In other recent articles, we have explained that whilst US corporate earnings in the recent December Quarter will be about 6% higher than the previous corresponding period, it is likely that earnings over the full 12 months (ended 31 December 2016) will be flat compared to 2015 year earnings. The 10% lift in US equity indices has therefore moved the trailing PER (2016 reported earnings) to a high level (estimated 17 to 18 times).  It is not at a historic high (for instance it is below the 2000 peak), but it is at a concerning level that can only be justified if forward earnings rise significantly. How will earnings rise? At this point the best scenario is earnings growth driven by Trump’s promised tax cuts and in response to an expanding US economy driven by a massive infrastructure building program.
The table below shows where all the share price action has been. Financials, Energy, Industrials and Telecom companies in the S&P have bounded higher. Consumer based stocks, healthcare and real estate have not moved much at all.

Figure 1. S&P 500 Returns by Sector
Source. Thrivent Funds
The above price moves contain a bit of reality (higher oil prices in the second half on 2016) with solid earnings growth in IT companies but with a speculative element seen in financial stock prices. Arguably the leap in share prices of financials in the December quarter reflects a significant bounce from the oversold positions of the US commercial bank sector. However at this point, mainstream US banking is exhibiting no significant growth and this is consistent with the negative price returns on consumer stocks in the December quarter. The middle class of the US has not suddenly been stimulated by the election of Trump. They are not growing consumption with credit but they will have to if the movement in bank share prices correctly anticipates the future.
Identifying from where US earnings growth may come is easy at a superficial level. However, a deeper thought process exposes the contradictions in the proposed Trump economic policies. The most obvious contradiction or problem is that the US government currently has a massive debt load that exceeds $18 trillion meaning that US Government net debt to GDP is approaching 100%. The Trump Presidency starts with record levels of government debt and his programs suggest debt will grow substantially.
It is important to understand that the cost of US government debt in recent years has been supported by Federal Reserve policies that have kept cash rates down and put a floor under an over priced bond market (low yields) through quantitative easing. By keeping the cost of government debt low there has been no financial necessity for the US government to balance its fiscal budget. The economic growth and recovery that the US has experienced over the last 7 years has not translated to fiscal surpluses. Government debt has grown faster than GDP in each of the years since the GFC.
Trump’s expansionary policies and lower taxes will exacerbate the fiscal problem in the short-term. Inflation should rise and so should interest rates. The interest cost of US Government debt running through the US budget will become a significant issue unless the Federal Reserve continues to hold interest rates lower than its inflation mandate suggests. A weak or reticent Federal Reserve will support the US equity market and it will flourish – more so if US fiscal policy becomes unconstrained and undisciplined. Earnings will rise and be unchecked by monetary settings that should be utilised to push cash interest rates higher which then flow through to longer maturity bond yields. It could well lead to a fool’s paradise and a rerun of previous boom busts in the US equity market.
In our view the dilemma for equity investors today is this – the expanded US PER reflects an expectation of earnings growth that leads to three possible scenarios. If earnings disappoint, then equity prices will fall by a significant extent. If earnings meet expectations, then the price already reflects that fact. This may lead to a “buy the rumour and sell the fact” scenario and prices correct. The final possibility is that earnings across the market in 2017 exceed expectations. This is possible, but unlikely unless the USD devalues, oil (energy) prices rise, the US consumer confidence lifts and inflation leads interest rates substantially higher to benefit financial stocks. The problem is these events will work against each other with higher inflation and interest rates pushing up the USD and snuffing US economic growth and earnings plus compressing PERs.

Figure 2 & 3. S&P 500 Index – Price/Earnings Ratio & Earnings Yield
Source. FactSet
 
