.4% (reported in June 2022), the last inflation print showed just 2.6% annual growth. Polling from the New York Fed shows inflation expectations one year out at 2.9%, their lowest level in four years.

All the above implies that when the Federal Reserve next decides to reduce interest rates, it is doing so from a clear position of strength. Expectations of both the pace and magnitude of future moves in the Fed Funds Rates have unsurprisingly been recalibrated post the election. Only 75 basis points of US rate cuts are now discounted by the end of next year, versus close to 150 basis points at the start of October. Nonetheless, the logic for Jerome Powell to “approach [rate] decisions carefully” seems sound to us. Admittedly, the rise in loan delinquencies and bankruptcies are important factors to monitor, but with an economy this robust, there is no rush to cut rates. Crucially, interest rate cuts that coincide with economic growth tend to be supportive for equities.

Part of Jerome Powell’s caution may, of course, be influenced by the Trump factor. The incoming President’s only constancy is, arguably, his unpredictability. For Donald Trump, a second term of Presidency may seem, to him, a vindication, particularly in the context of him being impeached twice, defeated in 2020, prosecuted four times and convicted of multiple felonies. It may, therefore, provide him with a licence to be more radical in his approach to policymaking. At the least, he will likely seek to remove constraints on his decision-making wherever possible.

There is, however, the difference between rhetoric and reality, bravura and the business of governing practically. Investors learned from Trump 1.0 the importance of knowing when to take the President seriously versus literally. Hopefully this will prove informative for his next term. It is also worth bearing in mind that the equity market did very well (recording a gain of more than 60%) under the previous term of Trump Presidency, albeit in an era of more stable geopolitics and with valuations less extended.

What seems clear to us are two things. First, there is a fortuitous confluence (for both the Trump administration and investors) of strong US economic performance and relative weakness in the rest of the world. Next, in a competitive ecosystem, a deeply transactional President will seek to use all the leverage at his disposal to improve America’s positioning. The easiest wins for the new administration are likely to be around deregulation and taxation. Potential tariffs and targeted deportations may be both more complex and controversial to implement.  

Much has been written elsewhere on all the above but consider that there is a strong playbook in place for supply-side reforms to the economy (witness the effective of Reagan’s and Thatcher’s policies in the 1980s). Further deregulation may also help unleash a new round of M&A and IPO activity. Corporate deals accounted for just 2.3% of GDP last year, versus 9.0% in 2000 (per Bloomberg). Meanwhile, tax cuts could be a clear source of upside. They are also effectively easy to implement with a Republican majority in both Houses. Every percentage point reduction in the US corporate rate could lift earnings for the S&P 500 Index by nearly 1%, according to Goldman Sachs.

The correct lens with which to view tariffs, in our view, is to think of the Prisoner’s Dilemma. In this famous case of game theory, cooperation is always better than dissension, assuming that consensus can be achieved. Tariff threats could be seen as just that, a bargaining tool. Tariffs also do have unintended consequences, especially given the highly interconnected nature of global trade. At the same time, it seems prudent to assume that there will be an uneven and volatile path ahead. Faster nominal US GDP growth and a shift away from globalisation are not mutually incompatible outcomes.

For investors, there are (at least) four caveats to this world view, which will matter when it comes to asset allocation considerations. First, the US budget deficit constitutes a major metaphorical elephant in the room. The country’s current debt to GDP ratio is already the second highest in the OECD and will reach an all-time high (in absolute terms) during the middle of this decade, according to the bipartisan Congressional Budget Office. Although few investors seem currently concerned about future deficit-funded growth, sentiment can change quickly. A worst-case, tail-risk scenario could be the possibility of weak demand for new debt in Treasury auctions (per the UK experience under Liz Truss) potentially followed by a Sovereign debt downgrade.

In the near-term, investors may want to be mindful of the current expectations embedded in equities. Wall Street may be too hopeful on Trump’s intentions versus his ability to deliver on them. Put another way, in order to ensure market momentum, earnings need to keep delivering. The third quarter reporting season saw a below-average ratio of earnings beats across the S&P 500 Index relative to five-year trends, while consensus is optimistically looking for an acceleration in earnings growth to 13.4% in 2025 (per FactSet). If achieved, this would be the biggest rate of change since the 2021 post-pandemic rebound. It also seems fair to ask what may happen should the AI bubble burst. Past experience (in the dotcom boom) would suggest that investors can be correct on the thematic thesis, but wrong on valuation. There has been elevated expenditure on AI infrastructure, but little emergence of profits. Higher bond yields could dampen sentiment towards equities too.

Finally, do not forget the potentially destabilising impact of geopolitics. Many states may look to use the arrival of a new President to advance their own disruptive agendas. Even if domestic US growth could be poised to trend higher, the path forward will unlikely be either linear or untroubled. Despite clear optimism, there is little scope for complacency.

Alex Gunz, Fund Manager, Heptagon Capital