Edward Harrison is the founder of the blog Credit Writedowns and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.
We are seeing decent selling in today’s US equity markets, with the VIX up some 25%. Bonds are rallying. And most people are pointing to the Trump scandals. But this is only one day. What is happening with Trump – while negative – will not change the arc of the US economy and markets.
The markets. First, let’s remember that the market faces some headwinds based purely on the fundamentals. Large cap stocks are trading at relatively high multiples of earnings even on a forward-looking basis.
Source: Ed Yardeni
And the multiples for mid-cap and small cap stocks are even higher than large cap ones.
Source: Ed Yardeni
So, absent continued multiple expansion and financial engineering, US equities are dependent on increases in operating earnings in an economy growing fairly slowly in nominal terms. Where 5% growth was a floor during an expansion, it is now a ceiling.
Source: St. Louis Fed
At this point in the cycle, and with historically high operating margins unlikely to increase, nominal growth is going to be the major factor driving market top-line growth and earnings. Moreover, while large caps can translate increased earnings from abroad into US dollars, I am sceptical about the ability of US companies to get organic growth without the aid of leveraging and multiple expansion. That limits upside.
The political economy. Given that backdrop, the delay and potential failure of Trump’s legislative agenda is negative for markets. That’s what I was saying last week, with my post on Comey’s dismissal. Moreover, given where we are in the business cycle, monetary policy is likely to offset a lot of fiscal stimulus that Trump had been planning, making the 3 to 4% growth he talks about close to impossible to achieve on a sustained basis. I think markets are starting to realize this and are adjusting to this baseline – but in the context of very positive near-term economic growth. That is supportive over the near-term but less so over the medium-term. That’s what I was saying this morning.
The politics. Now, Mike Pence is the Republican establishment figure in the Trump administration. For some time, I have been saying that Congressional Republicans would prefer him to Trump.
If Trump were bad enough, some Republicans would want him impeached to make way for Pence. Just a thought on how this could go down
— Edward Harrison (@edwardnh)
So now that the Trump Administration is under siege, Republicans are now starting to make calculations about how to play this. Republicans in Congress want to preserve their own reputations while ushering healthcare and tax bills through Congress. Up until now, the Republicans had been just buying time, thinking the Russia investigations would blow over.
The Comey memo – and the prospect of more Comey memos – has changed everything overnight. Now, Republicans are realizing this won’t blow over. And so they have to decide what to do and when to do it so that their Congressional majority remains intact in 2018.
My guess is they will slow walk this – asking for subpoenas and doing lip service to investigation as and when necessary – but no more. If Trump continues to blow up, eventually they will be forced to turn to Pence to make sure they retain the house and Senate in 2018.
Conclusion. I don’t think any of this is fatal for the economy or the markets. Arguably, from a market perspective, Mike Pence would be a more effective President regarding the legislative agenda. What’s more, if you look at past political events – the assassination of JFK or the impeachment of Bill Clinton for example, there was no negative market reaction. Indeed, markets rallied after JFK was killed. And we got the TMT bubble after the Clinton impeachment.
Bottom line: There are more shoes to drop here in DC. And it may produce temporary hiccups in the market. But this won’t matter that much to markets over the medium-term. What does matter is a rebounding economy buoyed by a resilient consumer and low joblessness fighting against a Fed hiking into a flattening yield curve and earnings market multiples that are high by historical standards.