It is our view that contradictions abound in analysing both the US economic outlook and Trump’s economic policies. This is one reason why the famous hedge fund manager, George Soros, has opined that Trump’s policies will fail. More recently Soros penned a thought-provoking letter that was discussed at the recent Davos Economic Forum titled “These times are not business as usual”. His view is that the world is moving into a destabilised period due to the policy ramifications of the new US Administration and the covert activities of the Russian leadership.
Whilst Soros is a controversial hedge fund manager with some questionable trading activities, there is no doubt that he is a highly educated free-thinker. He has navigated markets for many decades and built up a personal wealth in the billions. He publicly bet against the election of Donald Trump and lost out badly. However, it is not his longer term investment success that justifies our attention but his living history over the last 80 years of change across Europe.
The full text of Soros’s article is here. Our intention in the next section is to focus on some of his key points regarding the current world economy and the rise of Trump to determine the possible ramifications for asset markets.
Some of Soros’s major points:
“I find the current moment in history very painful. Open societies are in crisis, and various forms of closed societies — from fascist dictatorships to mafia states — are on the rise. How could this happen? The only explanation I can find is that elected leaders failed to meet voters’ legitimate expectations and aspirations and that this failure led electorates to become disenchanted with the prevailing versions of democracy and capitalism. Quite simply, many people felt that the elites had stolen their democracy”
– In our letter to investors in December 2106 we noted the onset of political leadership change across the world. It seems to us that the vote for change – was just that. It was not necessarily a vote for new policies but a protest against incumbents whom did not acknowledge the extension of the wealth divide or the lack of security felt by an aging population.
“Globalization has had far-reaching economic and political consequences. It has brought about some economic convergence between poor and rich countries; but it increased inequality within both poor and rich countries. In the developed world, the benefits accrued mainly to large owners of financial capital, who constitute less than 1% of the population. The lack of redistributive policies is the main source of the dissatisfaction that democracy’s opponents have exploited. But there were other contributing factors as well, particularly in Europe.”
– This exemplifies as to why Trump’s election, even if aided by the perculiar structure of College votes, was a protest vote against incumbents. Why would people concerned by the distribution of wealth vote for a billionaire? Hilary Clinton offered more of the same and was seen as an incumbent.
“Democracy is now in crisis. Even the US, the world’s leading democracy, elected a con artist and would-be dictator as its president. Although Trump has toned down his rhetoric since he was elected, he has changed neither his behaviour nor his advisers. His cabinet comprises incompetent extremists and retired generals.”
– Whether Soros is correct or not it does make us observe that if business leaders and capital managers lose confidence in a Trump Administration then the USA could suffer from a capital strike. This could take two forms. External capital providers and creditors may not invest in the US or simply seek their capital back. A mass withdrawal of capital, led by the Chinese Administration that sells down its bond holdings, would pose significant problems for the US Treasury and Federal Reserve. If US corporate leaders lose confidence in the direction of the US or its engagement with the rest of the world, then capital will not mobilise. It is early days in the Trump Administration but the exuberance of the stock market has now been tempered by policy in action. A surge in US stock prices from here, without a tempering of Administration edicts, would suggest that the divide between Wall Street and reality has become too large.
” I am confident that democracy will prove resilient in the US. Its Constitution and institutions, including the fourth estate, are strong enough to resist the excesses of the executive branch, thus preventing a would-be dictator from becoming an actual one.”
There are 3 clear operational checks (outside the fourth estate – the media) to the Trump Administration. There is the enforcement of the Constitution by the Supreme Court (the legal check), the Parliament passing of legislation (legislative check) and the Federal Reserve (financial check). The legal check is already being activated to review the immigration policies pronounced last week. The Parliament has not yet met, but it is controlled by the Republican Party.
The most significant and unknown check will be the Federal Reserve whom will influence the cost of debt for the Trump administration. Late last year the Federal Reserve Chairman suggested that there may be three interest rate adjustments in 2017. It would be a slow adjustment of interest rates towards what is regarded as a normal level consistent with US economic growth and inflation. However, what now must be a huge risk for the Trump administration is that the Federal Reserve becomes a roadblock. How could it do this? Well it may, in spite of the need for quantitative easing support (printing of money), simply refuse to protect the US bond market from a correction driven by foreign creditors. Or it could move up interest rates quicker than expected to stifle the President from imploding the US economy. Remember electors will always blame the President rather than a Federal Reserve Chairman.
The above may sound far fetched but at this point there seems no evidence to suggest that the US President and the Federal Reserve Chairman have even met in their current roles. Furthermore, the President has indicated that he is keen to replace Chairman Yellen but she has stated that she is staying until 2018.
Our view is that the last week, the first of the new US Administration, has sounded alarm bells for asset markets. Investors and business leaders like certainty, whilst traders like uncertainty and volatility. The actions of the US Administration must be closely monitored, as its behavior will determine whether 2017 is the start of the US economic revival or merely a chaotic environment that creates highly volatile asset markets, which reflect an economy and society in deep divide.
Given the current environment and the rally in markets, we are increasing cash levels in our growth portfolios with the expectation that a highly volatile period awaits in coming months.