Asset Allocation in a Trump Market [Paper]
- Global capital markets were delivered another “Brexit-type” surprise in November with the election of Donald Trump and the Republican sweep of Congress.
- The capital markets swiftly made adjustments based on a preliminary understanding of the Trump legislative agenda. Some asset classes have been deemed “winners,” others “losers” in the post-election stock market rally, as investors attempt to sort out the investment implications of a Trump presidency.
- Although certain U.S. equity market indexes moved to all-time highs, global markets have not necessarily moved to the same degree.
- A fully diversified, balanced portfolio that includes equities (both U.S. and international), fixed income, and alternative investments has generally increased in value, post-election, but not to the degree of a portfolio invested 100% in U.S. equities.
- Given the surprise Republican sweep of the presidency and both legislative houses, and given the initial response from the global capital markets, investors may wish to review their current portfolio holdings with their financial advisor to determine if adjustments are needed to meet their long-term goals and objectives.
Donald Trump's surprise election victory, as well as the Republicans gaining control of Congress, has generated an initial positive response in the U.S. equity markets, leading to measurable gains in several indexes, including the Dow Jones Industrial Average, which has gained 8.4% since the election, and the Russell 2000® and S&P 500®, which are up 14.3% and 7% since the election, respectively (all returns through January 31, 2017). In addition, all major U.S. indexes, including the S&P 500 and NASDAQ Composite, set new record highs in 2016.
We believe the strength of these markets results from investors believing that the combination of a pro-business Trump presidency and a Republican-controlled Congress would lead to an era of less regulatory oversight, lower corporate and personal taxes, and increased federal infrastructure spending that, among other policies, bode well for businesses and the economy.
U.S. EQUITY MARKET RETURNS POST ELECTION
Since the election, certain sectors have been big winners, while others have not fared as well. For example, stocks in the financial services/banking sector have surged since the election,as investors anticipate less regulatory oversight and lower corporate taxes for companies in this sector. Bank stocks, which have significantly lagged the broad equity market indexes since the 2008 financial crisis, have led the equity market’s post-election rally, reflecting investor belief that U.S. interest rates will be moving significantly higher, which tends to benefit banks which stand to gain from the improved spread between deposit and lending rates (Figures 1 and 2).
On the other hand, the sectors that were the best performers pre-election (such as energy and utilities) have not fared as well post-election (Figures 1 and 2). The stocks in these sectors are often seen as “bond proxies” because of their attractive dividend yield and were the primary beneficiaries of investors’ search for yield in a low interest rate environment. As interest rates have risen post-election, these stocks have been used as a source of funds for investors who rebalanced their portfolio into those asset classes perceived to be beneficiaries in the Trump legislative agenda.
When analyzing the post-election “winners and losers,” it is clear that the U.S. equity market is performing as if it is in an “early cycle” phase, which is typical when the economy is emerging from a recession. In this phase, the stocks of companies in the more cyclical sectors of the economy (financials, industrials, materials) are the early leaders in equity market performance, while more consistent growth sectors (consumer staples, technology, health care) have had a more muted response relative to their more cyclical counterparts.
Given that the U.S. economy is in the seventh year of an economic expansion, and essentially at “full employment” with unemployment hovering near 5%, this dramatic post-election move by investors into “early cycle” winners is very unusual. It reflects the belief that a strong fiscal stimulus will be applied to an economy that is already growing (albeit slowly) through the reduction of corporate and individual tax rates, less regulation, and significant increases in infrastructure spending.
THE RECENT STOCK MARKET RALLY AND YOUR PORTFOLIO
Despite the strong returns in the U.S. equity markets, a well-diversified portfolio, which includes some combination of U.S. and international equities, fixed income, and alternative investments, has not kept pace with an all-equity portfolio due to exposure to the fixed income market, as bond prices have declined as interest rates have increased post-election (see Figure 3).
Municipal bond investors experienced a decline in portfolio values due to a combination of the general rise in U.S. interest rates, post-election, and concerns regarding the impact of declining tax revenues if both corporate and individual tax rate legislation are enacted.
For the most part, stocks and bonds have rallied together since the stock market bottomed in early 2009. However, the most recent stock market rally was not accompanied by falling interest rates for the first time in the last several years
Typically, stocks and bonds tend to diverge in the latter stages of a bull market when the economy tends to be accelerating and gaining strongly. In the current environment, a well-diversified portfolio will have difficulty keeping up with all-equity index.
It is important to remember that a portfolio composed entirely of stocks will generate a higher return during a bull market than a portfolio composed of stocks, bonds, and alternative investments, or a 100% bond portfolio. However, the diversified portfolio will likely be less volatile than a portfolio containing all stocks. So while investors with diversified portfolios may not be gaining in lockstep with the overall equity market, they are, however, shielding their portfolios from significant losses in the event of a major equity market correction.
Figure 4 reminds us of how a “balanced” portfolio typically performs over a long time period. A balanced portfolio is designed to provide consistent long-term returns, forgoing the “top position” return in any single year in exchange for avoidance of being in the “bottom position” caused by a significant drawdown of account value.
There is a "huge" difference between proposals on the campaign trail and the timing and structure of actual legislation. Further, President Trump is not a traditional Republican president, and it remains to be seen how well he can work with Congress to meet the goals of his legislative agenda. For now, investors have focused on the positive aspects of the Trump legislative agenda, rather than the uncertainties. We would not be surprised to see, after this initial positive response by the capital markets, periods of heightened uncertainty as investors sort through the implications of the economic outcomes when tax, trade, and regulatory legislation is formed and passed by Congress.
We believe there are real, structural changes in fiscal, tax, and regulatory policies headed our way that will have important implications for global equity, fixed income, and real asset classes. Further, investors should not underestimate the positive implications of the transition from monetary policy to fiscal policy as the primary driver of global growth.
We are in the very early stages of these important changes. The global capital markets quickly made their initial assessment of the “winners and losers” in this new environment. However, these adjustments in global pricing of asset classes are just beginning.
With that, we believe that it is very timely and important to review your initial investment guidelines developed with your financial representative. Such a review can help reaffirm your long-term investment goals and appetite for portfolio risk, and determine if adjustments need to be made to your asset allocation based on changes in the political regime in the U.S. and the transformative policies that will result.