Second, Trump is a big proponent of financial deregulation and has already taken steps to ease the regulatory burden on financial institutions through executive orders. Deregulation offers the potential benefit of freeing up more capital for financial institutions to lend, supporting loan growth, and can also reduce legal and compliance costs. Deregulation may also provide additional revenue opportunities that may not have been available under an Obama or Clinton administration. For example, the Volcker rule, which prohibits banks from engaging in proprietary trading and restricts hedge fund and private equity investments, may be only loosely enforced or watered down to allow banks to do more with their capital.
Like small caps, financials have more going for them than just a potential policy boost. The sector, one of the more domestically focused, is benefiting from underlying recent improvement in the U.S. economy. Inflation has picked up and is starting to—intermittently—put some upward pressure on interest rates. The Federal Reserve (Fed) raised its target interest rate (the federal funds rate) twice in the past four months with little consideration for prospective pro-growth policies (although the strong stock market may be playing a role in Fed psychology). Healthy credit markets reflect oil’s rebound, while financials enjoyed a very strong fourth quarter earnings season with little help from Washington, D.C.
Even if only a scaled-down version of the Trump agenda is implemented, we believe the underlying improvement in the U.S. economy and potential for higher interest rates are enough for at least a moderately positive view of financials. Add to that the potential upside of corporate tax reform (the sector’s domestic focus may result in an above-average benefit from a reduced corporate tax rate), deregulation, and still reasonable valuations, and we would view financials’ recent underperformance, also shown in Figure 1, as a potential opportunity.
INDUSTRIALS
Trump’s plans to increase spending on infrastructure and defense have made the industrials sector a popular Trump trade. Trump has proposed a massive $1 trillion spending plan over 10 years ($100 billion per year) through public-private partnerships; numbers we believe are very unlikely to even be approached. We have expected the deficit hawks in Congress to significantly reduce, or eliminate, the potential for a federally funded infrastructure spending program, while the availability of large and profitable projects the private sector would take up is limited. On top of that, given the Republicans’ inability to get an Affordable Care Act (ACA) replacement to the House floor for a vote on March 24, 2017, getting a significant spending bill through Congress is likely to be very difficult.
Recent headlines have suggested a possible pairing of corporate tax reform and infrastructure spending. Though possible, we view this path as unlikely. Such a deal would likely require adding to the deficit (a problem for the Freedom Caucus in the House) or support from moderate Democrats, which is tough to see even though Democrats are generally pro-infrastructure. In this scenario, corporate tax reform would be particularly difficult to achieve and we see infrastructure getting pushed out to 2018.
Turning to defense, Trump has proposed a $54 billion increase in the defense budget, which would put defense spending at about 10% above fiscal 2015 levels. Although we do not know what budget increase will ultimately be passed (it’s probably smaller), it is clear that defense spending is a priority of this administration and is likely to rise. Global defense spending growth may also pick up from its marginal pace of recent years as a result of Trump’s call for other nations to shoulder more of the financial load for their own protection and global interests.
Of these three so-called Trump trades, the foundation for this one may be weakest. Although we expect a pickup in capital spending, partly due to expected policy support, it has been lackluster in the U.S. in recent years. The sector’s valuations are above average and the risks to the sector from trade protectionism, lower oil prices, and a strong U.S. dollar are concerning.
Industrials’ relatively small post-election rally [Figure 1] leaves less to give back should investors become more skeptical in the Trump agenda. However, we believe the sector may need help from stronger global growth, the long-awaited pickup in capital spending, and higher oil prices to produce strong performance in 2017. It may come, but several things have to fall into place.
CONCLUSION