It’s been a challenge to keep up with the news lately. Since becoming President, Donald Trump has been busy and many of his actions have created emotional responses on both the right and the left. Viewing his actions as an investor, it’s important to take an unemotional perspective. Just like we have trouble making profits in the markets when we allow emotions to interfere with our judgement, it will be difficult to make profitable decisions about Trump’s policies when we allow emotions to get in the way.
After the first few weeks of his administration, we can make a few assumptions about his goals. Trump seems intent on reducing regulation, cutting taxes in some ways while increasing them in other ways, developing a tougher trade policy, shaking up foreign policy and restricting immigration.
This may be difficult, but let’s suspend our emotional responses to each policy and consider how it will affect a typical public company. We’ll tackle each issue in turn and then tie it all together.
Reducing regulation, like almost every policy choice of every President in history, carries both bullish and bearish implications. From the company’s perspective, the cost of compliance would seem to go down and that is bullish. Now, stripped of our emotional response to this idea, it’s important to note that many regulations simply codify common sense. Companies may no longer be bound to follow a regulation but will choose to continue following policies that enhance safety, for example, even if that decision carries a cost. We might eliminate a requirement for workers to wear eye protection at times but companies will still require it because it makes sense to do so. On the bearish side, without regulation there will be less or unpredictable use of many of the best practices and this could lead to increased costs for companies. There could be higher insurance costs or litigation costs that offset reduced compliance costs. On net, cutting regulation comes with both cost savings and increased costs and is most likely neutral for most companies.
The same is true for idea of cutting taxes in some ways while increasing them in other ways. One popular idea is to cut income taxes. This should increase the bottom line for most companies, assuming everything else is equal. Well, we already know everything else will not remain equal. Congress may decide that income tax cut needs to be paid for with a border adjustment tax. This is a complex idea so let’s take a simple example of what it could mean.
Much of America’s produce is imported. The average retail price for an avocado is about $1 and many avocados are imported. A border adjustment tax of 20% would add costs to the avocado and those costs will be passed on to retail customers. Companies rarely, if ever, accept lower profit margins when taxes rise. The border adjustment tax will be added at the border and will increase the wholesale cost. Assuming the wholesale cost of the avocado is $0.50, the tax will add a dime to its retail cost and increase the consumer’s cost to $1.10.
Government revenues will be neutral under this scenario with the border adjustment tax paying for the income tax cut. Companies are likely to pass on the costs of the border tax to consumers. Companies are also likely to retain the benefits of the income tax cut. This should lead to relatively stable operating margins but may not result in higher profits because total sales are likely to decline for some companies and increase for others. At the grocery store, for example, consumers may spend a little more but this means they may have to cut back on movie theater spending.
Again, on net, we have tax policies that are likely to reduce revenue for some companies and increase revenue for others while profits hold relatively steady. There will be disruptions at the company level but we need to wait for specific policies to be enacted before we can determine individual winners and losers.
This same theme will be true for changes related to a tougher trade policy. This idea of tariffs is not new. It was a dominant factor in the 1896 Presidential election which was also held at a time of economic concerns with higher than average populist sentiment.
In that election, the winner, William McKinley, was widely supported by the “tin men” who often showed up at his rallies wearing tin hats. McKinley promised a tariff on tin products imported from overseas which local tin producers wanted to maintain their businesses. Consumers, of course, paid for the tariff with higher prices on tin goods. The losing candidate, William Jennings Bryan, promised prosperity through inflation, noting that higher prices would lift the economic prospects of farmers and small businesses. It’s likely 1896 was the last time campaigns focused on monetary policy but the most recent campaign raised the same issues in a less direct manner.
Markets at that time were largely in a trading range.
Tariffs will protect some jobs and they will raise some prices. This is an example of the good and bad associated with any economic policy as we can see if we consider Wal-Mart for a moment, again without emotion. Everyday low prices from America’s largest retailer held down inflation and one MIT economist estimated the stores increased the buying power of consumers by about 3.75%. These lower prices, however, mean lower wages and each Wal-Mart store costs taxpayers $1 million or more in increased costs for safety net programs. Given the choice, most consumers would want lower prices and higher wages. But, you can’t have both. This is a basic law of economics.
With tariffs, once again, there will be winners and losers under Trump’s trade policies. Tariffs will create winners among domestic manufacturers and this is the area investors should probably watch most closely. As tariffs are announced we will look for potential investment opportunities. Consumers will be the losers paying higher prices and consumer discretionary stocks are likely to suffer.
Trump is also expected to shake up foreign policy and here there are likely to be significant market effects. However, rather than focusing on companies it could be best to watch foreign exchange markets, gold and, especially, oil. Changes in the US relationship with Russia, for example, might impact the euro. Those changes will almost certainly impact the price of oil since Russia is a large oil producer. The Middle East will be a hot spot under Trump, just as the area has been for every President since Jimmy Carter. This is likely to lead to wide swings in oil prices and traders should consider taking positions in exchange traded notes (ETNs) that offer exposure to oil. An ETN is similar to an ETF but holds derivatives rather than stocks and are a great investment choice for exposure to some commodities.
Finally, Trump’s most controversial policy changes may be related to restricting immigration. This could affect some stocks in a small way, increasing the cost for some tech companies that recruit the world’s best talent for example. It could, perhaps most significantly, raise costs sharply for some companies that rely on immigrants for their work force, especially meat producers who have become large employers of immigrants willing to take on a physically challenging job. This policy, if enacted, will likely lead to few gains in the stock markets and could be a source of trade ideas on the short side.
These will be dramatic changes, but remember we have seen similar policies before. In the early-1900s stocks were in a trading range with frequent bouts of volatility. That’s likely to happen again.
Like you, we will be watching the news and reacting to policy rather than rumors. When policies are clear, we will have more specific trade ideas. Until then, we urge you to watch foreign policy, trade policy and immigration policy as the most likely sources of Black Swan events.