by Asset Allocation Committee

With Donald Trump and Hillary Clinton becoming the presumptive nominees for the Republican and Democratic Parties, respectively, this week’s Asset Allocation Weekly will offer some of our initial thoughts on this election cycle.  We will offer more in-depth analysis in the coming months but these highlights express our starting points about the candidates and the election.

This election is shaping up to be establishment versus populist: As we discussed in our three-part series on the election in the spring of 2014,[1] we noted a rising trend of populism in the U.S. that could lead to a populist candidate and president.  Donald Trump is running as a classic “traitor to his class” by supporting populist positions such as anti-globalization (anti-immigration, anti-trade) and support for middle-class entitlements (Social Security, Medicare, Disability).  These positions are in direct opposition to the establishment’s positions on free trade, open immigration and entitlement reform.  Sen. Clinton finds herself as the establishment candidate, which has been well exposed in her primary campaign against Sen. Sanders.  In Europe, both the right- and left-wing establishments tend to coalesce around one establishment figure to fend off a populist challenge.  If we see a similar pattern in the U.S. (which we would expect), look for talk about a third-party “real conservative” challenger to dissipate soon.  Otherwise, if a third-party establishment figure runs, it will simply split the vote and allow Trump to win easily.  Instead, we look for the right-wing establishment to either stay home or vote for Sen. Clinton.  In any case, unlike in most elections, there will be major differences between the candidates which will probably lead to historic voter turnout.

Domestic Policy: If you liked the last eight years, you should vote for Sen. Clinton.  She is running a campaign similar to what a vice president runs when he is trying to succeed a sitting two-term president.  Although this didn’t appear to be her initial plan, the surprising performance of Sen. Sanders has forced her to defend President Obama’s policies to frame her opponent as being too radical and she has used Sanders’s criticism of President Obama to suggest that he is denigrating the current Democratic Party president.  This means she really can’t run on a domestic policy platform that aims to fix all that has gone wrong and allows Mr. Trump to claim that current conditions are bad and that a new policy stance, which he would provide, would make things better.  Since many Americans claim things are bad,[2] it makes Sen. Clinton’s position difficult to defend.

This election will likely be determined by Sen. Sander’s supporters: In 2014, Ralph Nader published a book titled Unstoppable.[3]  In the book, he argues that populists on both the left and right have a common cause around which to unify and overthrow the political establishment.  As we noted in our aforementioned WGRs, the establishment supports deregulation, globalization and the unfettered introduction of new technology.  Although these policies are very successful in bringing down inflation through supply side efficiency, they have the effect of holding down wage growth that harms most populist households.[4]  Nader acknowledges that there are major disagreements between left- and right-wing populists on social issues.  However, on economic issues, the differences are significantly less and the two sides could find common ground.  If Sanders’s voters decide that Donald Trump can improve their economic situation and swing toward him, he has a solid chance for victory.  If Trump can, at a minimum, discourage Sanders’s supporters from voting for Sen. Clinton, he will improve his odds of winning.  Although we doubt Ralph Nader had Donald Trump in mind when he penned his book, Trump may be best positioned to bring Nader’s coalition of populists together.  This may be even more evident in foreign policy (see below).

Foreign policy is about be flipped: Sen. Clinton is hawkish; she supported the invasion of Iraq, a much heavier military presence in Syria and the overthrow of Muammar Gaddafi.  Using Walter Russell Mead’s archetypes,[5] Sen. Clinton is a Wilsonian.  She believes that the U.S. is a source of good in the world and that using military force is legitimate in order to protect the weak or support goals like democracy in the world.  Trump is a Jacksonian; this archetype can be belligerent but only if the national honor is besmirched.  Trump has indicated that we will give up our superpower duties[6] by forcing European and Asian allies to pay for their own defense.  At the same time, he is promising a major boost in military spending to ensure that “nobody messes with us,” a classic Jacksonian position.  On the one hand, Trump promises that we won’t be drawn into wars to protect others; on the other, he would likely order the U.S. Navy to shoot on sight any Russian warplanes buzzing around U.S. vessels.  The differences between Trump and Clinton offer an unusual shift for voters; neoconservatives who currently are part of the GOP will be inclined to vote for Clinton, while those who oppose U.S. hegemony will tend to find Trump’s “America First” message appealing.  In terms of foreign policy, Sanders’s supporters have much more in common with Trump than Clinton.

The debates could be historic: Trump has proven to be an effective debater, a brawler that tends to force opponents to operate at a base level.  For example, Sen. Rubio ended up in a verbal sparring match more suitable for a middle school; however, Trump operates well in such situations while most politicians don’t.  Rubio didn’t…and neither did Governor Bush.  Sen. Clinton has a wonkish grasp of policy that will far exceed Trump’s knowledge.  But, if he forces her into his “alley,” the results could be devastating.  The debates could be the most watched television outside the Super Bowl and may swing the campaign.

