This coming Tuesday 28th February, US President Trump will address Congress for the first time. Usually Presidents do this in January at the State of the Union, however in election years it takes place a month later and although similar in structure it is not a formal State of the Union.
This speech is the most important risk event for financial markets since Trump’s shock election win last year heralded a rally in equity markets and fresh record highs for US stocks. It has political and economic ramifications, and it has the potential to drive financial market volatility substantially higher.
The political context:
From a political point of view, the President’s speech is a chance to re-set after a series of missteps in his first month of office, including the resignation of his National Security advisor and an unpopular decision to ban immigrants from some Muslim countries. It is also a chance for Trump, who has been busy working unilaterally in his first month in office passing multiple executive orders, to address Congress and outline what he wants done on Capital Hill in the next year.
Compared to Trump’s inauguration speech, this address to Congress is more like a Presidential laundry list that puts the meat on the bones of what he wants done in his first few years in office. Some officials with knowledge of the speech suggest that the President will lay out four main policy areas including: tax reform, border security, healthcare and fiscal spending/ infrastructure plans. We would also expect some talk about scrapping the Dodd Frank rule for US banks and rolling back on the current regime of financial market regulation.
Trump’s charm offensive to Congress
Presidents need to tread carefully during the State of the Union, as Congress doesn’t like to be micromanaged. Thus, Trump has to make his case for his policy plans and convince Congress, including 200 hostile Democrats, that they should put his policies into action and work with him to make them a success. Traditionally, Presidents should use an address to Congress as a charm offensive, which, so far, appears at odds with President Trump’s governing style.
The last point on the political front is worth noting. As mentioned above there are still 200 members of Congress from the other side of the aisle, who may use this speech as a chance to goad a President known for his outbursts and thin-skin. They could bring guests from groups that have already been targeted by Trump, including Muslim and illegal immigrants along with members of the trans-gender community. If Trump uses this speech to make cheap digs at his rivals then the overall impact could be negative, especially if he does so at the expense of disclosing much-anticipated details about his economic plans.
The market reaction:
In the lead up to this speech the equity market rally has tapered off slightly, and volatility has ticked up although it remains at low levels. As mentioned above, this is the most important speech of Trump’s Presidential career so far, and the market reaction to it will be a key gauge of confidence in the Trump administration.
Does the Bond and FX market see something the equity market is missing?
Interestingly, the FX and bond market have shown more scepticism about the “Trumpflation” trade compared to the US equity markets. US inflation-adjusted bond yields have fallen consistently in February and are now back at their lowest level since the election. When TIPS yields fall it can be a sign of risk aversion. Interestingly, the decline in TIPS yields has also corresponded with a decline in the US dollar. USD/JPY and TIPS yields have a particularly strong correlation, at more than 90%, so as TIPS yields fall the yen tends to rise, which is another sign of risk aversion.
It is also worth noting that the Federal Reserve has voiced concern about the President’s economic plans and said that uncertainty around future fiscal and economic policy is one of the biggest risks facing the US economy.
While Trump has been greeted with caution by the bond and FX markets, the equity market has exploded in euphoria since Trump won the election. His promises to cut corporation tax and reduce financial market regulation have been a key driver of strength in stock markets, particularly in the financial sector, but, in fairness, equities look strong across the board. Even tech stocks, which could be hit hard by the border adjustment tax (see more below) have enjoyed a substantial rally in recent months.
Assessing the chance of a market sell-off on the back of this speech:
Many analysts and economists have been predicting a market collapse in recent weeks, saying that US stocks have become too expensive, or that volatility is too low. We have urged caution about jumping on this bandwagon; a study by Bank of America (NYSE:BAC) found that historically, stock markets tend to rise by 15% in the last six months of a bull market. Thus, picking the top of the market is not easy.
We believe that two things could trigger a sell-off on the back of his address to Congress:
1, A misstep from Trump, for example, goading and deriding the opposition rather than using his speech to put the meat on the bones of his economic policy.
2, Criticism from members of Congress after the speech, which may suggest that he won’t be able to get his economic agenda put into action.
We believe that the first point is a low probability but high-risk event. Another scenario to consider would be a sell off on the back of excessive detail from Trump, for example on his controversial border tax plan. This pledges to tax imports while exempting exports, and could be the first step to a protectionist trade policy, which we believe would be bad news for financial markets. However, the President is not renowned for being a details guy, so this scenario seems unlikely.
Stopping this rally mid-flow could be harder than it looks
Stock markets have been willing to give President Trump the benefit of the doubt, and have reached fresh record highs even after a tumultuous first month in office. We doubt that the markets will put their animal spirits back in the cage so quickly. If Trump can deliver a text book address to Congress that isn’t too controversial, then US equity markets could still push higher, after all, Trump can’t physically push through tax and spend legislation, for that he needs the support of Congress. So, until we know how Congress feels about his plans, which could take some months, then US equities may continue to break into fresh record territory as markets once again give President Trump the benefit of time to deliver on his economic plans. At this stage, we would give this outcome a 60% probability.
Indices and corporations that could be impacted by the Trump legislation:
While it will be up to Congress to actually enact Trump’s economic plans, we think that it is worth taking a look at companies, sectors and indices that could be impacted by his policies.
1, Border Adjustment Tax:
This may be bad news for cut-price retailers who are big importers. Already Target (NYSE:TGT) and Best Buy (NYSE:BBY) have spoken out about this potential tax. In contrast, those in favour include Boeing (NYSE:BA) and some of the US pharma companies, who could get an edge on foreign competition who may need to increase their prices to combat the effect of a US border tax. Overall, this tax could be interpreted as protectionist, and in our view this is not good for US markets. If it features heavily on Trump’s agenda then we could see a risk off tone to financial markets at the beginning of March, and we would expect US indices to turn lower.
2, Corporation tax cut
Expectations of a cut in the US corporation tax rate have been one of the key drivers of this equity market rally. The markets are probably looking for something in the region of a cut to 20%, down from 35% currently. Markets may rally further if it looks like taxes could be cut by a larger amount, while they could falter if it looks like Trump would settle for a smaller tax cut in order to pass his tax plan through Congress.
3, Fiscal Spending:
A sizeable infrastructure fund could be good news for US building and services companies, including Caterpillar (NYSE:CAT), Dow Chemical (NYSE:DOW), General Electric (NYSE:GE), Honeywell (NYSE:HON), Emerson Electric (NYSE:EMR), Du Pont (NYSE:DD) etc. The size of a potential infrastructure-spending plan remains vague at this stage. We could see big gains for these stocks if a truly tremendous programme is confirmed on Tuesday night.
4, Financial regulation:
US Banking stocks, the S&P 500 and even foreign banks with a large US presence, such as Barclays (LON:BARC), could do well if Trump stands firm in his commitment to cutting financial regulation. This is one area of policy that we think Trump can get passed by a Republican Congress with little opposition, and we expect him to try and fast-track this through before Congressional elections next year. Signs of a firm commitment to shaking up the US financial regulation system could be greeted by even more strength in US banking stocks.
Conclusion:
Overall, the markets have been eagerly awaiting this speech, and there is a lot resting on it. If Trump can deliver a textbook speech, that avoids controversy and aims to build cohesion with Congress then the stock market rally may continue, however, the bond and FX markets have been less generous to Trump in recent weeks. Falling bond yields and a declining dollar are both signs of fatigue with the Trump trade and concern that the President may not be able to deliver on his ambitious economic programme. President Trump’s big trip to Congress on 28th February is definitely one event that market watchers should not miss.
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Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.