(For those who wish to skip the wonkish intermediate steps and analysis, please proceed straight to the conclusion)
"The new administration’s plan for a large fiscal stimulus seems poorly designed, oddly timed, and very unlikely to produce the sustained strong growth that Trump claims he will provide. Even in the unlikely possibility that we do achieve the growth Trump is calling for, it is not obvious that it would be the boon to the stock market that investors seem to think. The fiscal stimulus does, however, seem likely to lead to tighter monetary policy and has a reasonable chance of leading to rising inflation."
This is how the latest letter by GMO's Ben Inker begins, and by the tone and narrative, it is clear that the author is quite skeptical about the success of Trump's proposed policies. Inker first goes back to his previous scenario analysis in which the economy ultimately falls into one of two outcomes, "hell" or "purgatory", and makes it clear that he does not anticipate any notable changes as a result of the Trump administration. For those unfamiliar, here is a refresher:
The key metric that I believe has driven market valuations upward in recent years and could conceivably drive them right back down is short-term interest rates: So much of this comes down to a question of whether cash rates over the next 10, 20, or 50 years will look like the “old normal” of 1-2% above inflation or whether they will look more like the average of the last 15 years of about 0% after inflation. The scenario where they average 0% real is what we have referred to as “Hell,” whereas the other scenario is “Purgatory.” On the eve of the US election in November, the US 10-year Treasury Note was yielding about 1.55%, which suggested the bond market at least was very much in the Hell camp. As of year-end, that yield has risen 90 basis points to 2.45%, which is at least closer to a level consistent with Purgatory.
At this point he makes it clear that GMO, unlike other "fast money" flipfloppers, has not changed its mind:"a number of our clients asked us if we have changed our minds about the likelihood of Hell, as the market seems to have. The short answer is that we have not. If Hell is a permanent condition for markets, it should not be readily changeable by the policy choices of a single US administration, to say nothing of the fact that we do not yet know what those policy choices will be for an administration that has just taken office."
Inker's point that not only will implementation of Trump's policies be problematic, it may not achieve much at all, is valuable, even if it remains largely ignored by the market; earlier today JPM warned of essentially the same. He then lays out two discrete theories as to how the US economy got to a point where Trump is in charge, the first focusing on secular stagnation as explaining the slow grind lower in US productivity and output:
"This line of argument can be boiled down to saying that the reason why exceptionally easy monetary policy has not been particularly stimulative and/or inflationary is that the “natural” rate of interest has fallen to extremely low levels relative to history. If this argument is correct (and secular stagnation is a reasonably permanent condition for the developed world, not just a temporary effect of the 2008-9 financial crisis), then we should see that as interest rates rise to levels that are still low by historical standards, they will choke off economic growth."
The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful.
"This line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous. There is no question that monetary policy affects the financial economy."
Here Inker explains that no matter which of the two scenarios preventing US growth ends up being correct, he is skeptical US growth can rebound to the Trump promised 4%.
Sustained high growth in the context of a slowly growing population requires fast productivity growth, which the US economy has been particularly bad at delivering of late. Exhibit 2 shows 10-year trailing productivity growth in the US.
The current trend looks to be something south of 1.5%, and population growth is set to add somewhere between 0.2-0.5% to the workforce over the coming decade, absent a change in labor participation rates or a burst of immigration.4 While it is tempting to believe we can return to the 3% productivity growth that we saw for the decade ending in 2005, the reality is that is probably a pipe dream. The overwhelming driver of the spike in productivity in that decade was the extraordinary growth in production of IT equipment, which grew at 10% real per year for the decade ending in 2005, despite a declining number of people employed.
So, A massive reacceleration of productivity seems unlikely. And it’s possible that looking at the trailing 10-year number understates how slow productivity growth has gotten, as productivity over the last 3 and 5 years has averaged 0.7% and over the last 12 months a nice round 0%. Attempting to grow a 1.5-2% economy at 4% is a recipe for inflation, and this is where the Trump effect will help us answer questions much more quickly than we would with a president enacting more conventional policies. Any acceleration of inflation will require far faster interest rate increases than is generally being priced in and we will likely learn relatively quickly whether the economy can withstand those increases."
But here Inker asks the question that the markets appear to be taking for granted: "What if Trump succeeds?"
This line of thought, to the disappointment of stock bulls, does not lead to a favorable outcome for equities. Here are the key points:
if we assume for a minute that somehow the economy really does grow at 3.5-4%, this probably will not be the panacea for equity investors that some are assuming. First, it seems more or less impossible that the right interest rate level for an economy growing at 4% would be 0% real. So Hell, in that case, would seem to be off the table, and with it a big part of the justification for higher P/Es for the stock market. And while the faster growth would seem at first blush to be a big plus for equities – after all, it would mean that corporate revenues will grow significantly faster than they have been – our best guess is actually that faster growth might well be associated with a stock market trading at significantly lower valuations than today. The 1960s and 1996-2005 periods may have been the halcyon days of productivity in the US, but it is the current period that has been best for profitability, as we can see in Exhibit 3.