Next week, we will discuss the market impact of a Trump presidency and the asset allocation measures we would likely consider.  The following week, we will examine a Clinton presidency and perform the same drill.

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[1] See WGRs: 2016, Part 1 (3/31/2014); 2016, Part 2 (4/14/2014); and 2016, Part 3 (4/21/2014).

[2] On average, 66% of those polled think the country is going in the “wrong direction,” see: http://www.realclearpolitics.com/epolls/other/direction_of_country-902.html.

[3] Nader, R. (2014). Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State. New York, NY: Nation Books.

[4] We define the differences between populists and establishment in the aforementioned WGRs.

[5] See WGR, 4/4/2016, The Archetypes of American Foreign Policy: A Reprise.

[6] See WGR, 4/11/16, Intergenerational Forgetfulness.

 

by Asset Allocation Committee

In our latest adjustment to the asset allocation portfolios, we added to the REIT positions in three of the four models.  One of the reasons we remain friendly to this asset class has been the steady increase in rental income.

 

This chart shows rental income from the National Income and Product Accounts (NIPA).  Note that rental income has been rising at a very fast pace since the housing crisis.  In fact, as a percentage of national income, rents are at a postwar high, exceeding 4.25%.

 

In general, history shows that rising rental income tends to support rising REIT values.

A major reason rental income is rising is due to falling homeownership rates.

The rate of homeownership peaked at 69.3% in Q2 2004 and, in the wake of the housing crisis, suffered a precipitous decline.  Although we have reached a level where we believe stabilization is likely, we doubt this level will rise anytime soon.  And so, rental income should remain elevated until enough new apartments are constructed to depress rents.  So far, that hasn’t happened, although there has been an increase in multi-family construction.  We will continue to closely monitor rental income as a key input into our REIT allocations.

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by Asset Allocation Committee

We recently completed our quarterly rebalancing process in our asset allocation models.  One of our key assumptions is that the economy will avoid recession but growth will remain sluggish.  Recently, two reliable recession indicators, one from the Philadelphia FRB and the other from the Chicago FRB, have confirmed our expectations.

First, shown below is the Philadelphia FRB’s manufacturing index, which is a survey of manufacturing firms in the Northeast:

This index signals below-trend growth with a reading below zero, and indicates a recession with a reading under -10.  We smooth the data with a six-month moving average.  The current reading is +0.08, suggesting, at best, growth is at trend.  Note that the readings have been rather weak in this recovery.  In fact, the average index value (on a six-month average basis) for this recovery is the second lowest on record, with only the recovery between the 1980 and 1981-82 recessions being slower.

The Chicago FRB National Activity Index, which is a broad-based compilation of national economic indicators, shows a similar pattern.

Similar to the Philadelphia FRB manufacturing index, a reading below zero indicates below-trend growth.  The data clearly shows the economy is weak but not recessionary.

We expect the economy to continue on this path.  Until household debt falls to more manageable levels, consumption will likely remain sluggish which will tend to weigh on the economy.  This forecast for the economy means that:

1. Inflation should remain low;
2. The risk in long-duration interest rate instruments is low;
3. Monetary policy should remain accommodative, even with the Federal Reserve moving on a tightening path;
4. Equity markets can support a higher than normal P/E.

These expectations have been incorporated into our asset allocation models.  A shift to either recession or faster economic growth would require adjustments but, at this juncture, neither appears likely.  Until a shift in stance occurs, our current allocations will likely remain in place.

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by Asset Allocation Committee

Although it is a widely held assertion that lower gasoline prices will lead to stronger consumption, this correlation has been mostly absent following the most recent decline in fuel prices.  We suspect that household deleveraging has tended to weaken the expected impact of lower gasoline prices.  However, there does appear to be a strong relationship between consumer confidence and gasoline prices.

This chart shows how many gallons of gasoline a person can buy with one hour of non-supervisory average wage.  This ratio not only takes into account the price of gasoline but also the effect of wage growth.  Since 1964, the average worker has been able to buy 8.6 gallons of gasoline for an hour’s wage.  Periods of high oil prices are evident on the chart; the two OPEC oil shocks in the 1970s into the early 1980s and the high oil prices from 2003 to 2014 are obvious.

The relationship between gallons per hourly wage and consumer confidence is fairly clear, although there are some periods where the two diverge.  Generally speaking, two variables, the previously described ratio of wages and gasoline prices, along with the unemployment rate, do a reasonably good job of explaining the trends in consumer confidence.

Consumer confidence isn’t a great predictor of consumption or retail sales.  However, since 1990, it has had a good fit with the trend in price/earnings multiples.

This chart shows the Shiller P/E and consumer confidence.  The two series correlate at the 87% level.  It does seem that rising consumer confidence tends to reflect a degree of investor confidence as well.  Therefore, to the extent that lower gasoline prices and tightening labor markets boost consumer confidence, it is also reflected in multiple expansion, which is supportive for equity markets.

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