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Market Implications of the First 100 Days: What’s Next? MACRO INSIGHT | 2017 As the Trump Administration approaches the 100-day milestone, Morgan Stanley Investment Management’s senior investment leaders discuss how the President’s policy agenda is affecting their outlook on global equity, fixed income and listed infrastructure markets. The Trump Administration seems determined to encourage an increase in business investment while driving a fundamental shift in economic policy from managed growth to organic growth, although the market is learning that this may take longer and be more watered-down than initially hoped. We believe this means that Fed policy rates should rise, along with inflation expectations and interest rates. As a result, we think credit-sensitive sectors of the market should outperform. In the equity markets, we feel that the impact of the first 100 days has been slightly negative but largely irrelevant. We believe Q1 market performance is a result of an earnings recovery and not the Trump effect. Additionally, the anticipation of fiscal policy reform has greatly cooled since the inauguration. Looking forward, we believe the Trump administration could impact the market more favorably over the next 100 days than the first 100. Regarding infrastructure, the post-election reaction has been mixed, with some investors still confident in the President’s ability to stimulate certain areas of the asset class over the near-term, while others have taken the President’s inability to execute changes to health care policy and to progress tax reform as a sign that infrastructure initiatives may take much longer. While we would agree with the view that new laws designed to directly accelerate infrastructure spending may take longer than originally anticipated to materialize, certain actions taken within President Trump’s first 100 days are encouraging, most notably within energy infrastructure where the President has looked to advance certain capital projects sidelined during the Obama administration. As the President eventually executes on his tax policy agenda and the economy continues to improve, this also should support fundamentals in the sector and be additive to what has already been a robust start of the year for the asset class. AUTHORS JIM CARON Portfolio Manager, Global Fixed Income Team ANDREW SLIMMON Portfolio Manager and Head of Applied Equity Advisors Team MATT KING Portfolio Manager, Global Listed Real Assets MACRO INSIGHT First 100 Days and Beyond: A Framework to Understand Trump and Economic Policies JIM CARON Portfolio Manager, Global Fixed Income Team There is a lot of confusion surrounding the Trump presidency, as the administration is just beginning to define its economic policy. We therefore found it necessary to create a framework to help explain the potential policy paths (Exhibit 1). The framework comes in the form of a ”decision tree” that helps reduce complexity and illustrates what might be the logic behind the path of these economic policies that could otherwise be elusive to many. It is simply our attempt to understand things better and to use it as an input in our decision-making process. Let us explain the decision paths in more detail. A FUNDAMENTAL SHIFT IN ECONOMIC POLICY Trump is not only presiding over but ushering along a fundamental shift in economic policy from what we refer to as managed growth to organic growth. The connotation of managed growth has to do with the use of central bank purchase programs to reflate asset prices such as quantitative easing (QE). During this type of policy regime, fundamentals matter less than technical factors of supply and demand that come from central bank activities to lower risk premia and reflate asset prices. Organic growth is simply a regime in which asset prices are driven by more traditional factors such as economic fundamentals. The shift from managed growth to organic growth has already begun and has preceded the Trump presidency as was evidenced in mid-2016. President Trump, however, is accelerating the process. Evidence that QE polices are already unwinding is reinforced by recent discussions by the U.S. Federal Reserve (Fed) to reduce their balance sheet holding of U.S. treasuries and mortgage-backed securities purchased during QE. THE “YES” PATH If you believe this fundamental shift is occurring, then you follow along the “Yes” path. The next question is how this transition will occur under President Trump. We see it coming primarily from two areas: fiscal stimulus and regulatory reform. Fiscal stimulus. Some of the fiscal stimulus could come in the form of infrastructure investment and spending; however, this will be long-term and with little immediate impact on economic activity. Stimulus would be stretched out and parceled over many years. The main form of stimulus that would more immediately be felt is tax reform. In particular, we would look most kindly on reforms that not only lower rates but create incentives for business investment to increase productivity. Regulatory reform. In the financial markets, we tend to think of the positives of regulatory reform as reshaping Dodd-Frank so that it is less onerous. We believe such changes will benefit community, small and mid-sized banks that tend to lend to small businesses – a sector of the market that has had difficulty accessing capital and accounts for over 60% of job creation in the U.S. In the industrial and manufacturing sectors1 , President Trump has been signing executive orders and actively finding ways to reduce excessive regulatory burdens. This is expected to translate into increases in production and investment in these sectors of the market. 