In both the 1960s and the 1996-2005 periods, profits were about 6.5% of GDP, against an average of 8.5% in the most recent decade. The slowdown in productivity growth certainly didn’t seem to hurt corporate profitability much, so it seems odd to assume that a hypothetical increase in productivity will push it up still higher. In fact, for an economy in which consumption is around 70% of output, one can make the argument that a necessary condition of sustained strong economic growth would be the share of income going to labor going up from here. This would almost certainly require corporate profits to fall as a percent of GDP. And if profit margins fall materially, even a moderate acceleration of revenue growth would lead to falling, not rising, overall profits.
What about the cut in corporate tax rates? Surely that will be a positive for the stock market, Inker muses rhetorically?
It is possible that it will be, but it is neither theoretically clear that it should be nor empirically obvious that tax rate changes have been particularly important to profitability. Exhibit 4 shows after-tax corporate profits versus corporate tax rates since 1947.
It’s hard to see a lot of correlation here. While tax rates are currently at about their lowest levels and corporate profits just off of their highest, tax rates did their falling in the 1980s and the profit spike was a good 20 years later. Given that lag, it strains credibility to argue that the tax rate fall was an important driver of the rising profitability. What you would want to see is a relationship such that when tax rates fall over a period, profits rise. This does not seem to have been the case, as the correlation between tax rate change and profit change as a percent of GDP is positive over 3-, 5-, 7-, and 10-year periods.
This means that tax rate falls have generally been associated with falling, not rising, profits. Your microeconomics professor probably would have taught you that corporate taxes should be a pass-through, just as sales taxes are. Because corporations are interested in their after-tax return on capital, a change in corporate tax rates should generally affect output prices, not profits. That would make a fall in corporate tax rates at best a one-off windfall and possibly a wash. It is easy to imagine that a burst of economic growth might create a stock market bubble, as occurred in the late 1990s. But in terms of what the stock market is actually worth, if faster growth leads to interest rates returning to historically normal levels, the safe bet is that equity valuations will eventually find their way back down to historically normal levels as well.
So what does a Trump policy "success" mean for various asset classes and prices? As the above lays out, not even a world in which GDP somehow regains 4% annual growth assures the kind of surge to equity prices and valuations that the market has tried to price in. As Inker puts it, "it brings us back to the odd paradox about Purgatory and Hell. If Trump’s policies work or if they otherwise demonstrate that we are not stuck in secular stagnation, it’s bad for stocks and bonds and good for the economy. If we wind up back in recession, it’s good for bonds and not necessarily terrible for stocks because valuations can stay high, buoyed by low cash and bond rates.
Nonetheless Inker, true to his skeptical nature, is pessimistic:
It is hard to be particularly hopeful about the prospects of the incoming administration’s economic policies. Certainly, if they are predicated on an actual belief that the US economy can sustainably grow at 4%, they are more likely to lead to accelerating inflation than anything else. But there is a meaningful plus side to what Trump is doing. Whether he succeeds or fails, we are likely to learn some useful things about the economy and therefore where valuations will wind up in the coming years. While neither Hell nor Purgatory are particularly happy outcomes for investors, either one is arguably better than our current stay in Limbo, where it is difficult to even prepare for whichever future awaits us.
We are still putting the higher probability on the Purgatory outcome, which implies that rising rates will not kill the economy. But our collective confidence in that outcome is not close to high enough that it makes sense for that to be the only scenario we should be preparing our portfolios for. For now, we are still in Limbo and are focusing on making the best we can out of an uncertain investment landscape, building a portfolio that can survive either scenario. This means focusing first and foremost on those areas where we believe either leads to decent outcomes. Emerging market value stocks are first on that list, followed by alternatives such as merger arbitrage. After those come EAFE value stocks and US high quality stocks. At current yields, TIPS are a reasonable holding in multi-asset portfolios whether we are in Purgatory or Hell, although they do look a good deal better in Hell. Credit, while less exciting than it was a year ago by a good margin, fills out the list of assets that seem worth holding in either scenario. Other assets, such as broad US equities or developed market government bonds, seem hard to love in either of the plausible scenarios, and are consequently hard for us to want to hold.
The good news is that unlike any other administration, the jury on whether Trump's policies have been success or failure will only be out for a relatively brief period of time.