We hear lots of talk these days about, Why Donald Trump’s Market Rally Echoes Ronald Reagan’s.
We are big fans of Chaos Theory,
Chaos theory is a branch of mathematics focused on the behavior of dynamical systems that are highly sensitive to initial conditions—a response popularly referred to as the butterfly effect. Small differences in initial conditions (such as those due to rounding errors in numerical computation) yield widely diverging outcomes for such dynamical systems, rendering long-term prediction of their behavior impossible in general.
So we thought we’d take a look at the macroeconomic initial conditions at the start of the Reagan Presidency versus the incoming Trump Presidency.
Check out the data:
In most all macro categories that we have have researched here, the initial conditions just aren’t there for a Reagan type bull market, in our opinion. First, and foremost, are the monetary headwinds.
Reagan began his Presidency with interest rates nowhere to go but south with a 22 percent Fed Funds rate and a 10-year Treasury yield of 12 1/2 percent. Though interest rates were not the policy target of the Fed at the time, just several months into the Reagan Presidency the 35-year bond bull market ignited and drove almost all asset prices from real estate to stocks, including the expansion of the price to earnings multiple.
The polar opposite monetary conditions exist at the advent of the Trump Presidency. Interest rates have nowhere to go but north, we believe, especially if Mr. Trump’s fiscal policy is implemented.
Mr. Trump will not have the labor slack and surplus to draw upon to drive economic growth. The country is pretty much at full employment although the level of tautness in the labor market can be debated. This risks much higher inflation than anticipated if his policies are passed and thus a more aggressive Fed. Also note the aging of the baby boom generation, which has driven much of the growth over the past 30 years.
President Reagan began his Presidency with a relatively small stock of debt. Mr. Trump will inherit a debt-to-GDP ratio almost three times that of President Reagan. This leaves less room for deficits as a result of his tax cuts and increased spending. The Trump plan is to increase economic growth and thus tax revenues through supply side and micro and regulatory policy. This is the second chance for this argument to succeed. Watch this space.
The high debt stock, coupled with expected large deficit spending, risks a spike in real interest rates and a sovereign credit downgrade.
Real Oil Price
President Reagan took office with a relatively high real oil price. Note this was in an era when high oil prices were considered “bad” for the economy. The real oil price dropped almost 75 percent in the first five years of the Reagan administration. President Trump will inherit a real oil price half that of Mr. Reagan, coupled with the ambiguity of not knowing if higher oil prices are good or bad for the economy. We don’t know where to go with this one.
Mr. Trump inherits a real trade weighted dollar a little over 10 percent stronger than President Reagan and, most likely, headed north given the world’s divergant growth and monetary policies. This could act as a headwind on corporate profits and export growth.
Individual Marginal Tax Rates
This is the pearl and central to the supply side argument. Cutting marginal tax rates to incentivize economic behavior and growth, which will increase tax revenues that offset the revenue loss from the tax cuts. Note, President Reagan cut the top rate from 70 percent to 28 percent. That was Yuuuge! Mr. Trump just doesn’t have the room to do such large tax cuts as he starts at a lower base with the highest tax rate at around 40 percent.
Corporate Profit Margins
President Reagan took office with a lot of corporate inefficiency and room to expand corporate profits. It feels we are close to peak margins. Didn’t we just have an election to improve the wages of the average worker? Watch this space.
Much like the debt stock, Mr. Trump will inherit a stock market that is relatively highly valued. Note, one of Warren Buffet’s stock market valuation metrics, Stock Market Cap to GDP, is more than 160 percent higher now than it was when President Reagan took office. The U.S. will need lots of economic growth to “grow” into this metric.
There you have it. The macroeconomic initial conditions at the beginning of two Presidencies. This is just our first quick whack at this analysis.
President Trump is going to have to depend on “animal spirits” to do a lot of the heavy lifting and an exquisite execution of supply side, microeconomic, and regulatory reform to increase potential GDP growth. Higher growth will increase the top line of companies and improve earnings. But we think, after looking at the data, the window is narrow.
Can we rally a lot? Absolutely. And probably will given the better business conditions initially created by regulatory reform and the fiscal stimulus.
A Reagan bull market? We don’t think so.
By the way, and contrary to the conventional wisdom, the Reagan bull market is only the 5th largest Presidential bull market since Teddy Roosevelt, just behind the Obama bull market.
We could be wrong and it surely hasn’t paid to short or underestimate Donald Trump. But, he just won’t, and probably, can’t, have the macro tailwinds that President Reagan had at his back given the initial conditions of the macro data.