Following weeks of post-election giddiness on Wall Street, will the stock market run into obstacles that trip up President Donald Trump’s ambitious economic stimulus plans? The dangers range from soaring federal budget deficits and inflation to a strengthening US dollar (which hurts US exporters) and global trade wars—any of which could wallop investors. Bottom Line Personal asked top investment strategist Hugh Johnson to describe how today’s six biggest threats could end the bull market and to evaluate the likelihood that any of these scenarios will occur…
Threat: Economic growth falls short. Trump has said that his stimulus plans will rev up annual economic growth to 4%, compared with an average of 2% over the past six years. His plans include up to $1 trillion in infrastructure spending…corporate and personal tax cuts…and relaxed government regulations. But if those steps fail to stimulate the economy enough to boost overall tax revenues, annual federal deficits could increase by an average of $400 billion—especially if investors demand much higher yields on US Treasuries as borrowing expands. Faced with this alarming scenario, the White House and Congress could be forced to scale back some of the tax cuts and spending increases to get deficits under control. Stocks that have soared based on the stimulus plans could plunge, and the economy could fall into recession.
My take: This scenario is my biggest fear. Sustained economic strength depends on growth of the labor force and productivity—that is, how efficient workers are. Healthy economic growth in the last half of the 20th century was fueled by huge numbers of baby boomers and women joining the workforce. But with millions of baby boomers retiring now and a marked slowdown in productivity gains since the technology-fueled boom of the late 1990s, I expect growth in gross domestic product (GDP) of just 2.4% in both 2017 and 2018. That, along with improved corporate earnings, will be good enough to keep the bull market alive until 2018 or even 2019. But increasingly, a retreat from tax cuts and spending plans will become likely, leading to a recession and the end of the bull market.
Likelihood that inadequate economic growth will end the bull market: High.
If you expect this outcome: Consider paring back your equity allocation over the next few years.
Threat: “Trumpflation.” If Trump’s stimulus plans succeed in producing GDP growth at an annual rate of 3% or more, that could lead to a spike in the inflation rate. To prevent the economy from overheating, the Fed would likely become more aggressive in raising short-term interest rates, which would increase corporate borrowing costs and could hurt corporate earnings. It also could lure investors out of stocks and into bonds, which would look more attractive because of higher yields.
My take: A high inflation rate often is a major factor in killing bull markets. But unless economic growth is stronger than I expect, there shouldn’t be dramatic increases in inflation or interest rates.
Likelihood that higher inflation and higher interest rates will end the bull market: Medium.
If you expect this outcome: Consider paring back your equity allocation even more quickly than in the first scenario.
Threat: The US dollar gets even stronger. The US dollar has jumped by 20% against 16 foreign currencies over the past two years, hitting a 14-year high in December. If Trump’s plans spark much higher interest rates, that could attract foreign investors to US Treasuries and send the dollar much higher still. That would be a boon for US consumers because imported goods and crude oil, which is denominated in dollars, would cost less. However, it could be a major blow to US exporters because their goods would become more expensive and less attractive to foreign consumers.
My take: This is the threat that investors tend to overlook. I expect the dollar to strengthen another 10% in 2017. That would help propel stocks of small US companies because they tend to get most of their revenue in the US…and it would help European exporters, which would gain a competitive advantage. But many of the companies in the Standard & Poor’s 500 stock index would suffer because they generate about 50% of their revenue outside the US.
Likelihood that a stronger dollar will end the bull market: Medium.
If you expect this outcome: Increase your allocation to small-cap stocks.
Threat: Trade wars escalate. Trump has threatened to slap high tariffs on imports from Mexico and China. Not only would that make certain imports far more expensive for US consumers, but those countries could retaliate, endangering billions of dollars of US export business. Trump also has threatened to pull out of the North American Free Trade Agreement (NAFTA) with Mexico and Canada, the two largest US trading partners. That could hurt the competitiveness of corporations including GM, IBM and Coca-Cola, which make products in Mexico and ship them to the US.
My take: This is the threat about which I’m most uncertain because it’s hard to determine how protectionist Trump will be.
Likelihood that trade wars will end the bull market: Medium.
If you expect this outcome: Be cautious about owning stocks of giant multinational companies until we get a better feel for Trump’s trade policies.
Threat: Rising mortgage rates short-circuit the housing market. The average interest rate on a 30-year fixed-rate mortgage topped 4.1% in December, up from less than 3.6% before Election Day. If bond investors continue to be nervous about higher inflation, mortgage rates could top 5%, a level not seen since 2011, increasing monthly payments enough to push many borrowers out of the market. Housing prices and home sales would drop—and drag down housing-related stocks.
My take: Mortgage rates will rise over the next few years but remain modest by historic standards. I expect 30-year fixed rates of 4.25% by the end of 2017 and 4.5% in 2018.
Likelihood that higher mortgage rates will end the bull market: Low.
If you expect this outcome: Avoid housing-related stocks including home-improvement retailers, appliance manufacturers and home builders.
Threat: Immigration barriers create worker shortages. Trump has vowed much more restrictive policies on immigration. That could hurt industries that depend on cheap immigrant labor, ranging from Florida and California citrus growers to fast-food restaurants, as well as small businesses that serve immigrant populations. It also could prevent highly skilled foreigners from coming to the US to work, for example, with Silicon Valley tech firms.
My take: This scenario is unlikely to play out fully because once Congress sees how expensive and complicated an extensive crackdown on immigration would be, it might not give full backing to the effort. Ironically, the US will need a significant increase, not a reduction, in immigration if it wants to greatly boost its economic growth in the coming years because that’s the only way to expand the workforce.
Likelihood that immigration barriers will end the bull market: Low.
If you expect this outcome: Consider paring back stocks of companies that depend on immigrant labor, including US technology companies.
FINANCIAL STOCKS COULD BENEFIT FROM TRUMP
Financial-services stocks soared after Election Day partly on expectations that government regulations will be scaled back. Many investors expect President Donald Trump to dismantle the Dodd-Frank Act, which gave regulators sweeping powers over the industry in the aftermath of the 2008 financial crisis and which created the Consumer Financial Protection Bureau (CFPB). Trump might weaken the CFPB by naming a new, nonactivist director of the agency. But it’s unlikely that Congress will repeal the entire Dodd-Frank Act because Democrats could attract enough Republican votes to block that effort in the Senate. Instead, some parts of the law may be changed and others not enforced as strictly as in recent years. As a result, certain kinds of financial-services companies should benefit more than others, including well-capitalized small banks, which Republicans have considered to be treated unfairly by the Dodd-Frank Act.