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THOUGHTS FROM THE CIO — JANUARY 2017 The Best (and Worst) of the Investor-in-Chief • For the economy and markets, the best thing about Donald Trump is his experience as an investor and his understanding of the conditions and risks needed to promote growth. • The worst thing about Donald Trump is his experience as an investor and his tendency to take outsized risks that have the potential for unanticipated consequences. • Following an exceedingly stressful election, I release some pent-up energy by unloading on President Andrew Jackson and the destruction of the Second Bank of the United States (my sincerest apologies to Jackson supporters). GORDON B. FOWLER, JR. President, Chief Executive Officer & Chief Investment Officer • The note concludes with a summary of Glenmede’s views and portfolio positioning as we head into the Trump era of government. A Mischievous Challenge Recently, a client suggested the title “The Best Thing about Donald Trump is…” for my next Chief Investment Officer writing. The suggestion came with a mischievous grin and hardy encouragement of capturing readers’ attention. No other ideas were offered as to the substance of the writing.1 During the course of year-end events with clients and employees, as well as within my own social circles, I observed how the election was frequently the elephant in the room, making appearances in the form of passionate commentary and reactionary glances. In fact, the recent election cycle has probably been the most seismic U.S. political and economic event of this decade. As a result, avoiding the subject and its implications for the economy and markets might be prudent. Having said this, and recognizing there are strong opinions on all sides of political debate, I will nonetheless seek to identify the “best” and “worst” thing of our president, purely through an investment lens.2 1 2 I have learned not to make assumptions about a person’s voting records and this individual cleverly dropped conflicting clues regarding his political leaning. I will restrict my comments to thoughts on the economy and the markets. After all, you look to us as an investment and wealth manager, not an arbiter of moral and social perspective. My opinions on these subjects will be no more interesting or valid than any other guy seated on the proverbial bar stool. Hail to the Investor-in-Chief The “best thing” about President Trump is his business experience. By my reckoning, if real estate development is a form of investment management, we have our first Investor-inChief in the Oval Office. The principal benefit will be his comprehensive view and intuitive feel for what drives the economy and business. The president has a bottom-up and top-down understanding of how markets work and importantly, how people in the markets work. He has also proven to have ample experience taking risk. If we were to poll ‘Mr. and Ms. Market’ about their expectations of a Trump presidency, we would probably get a positive outlook. In the 30 days following the election, the S&P 500 rose by 5 percent. While much of this growth could be attributed to better than expected economic data, business sentiment also improved. The market clearly likes the idea of economic policy reform and corporate tax cuts. Of course, this is a mixed bag for larger multinational companies that would pay more taxes if forced to repatriate offshore earnings.3 By contrast, smaller capitalization companies with little access to offshore loopholes have rallied by 16 percent in the 30 days after the election. When you include the effect of federal and state corporate taxes, and recognize earnings are paid to investors in the form of dividends, the current tax rate on corporate earnings for individual owners in the top tax bracket is ultimately more than 55 percent. The market also likes the potential for further infrastructure spending and the prospect of regulatory rollbacks in the financial, energy and healthcare sectors. The bond market is less sanguine given the prospect for more federal debt, higher inflation and higher interest rates. My principal concern with the president is, perhaps, the flip side of what the market favors: his experience and history as an investor and risk-taker. Before I elaborate my concerns, let me digress with a few comments on a man I view as possibly the most overrated president of the United States, Andrew Jackson. America’s First Populist President Andrew “Old Hickory” Jackson, perhaps America’s first populist, was elected the seventh president in 1828. He was known as having a violent temper, and for having fought numerous pistol duels in which he sought to not just defeat his enemies, but destroy them. During his tenure, he created the spoils system — a form of political patronage — and legislated the Indian Removal Act, a ruthless removal of Native Americans from the Southeast, often referenced as ‘The Trail of Tears.’ Jackson also pursued populist economic policies that led to the Panic of 1837, followed by a long and biting recession that lasted until the mid-1840s. In 1832, in a fit of populist pique against Northeastern financial interests, Jackson vetoed the bill to re-charter the Philadelphia-based Second Bank of the United States, which had essentially 3 According to the nonpartisan Tax Foundation, the top marginal tax rate on corporate earnings is 38.9 percent including federal and state taxes. This alone, though, is an incomplete measure of taxes on earnings. If earnings are paid to individual investors via dividends, these dividends are then taxed again. Even if we exclude the tax on dividends, the U.S. has the second highest corporate rate behind the United Arab Emirates (55 percent) and slightly ahead of Argentina (39 percent), the Congo, Guinea, Malta and Zambia (all 35 percent). Review&Outlook Page 2 functioned as the country’s central bank. As the Second Bank wound down, state-chartered banks relaxed their lending standards, leading to precarious balance sheets and inflated land prices, particularly in the West and South. This real estate bubble unraveled with Jackson’s executive order, the Specie Circular, which mandated that Western lands be purchased with gold or silver. This sent the gushing credit spigots into sudden reverse, causing a massive and lasting real estate and commodity price crash that caused bank runs and loan redemptions throughout the country. While Jackson’s populist, anti-establishment moves were largely responsible for the size and duration of the crash, the blame fell on his unlucky successor, Martin Van Buren. Jackson, the ill-tempered brute, remained the champion of the common man and was eventually awarded a featured spot on the twenty-dollar bill issued, ironically, by the eventual successor to the Second Bank, the Federal Reserve.4 Objectively, it’s unlikely Jackson and his contemporaries understood the effects of not renewing the Second Bank charter or requiring payment for land in gold and silver. The mid19th century grasp of macro economics was probably commensurate with the knowledge of medicine, i.e., two or three steps beyond treating patients with leeches. Hence, Jackson waded into unchartered territory armed only with the will of the people, a penchant for revenge and theoretically, common sense. In every age there are people who resist change and are, inevitably, characterized by populists as the “establishment.” Sometimes that resistance to change is motivated by selfinterest, and sometimes it reflects a genuine concern that society is more complex and fragile than it appears. In “draining the Capital Hill swamps,” Jackson brushed aside establishment thinking and prudence, ultimately leading to unfortunate and unintended consequences. President Trump as a Risk-Taker Old Hickory was certainly not the first president to take risks. After all, running for government, is a high-risk venture. President Trump, nonetheless, may stand in a class by himself. In his brief political career, he has seemed to relish his public disregard of the behavior and protocols associated with our nation’s most senior officials. To date, his non-conventional approach has succeeded, defying pre-election analysis and statistical predictions. The success of President Trump as a risk-taker and investor is hard to evaluate given the murkiness surrounding his organization’s finances. Clearly, along the way, the president has taken a fair number of risks and reportedly come close to financial ruin. Proximity to ruin usually tempers a person’s behavior and it is possible his business practices have gone from what some characterize as “crazy” to “crazy like a fox.” Ultimately, real estate development is a risky business and, even a more tempered and “mellower” Trump is unlikely to have veered too far from his original character. 4 To be fair, historians credit Jackson for resolving the nullification crisis and holding the Union together after South Carolina attempted to nullify (or invalidate) the federal “tariff of abominations.” Allowing states to nullify Federal laws would have effectively made laws passed by the Federal government meaningless. Had Jackson handled the crisis poorly, South Carolina might have attempted to secede. Interestingly in the aftermath of the crisis, Jackson predicted that secessionists would shift from the issue of tariffs to slavery as a pretext for leaving the Union. January 2017 Page 3 The Best and Worst of the Investor-in-Chief If we assume the president will be a big risk-taker, we should then question what risks he could take that would adversely affect the economy. There are numerous possible answers, but most analysts and economists of different ideological stripes, if they had to pick one, would focus on trade. The Most Likely Risk to a Trump Presidency: Trade Policy It is hard to know what the president really believes. His statements over the years on tax cuts, entitlement spending and monetary policy have been inconsistent. Trade, however, seems to be the one area about which he is passionate. He has consistently taken a more aggressive and protectionist stand than most conventional post-WWII politicians. The political issues surrounding trade are fairly familiar — while the deficit has shrunk more recently due to the U.S. rise in oil production, it remains larger than during the period following World War II. EXHIBIT 1: U.S. Trade Deficit as a % of GDP (excl. military aid) 2% 0% -2% -4% -6% -8% 1967 1973 1979 1985 1991 Source: U.S. Census Bureau & Conference Board 1997 2003 2009 2015 Data thru 9/30/2016 What is less well-known is how important trade has become to the American economy. Through most of the ‘50s and ‘60s, exports and imports accounted for less than 10 percent of the American economy, compared with close to 30 percent today. EXHIBIT 2: U.S. Trade as a % of GDP 35% 30% 25% 20% 15% 10% 5% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Source: OECD Data thru 12/30/2015 *Trade is measured as the sum of exports and imports of goods and services. Review&Outlook Page 4 The Best and