1 Source: Morgan Stanley 2 MORGAN STANLEY INVESTMENT MANAGEMENT MARKET IMPLICATIONS OF THE FIRST 100 DAYS: WHAT’S NEX T ? DISPLAY 1 Investment Decision Tree: Trump and Economic Policies A FUNDAMENTAL SHIFT FROM MANAGED GROWTH TO ORGANIC GROWTH? YES FISCAL STIMULUS NO REGULATORY REFORM HIGHER POTENTIAL GROWTH INVESTMENT IMPLICATIONS Higher: r*, inflation, rates Credit: less rate sensitive Source: MSIM, Data as of April 17, 2017. Note: r* refers to the neutral real equilibrium Fed Funds rate. INVESTMENT IMPLICATIONS Lower: r*, inflation, rates Credit: more rate sensitive MACRO INSIGHT Ultimately, the goal of President Trump’s economic plan is to increase potential growth. Note that potential growth has been declining over the past several years as corporations have been reluctant to invest in their business. If one does not invest in their business, it is no wonder why productivity and potential growth have steadily fallen. President Trump’s policies are aiming to reverse this trend. Judging by the meetings President Trump has had within the first 100 days in office with business leaders from both small and large companies, he is sending a strong message to corporate America that his administration will support and encourage in every way the increase of business investment. From a fixed income investment perspective, it means to us that Fed policy rates should rise, along with inflation expectations and interest rates. However, we expect this rise to come at a measured pace. Fed policy is still very easy, and hikes in the Fed funds rate should be viewed as a reduction in excess accommodation, not a tightening, until the nominal Fed funds rate exceeds their neutral target rate of 3.00%. As a result, we think credit-sensitive sectors of the market should perform better as support for fundamental economic drivers of the market improve and reduce default risks. THE “NO” PATH If we find evidence that there is no fundamental shift taking place, we could possibly return to the old post-crisis playbook of the past several years, with central bank polices dominating the technical drivers of asset prices. The Fed would likely keep rates on hold or possibly cut them. Potential growth and inflation expectations would fall. Interest rates would stay low and credit may underperform longer-duration, interest rate-sensitive assets. CONCLUSION It is clear that President Trump would like to go down the “Yes” path; however, it is unclear how well he will be able to execute his economic plans. At the start of his presidency, the market was pricing a high likelihood that his polices could succeed quickly. As we come to the end of the first 100 days, the market is learning that it may take longer for his polices to be enacted and that we may end up with a somewhat watered-down version of what was originally hoped for. Nevertheless, from a macro perspective, the market still believes the “Yes” path is the right path and that it will prevail. It’s just a matter of time and degree. 4 MORGAN STANLEY INVESTMENT MANAGEMENT MARKET IMPLICATIONS OF THE FIRST 100 DAYS: WHAT’S NEX T ? What Have Been the Implications of the First 100 Days of the Trump Administration on the Market? ANDREW SLIMMON Portfolio Manager and Head of Applied Equity Advisors Team Let me answer this question for US equities succinctly: very modest negative, but largely not relevant. In my January 2017 Outlook, “Did 2016 ‘Steal’ 2017 Returns?”, my contention was that the strong fourth quarter 2016 U.S. equity returns was the result of the anticipated earnings recovery in 2017. As I wrote: As much as many pundits have ascribed the market rally to the ascendancy of the Trump presidency, what really was starting to change was the upcoming earnings inflection. To be clear, S&P 500 earnings growth for the entire year (2016) was a paltry 0.6%. And yet the index appreciated by 9.5%, all of which came later on the year. Why? Because as we enter 2017, earnings growth is estimated at 12%. Much better earnings growth than we have experienced the last two years. Now as we end the first quarter of 2017, the SPX has tacked on another 6.07% return. The good news is that this move year to date continues to be validated by the earnings recovery we are currently experiencing. Hence I don’t anticipate much downside for the market. The bad news is that adding in equity returns for 2016 and 2017 means we have now largely captured the 2017 earnings recovery. To make further gains from here, forward earnings must continue to inflect higher. Therefore, we need to see either much stronger economic data or some other catalyst. If not, we very well may not see much further gains for equities until late this year, when, consistent with history, the market begins to focus on 2018. But what about the