As the world prepares for Donald Trump to assume his position as President of the United States, we’ve seen the stock market react violently — both up and down.  Additionally, bonds can’t seem to find any shelter from the recent sell-off, and although we believe there’s panic underpinning the selling, we can’t ignore the tectonic shifts in U.S. politics that will have effects in the real economy and the capital markets.

First, a caveat… and an important one.  We can’t predict how successful Mr. Trump will be with implementing his campaign platform policies even with a Republican Congress.  We can, however, look to history to provide some context for where the economy might be heading.

In his business endeavors, Mr. Trump has borrowed money and built things.  His focus on infrastructure is a page from the same book, although his advisors envision leveraging the private sector to pay for certain projects where there’s a potential profit to be made.  In any case, we expect Mr. Trump to attempt to throw some federal dollars at the issue, which may be problematic given Republican reluctance to infrastructure spending.

Mr. Trump’s tough stance on global trade and his focus to renegotiate trade terms both have potential impacts on U.S. growth and inflation.  While not the complete story, inflationary pressure on durable goods — items like computer equipment, industrial machinery, and cars — has fallen dramatically since NAFTA took effect in 1994:

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(Source:  St. Louis Fed / BEA)

The quick interpretation of this chart:  Shifting the cost of making things to overseas locations has resulted in lower price inflation for the U.S. consumer.

It is reasonable to assume, then, that changes to trade policies will have an inflationary effect and could dampen U.S. growth.  Infrastructure spending could offset the hit to growth, but that also adds fuel to the inflation fire.  Again, Mr. Trump has an uphill battle to see all of his policies implemented… but we want to cover most of the bases at this point.

So what now?

– All of Mr. Trump’s policies have a reflationary element to them; that is, we expect inflation to pick up in the U.S.

– This will hurt bond prices as yields rise, although we’re quick to admit we have a chicken/egg dilemma:  as inflation picks up, yields rise and bond prices fall.  However, the uncertain political climate and shaky global economic picture could drive investors to the safety of bonds… which could depress yields and increase bond prices.  Which scenario happens first is still to be determined.  Regardless of the outcome, the market expects a faster pace of Fed tightening:

oiscurve

(Source:  The Daily Shot / Bloomberg)

– Mr. Trump’s policies on trade and our foreign relations will play out in a near-term exodus from international investments (especially emerging markets).  Emerging market bonds took a beating, especially when the currency effect (U.S. Dollar strength) is included:

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(Source:  The Daily Shot)

– Trying to connect the dots and play out every scenario becomes an intractable problem — the uncertainty is too great and Mr. Trump’s efficacy as a bipartisan negotiator has yet to be tested.  In fact, we still don’t know how the rank-and-file GOP will respond to him once he takes office.

We expect near-term uncertainty to distort asset values and lead to continued volatility.  However, through the lens of history we can see that a Republican controlled Washington has produced solid stock market returns during the 3 post-WW 2 instances of a Republican sweep.  This accompanies a cautionary tale: Since 1920, recessions during a new president’s first year have been three times as common as in other periods.

With that said, we see the benefit of balancing fixed income (bonds) alongside inflationary assets.  While this isn’t a departure from our normal portfolio construction, we have elected to limit the duration (time to maturity) in fixed income and take a closer look at assets that are typically sensitive to rising rates and inflation.  Over the long-haul Mr. Trump may be pro-domestic growth, but there will probably be some hiccups as we travel down that path.

Although it’s difficult to look further down the road given the uncertainty of American politics, we remain committed to doing the research, controlling the costs, and staying the course — all within our clients’ risk tolerances.

Please reach out if you have any questions — we look forward to hearing from you.

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