Worst of the Investor-in-Chief Critics of current trade practices argue that far more production should occur within our borders. During his campaign, President Trump made the case for taking a forceful stance relative to our bigger and more competitive trading partners, stoking fear of a trade war. Regardless of the merits or demerits of globalization, the American economy and its corporations are deeply enmeshed with domestic and international producers and suppliers. A recent picture in The Wall Street Journal illustrated the cross-border origins of something as mundane as a car seat. The manufacturer, Adient, sources its fabrics, stampings, foam pads, plastics, and parts of the backs, cushions and seat tracks from U.S. locations. However, the leather, track rails, headrest, armrest, trim covers and the remaining parts of the backs and frames come from facilities in Mexico. Rapidly untangling such webs, which have taken years and great expense to build, could be a shock to the system. Economic shocks like the collapse of the internet and housing bubbles, are rarely good. This brings me back to Andrew Jackson. He and his advisors didn’t know what they didn’t know about the complexities of the banking system. They applied a simplistic solution to address a perceived imbalance of power by the Northeastern banks. In retrospect, their actions triggered a substantial panic and multi-year depression. Global trade in modern America is a vast, complex system. It can be difficult to appreciate the many linkages between our and the world’s economies. Our present understanding of the impacts of varying trade tactics and policies will probably be viewed in future years as simplistic. Does this line of thinking imply a likelihood of a large-scale trade war and a subsequent recession?5 On the one hand, we could just see posturing and bluster as the president seeks to negotiate better deals with our partners. It is also possible that as president, Trump could, quite unknowingly, incense the wrong nation at the wrong time. That risk is likely higher with a leader who believes his success and mandate to lead rest on defying convention and tradition. Positioning Portfolios in the Trump Era Generally, we think it is a mistake for politics to influence investment decisions. Ultimately, markets grow along with the economy and earnings, which tend to move based on economic events and business cycles. Even if one could successfully formulate non-consensus forecasts, the outcome could still be quite surprising. Two cases in point would be Brexit and the U.S. presidential election. In both situations, the respective British and U.S. markets fell when vote results were announced, but subsequently rallied. The confluence of new Trump economic policies and a maturing economic cycle should have implications for investment policy. Our Investment Strategy team, led by Jason Pride and Casey Clark, summarize these themes as shown in the table on the following page: 5 A number of prominent economists would likely argue that trade wars don’t cause recessions—a technically correct statement. A severe disruption to a large sector of the economy would, however, weaken growth. It might also lead adversely impacted firms to delay the inevitable restructuring by borrowing. When ailing industries lose the ability to borrow, financial crisis and recessions often follow. January 2017 Page 5 EXHIBIT 3: 2017 Themes & Investment Implications 1. The Expansion Prolonged Economic growth appears to have been accelerating since before the election. This provides a positive backdrop for 2017. Good for equities and risk assets 2. Disinflation No Longer Inflation appears to be rising with commodities coming off their lows and wage growth increasing. The risk is now that inflation rises too fast. Good for real assets (commodities, real estate, MLPs, and Energy) 3. Rates’ New Upward Bias Monetary policy is normalizing. Expect the Federal Reserve to continue raising short-term interest rates at a gradual pace in 2017, unless pressured by faster inflation. Minimize uncompensated duration risk (underweight fixed income & offset with hedge funds) 4. From Global to Local The pace of globalization appears to be reaching a plateau and even be at risk with the rise in protectionist, anti-trade sentiment across the globe. Favor regionally focused businesses (smaller cap in U.S. and Japan/EM Asia, & de-emphasize multinational) 5. Security Selection Back in Style Rising return dispersion and volatility should bode well for disciplined stock pickers this year. Favor active management (fundamental & value but not market cap-weighted indices) Should we factor into portfolios the possibility of a trade war? Our theme favoring regional over local markets is a soft response to that possibility and recognizes the fact that globalization could well be peaking. From a broader perspective, we think any disruptions to trade policy would emerge slowly, giving us time to react. It is possible the markets could get quite jumpy if the new president sets a date to cancel an existing trade deal such as the North American Free Trade Agreement (NAFTA). On the other hand, President Trump has surrounded himself with experienced business operators. Theoretically, his advisors will counsel him back from the cliff. As always, we will keep a watchful eye on the economy and the markets and remain in close communication. Review & Outlook is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative. 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