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The Trump complex

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It is hard to predict the impact an unconventional president with no political experience and who communicates with the world via Twitter will have on financial markets.

Adding to the uncertainty are the policy contradictions. How will Donald Trump’s intended relaxation of individual and corporate taxes and increased infrastructure and defence spending be funded given his intention to implement protectionist trade policies, which are likely to have negative impact on the economy?

At the heart of this contradiction is a policy clash; Mr Trump and the Republican Congress have different economic plans. Jan Dehn, head of research at Ashmore Group, says: “While part of Mr Trump’s plan overlaps in part with that of the Republicans’, other aspects are at odds with it.”

The confusion is further compounded by Mr Trump’s personal agenda. He is delivering immediately on many of his campaign promises but without thinking through either the delivery or the legal constraints of these policies, adds Mr Dehn.

All these complexities are being played out against the backdrop of the late-stage economic cycle. Mr Trump’s presidency coincides with the end of a significant rally in the US economy and financial assets.

Mr Dehn says: “The US has full employment, stock markets are at historic highs, bond markets at historic lows and the dollar is 20% overvalued.”

To ensure re-election, Mr Trump needs to keep the economy booming. Infrastructure spending could help to bolster the economy but it is unlikely to happen quickly.

While there is cross-party agreement for infrastructure spending as a concept, there is very little consensus around how this should be implemented. Brendan Mulhern, global strategist at Newton Investment Management, says: “Without a proper plan and fiscal hawks in the cabinet, any policy will take a long time to foment.”

Fiscal policy would be a more straightforward way to bolster growth. Both Mr Trump and the Republicans agree on the $1.8 trillion corporate tax cut but implementing this would create a significant hole in the US government budget.

To fund this tax cut, the speaker of the US House of Representatives, Paul Ryan, has suggested changes whereby firms no longer pay tax on foreign profits but companies would no longer be able to deduct the cost of imported goods from the profits. Together these two policies would act as a ‘border adjustment’, which would penalise imports and subsidise exports.

In theory such border adjustment should have a neutral impact because both policies should push up the value of the dollar equally and the currency impact would be offset by the tax effects.

But it might take time for the dollar to appreciate as pushing it to higher levels might be difficult given the currency has already appreciated significantly. There is a risk that the impact would be felt more heavily by the importers and there is also a risk that this policy will be in breach of World Trade Organisation rules.

In addition to these problems, the recent statements by National Trade Council director Peter Navarro about Germany abusing the euro for its own gain indicate that the US wants to move to a weak dollar policy. Mr Dehn says: “That’s a major shift in US policy.”

All of these factors make it less likely that Congress will approve such a dramatic cut. Mr Dehn says: “It’s likely the corporation tax cut will be only a third of the original size.” That will put a greater onus on a weak dollar policy as the principal mechanism to drive US growth.

But if Mr Trump continues to pursue his personal agenda and implements his protectionist policies, the weak dollar policy could be undermined.

Katie Roberts, investment director at Fidelity International, says: “If Mr Trump pursues his protectionist agenda this could undermine the weak dollar policy as it could cause wage inflation as jobs are brought back to the US.” Employment rates are already high in the US which would put considerable pressure on wages, she adds.

The implications of this policy would not be confined to the US. Gavin Ralston, head of official institutions at Schroders, says: “These policies could slow growth not only in the US but around the globe.”

Mr Ralston says that of all Mr Trump’s policies this is the riskiest as it is difficult to predict the precise policy and the impact. He says: “We will be keeping a close eye on how this protectionist agenda develops.”

In such uncertain times, investors should maintain a cool head to determine the right investment strategy.

Mr Dehn says: “Investors need to calibrate asset prices relative to the underlying risks.” Now there are significant risks in the US coupled with very high asset prices, it makes sense for investors to allocate to non-dollar denominated assets.

Julian Lyne, global head of distribution at Newton Investment management, agrees: “Valuations moved up considerably in the post-election rally and we question how these can be sustained.”

Emerging market debt looks well-priced relative to other assets. A series of crises – the taper tantrum, the strong dollar, the fall in commodity prices and the start of a Federal Reserve hiking cycle – caused investors to shun these markets and assets are still undervalued as a result.

But these crises have acted as an effective stress test: despite this turmoil, there have been relatively few sovereign or corporate defaults, adds Mr Dehn. “While local currency debt has already appreciated, it’s likely this trend will continue.”

Emerging market equities also have appealing valuations and fundamentals, but investors need to be wary of continued volatility in these markets. Ms Roberts says: “We opt for an active approach, looking to reduce our overall exposure to market beta but capturing alpha by selecting the right companies.”

Concerns over the impact of Mr Trump’s protectionist policies continue to overhang emerging market equities. Paul O’Connor, head of multi-asset allocation at Henderson, says: “It will take some time to dispel some of the more bearish scenarios until there is greater clarity in Mr Trump’s trade policies.”

Mr Ralston adds: “It may well be the case that the impact of Mr Trump’s trade policies will be less negative than expected, so markets could correct quickly.” That makes it important not to have too underweight a position, he adds.

The potential for equity market volatility will not just be confined to the emerging markets. Mr Lyne says: “The LGPS may want to review its exposure to index funds.”

While ultra-loose monetary policy and a benign political environment drive up market-capitalisation weighted indices, a sharp increase in rates and political risk could result in unexpected volatility.

Mr Lyne says: “Investors should think about diversifying not only their investments to manage risk but also their approaches.” The LGPS should consider allocating away from passive strategies towards active strategies as well as incorporating absolute return strategies, he adds.

Dave Lyons, head of public sector investment consulting at Aon Hewitt, adds: “Diversifying away from market-cap weighted indices to indices using less volatile metrics would be beneficial.”

Investors should consider allocating away from equities into alternative assets and private market assets, he adds.

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