Trump effect? Clearly, anticipation of fiscal policy reform has greatly cooled since the inauguration. The health care setback has undermined the belief that corporate tax cuts, tax repatriation of cash holdings and infrastructure spending would happen in 2017. And that is probably why the market has largely flatlined since early March. But if the market had only rallied on these hopes, then surely the market would have given more back than it has since the health care debacle. To me, this validates the argument that the market is up on earnings recovery, not Trump. If Wall Street had begun to factor tax reform into their earnings estimates, then inevitably we would see significant negative revisions for the overall market. Which we are not seeing. And yet, what if fiscal policy reform actually does begin to take hold? That could well prove to be this next needed catalyst: We believe Wall Street would be forced to raise numbers if in fact reform does move forward, even if at a slower pace than what was expected earlier this year. Why? Because now expectations are very low. So the setup for positive surprise and potential positive estimate revisions could be in place. As I wrote in January: Fiscal policy reform won’t be linear. Expect some disappointment along the way. I will take low expectations over high expectations any day. And that sets up nicely for the next 100 days. For that reason, we believe the Trump administration could impact the market more favorably over the next 100 days than the previous 100. MORGAN STANLEY INVESTMENT MANAGEMENT 5 MACRO INSIGHT Listed Infrastructure Investing and President Trump’s First 100 Days MATT KING Portfolio Manager, Global Listed Real Assets In the immediate aftermath of President Donald Trump’s victory, infrastructure investing came into sharp focus as investors forcefully extrapolated outcomes based on campaign promises to improve the state of U.S. infrastructure. One hundred days after taking office, the ultimate impact of the Trump presidency on infrastructure remains uncertain. Details on his $1 trillion proposal continue to be scarce, particularly around the level of private market participation and the mechanisms by which federal policy will translate down to the municipal and state level. That said, directionally the rhetoric seems positive as the Trump Administration continues to emphasize their plans to improve the state of U.S. infrastructure. In turn, this could present opportunities for investors in listed infrastructure securities, where investors can find a number of companies that may potentially benefit from more attractive tax subsidies or policies the Administration may put in place to achieve their stated goals. Listed infrastructure companies may also benefit from new investment opportunities, a greater number of asset auctions and a more accommodating regulatory environment. While we would caution investors against premature speculation regarding the ultimate impact of the Administration’s infrastructure plan, we do believe the potential benefits may be greatest within certain sectors. In particular, Trump’s focus on improving transportation and energy infrastructure may benefit companies in these sectors on both a direct and indirect basis. THE CASE FOR GLOBAL LISTED INFRASTRUCTURE Regardless of the attention infrastructure has received post-election, the benefits of listed infrastructure remain unchanged. Infrastructure has gained an increasingly prominent role in investors’ multi-asset class portfolios over the past several years due to a number of advantageous investment attributes, including historically attractive risk-adjusted returns, diversification benefits from low correlations with other asset classes, an ability to generate current income, and potential protection against inflation. Infrastructure has also been sought for its ability to help generate long-term, inflation-protected, stable cash flows and many investors have turned to the asset class seeking a more reliable income stream. While much of the early attention the asset class received was focused on direct, unlisted investments, we believe an investment in listed infrastructure securities, can provide many of the same benefits as investing directly in the core infrastructure markets, with the added potential benefits of greater liquidity, lower fees, and greater geographic, regulatory, and industry diversification. In conclusion, for both the U.S. and outside of the U.S. fundamentals within the infrastructure universe, generally are stable to improving despite the uncertain macro environment. We believe that Trump’s focus on increased spending in infrastructure, should it materialize, may have a positive impact on infrastructure stocks. 6 MORGAN STANLEY INVESTMENT MANAGEMENT IMPORTANT DISCLOSURES This material is for use of Professional Clients only, except in the U.S. where the material may be redistributed or used with the general public. The views, opinions, forecasts and estimates expressed are those of the portfolio manager as of date presented and are subject to change at any time due to market, economic, or other conditions, and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. 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