Thursday, May 25th, 2017
Hello again everyone, I’m David Walker from StocksInValue. In this week’s investment committee we began as always with a discussion of the market and macro environment and what this meant for our portfolio positioning with regard to capital deployed, the risks the portfolios are taking, and expected outcomes. Since what you are buying with StocksInValue is access to the thinking of a fund manager, I thought you would be interested in two investing themes influencing your portfolio’s performance this year.
The first theme goes to what caused the sharp selloff on Wall Street on Wednesday night our time, followed by a more moderate down day on the ASX on Thursday. US political risk is driving markets and investors need to understand where this could take us. First to recap this week’s developments in Washington, the impending public testimony of sacked FBI director James Comey, the appointment of a Special Prosecutor and controversy over revelations President Trump shared classified intelligence information with Russia have increased the pressure on the Trump Administration and prompted calls from some corners of Washington D.C. for his impeachment.
These developments mean being in government does not necessarily equal party cohesion or the rapid advancement of a policy agenda. The so-called Trump Trade which propelled global equities higher since the 9 November election would deflate were the Administration unable to pass the tax cuts, infrastructure spending and deregulation the market wants.
Let me take you through how I see this playing out. I regard impeachment before the 2018 midterm elections as unlikely because although his nationwide approval ratings have fallen, President Trump continues to be popular with his voter base. And although some prominent figures from within the Republican party establishment have voiced concerns about Trump’s leadership as well as called for changes in staffing of the White House, the Republican party establishment continues to remain broadly loyal to the president.
For Republicans, control of the White House and both houses of Congress is a once-in-a-generation opportunity to pass key items on the party’s agenda, mainly Obamacare repeal, tax reform and de-regulation. The party is unlikely to want to jeopardise this opportunity unless there is no alternative.
If the party were under some scenario to agree to impeachment proceedings, and Vice-President Pence were eventually to take over as President, much momentum and credibility would likely be lost in the process and equity markets would fall significantly unless Trump’s stimulus package looked like passing.
Many modern US presidents have seen the appointment of special prosecutors, investigations or the initiation of impeachment proceedings (the Iran-Contra scandal under President Ronald Reagan, Whitewater under President Bill Clinton and more) during their tenure, and continued to govern and see out their terms. Impeachment procedures as drafted by the US Founding Fathers are vague, but crucially, impeachment of a President requires the approval of both houses of Congress.
Further investigations or revelations could potentially result in hard evidence of “treason…high crimes or misdemeanours” as stipulated in the US Constitution, so eventual impeachment cannot be ruled out completely. But to date no US President has been impeached by his own party, and given the highly charged partisan environment in Washington, evidence of a breach deemed sufficient to trigger impeachment proceedings would have to be very robust. However, if there is a change in the composition of control in Congress in the 2018 midterm elections, and Democrats pick up significant seats, the political calculus could change.
So my base case is investors should be prepared for continued headline risks and delays in Trump’s policy agenda, with some stimulus and deregulation policies ultimately derailed but some going through. Already the failure to pass healthcare reform and the distractions from the ongoing allegations of Russian interference in the US elections were delaying President Trump’s policy agenda. Efforts to reform healthcare are likely to resume in coming months and passage would boost Republican party morale as well as investor sentiment.
On other tax reform, there is still the potential for tax reform to be pushed out to 2018 as the chaos in the White House consumes political oxygen while the Republican party remains divided. Also losers from the reforms will lobby aggressively against changes to the status quo.
Since the election my base case has been no net stimulus from Trump in 2017. This does now look like happening. And I doubt Trump will be impeached and leave office this year. The outlook for Wall Street will therefore continue to be driven mainly by US economic growth, inflation and corporate earnings.
And on all those fronts the outlook is good as the economy grows with low inflation and corporate earnings rise with it. Multiples on Wall Street are high, which will restrain the rally. Political noise from Washington will cause minor volatility around this underlying benign outlook.
Our second theme goes to this overall favourable economic and earnings outlook for Wall Street, which provides those crucial overnight leads for the ASX. You will have heard about how the so-called fear gauge for Wall Street, the “Vix” index, went to 25-year lows recently. The chart on your screen shows the spike in the GFC with smaller jumps more recently before the resolve to today’s lows.
Below your screen I’ve included a link which explains what the Vix is, how it’s calculated and how to interpret it but the main point I want to make is the Vix has poor predictive power. Just because volatility is extremely low now does not mean markets are about to crash tomorrow. After previous periods in 1993 and 2006 when the Vix was this low, stocks kept on rising for another two to three months afterwards. And when the rallies did break there were only modest market corrections.
Now admittedly only two periods in the last 17 years isn’t statistically significant but it does suggest the Vix falling below 10 doesn’t necessarily predict imminent market turmoil. The Vix could stay low for some time yet. What low volatility does mean is a negative shock would probably cause a sharp reversion to higher volatility, in other words heavier market falls. But it won’t be the Vix index itself that predicts that event. It’s up to all of us as investors to predict those and manage our portfolios according to the probabilities we assign to our bull, bear and base cases.
So after this discussion, amongst other macro matters like Chinese data, US wages and inflation, we left overall cash weightings where they were because we decided macro risk hadn’t changed significantly since last week’s investment committee meeting. And that’s a window to how we operate as fund managers. I hope you’ve found this insight useful and I encourage you to form your own views on the topics discussed today because they are influencing your portfolio’s returns.
Thankyou for watching, and I’ll see you next time.