Q1 2017 – “Trump Trade Fade” (Part 2)
While optimism is prevalent there are always unforeseen factors that could adversely affect the market. Geopolitical risks seem to become more elevated by the week and naturally investors’ appetite for entering into another conflict throughout the world is low. Market participants would rather cheer on legislation that could help spur on economic growth. But even on that front, despite having a majority in both the House of Representatives and Senate (as well as occupying the White House), the Republicans have so far proven slow to govern, with a health care reform proposal stalling in the House of Representatives. The inability to even bring the Affordable Healthcare Act to a vote in the House, after previously voting to repeal Obamacare more than 60 times in prior sessions, leads to serious questions as to whether President Trump’s pro-growth agenda will be able to get off the ground.
With the April congressional recess now at hand, Congress will have just three months to address tax reform and an infrastructure plan until another full month recess in August. It has been more than 35 years since any major tax reform has occurred in America, so it will be unlikely that a change will take place within a three-month period, but any increased visibility on changes being discussed could help investors determine the potential benefit to the economy and businesses. A significant portion of earnings growth since the Great Recession has been driven by operational efficiencies (cost cutting), but a moderate amount of inflation and positive tax reform could help propel corporate earnings to the next leg of earnings growth. Regardless, any revisions to tax and regulatory policies should reinvigorate economic growth. An additional jolt to the economy could be any move on President Trump’s infrastructure plan, which while lagging details, has been described by one of the President’s Cabinet members as an investment program valued at $1 trillion over 10 years focusing on multiple sectors outside of transportation infrastructure, including energy, water and potentially broadband and veterans hospitals.
In closing, we mention another factor that could likely influence volatility into the marketplace which is the growth of passive investment vehicles. Over the past decade, passive index strategies have become a larger portion of the investment landscape. There are roughly 2,000 U.S.-listed ETFs in existence, with roughly 20 ETFs accounting for more than a third of all ETF assets in broad market indexes, such as the S&P 500. As capital flows into and out of these funds, there is indiscriminate selling or buying as the funds true up the positions to match their respective benchmark by the end of the trading day. For instance, after President Trump’s State of the Union speech on February 28th, during the following day, nearly $8.2 billion poured into the SPDR S&P 500 (SPY), the world’s largest ETF. Active managers have the luxury of making real time allocation decisions to accommodate the net flows into their funds, but ETFs must invest their portfolio by the end of the market close to mirror its respective index, regardless of valuation considerations or liquidity of the underlying securities. With flows of this magnitude for the SPDR ETF, it would represent nearly 9.4% of the average daily volume for the top 100 thinly traded securities within the S&P 500, with some of the securities accounting for mid-teens to 20% of the average daily volume.
A recent financial publication article that noted that the stocks whose daily trading volumes were most affected by ETF flows also performed the best, concluding that investors should not expect significant outflows to take stocks down. We would have a different assessment given the basic rule of supply and demand and influences of the movement of capital and would caution investors to understand their exposure to the market, particularly in the latter stages of the economic cycle.