As of March 22, the S&P 500 has returned about 10% since the November 2016 election. Some observers have suggested that the market rally was largely based on the anticipation of specific legislation, most notably a corporate income tax reduction. Yet in recent weeks the Trump policy agenda has run into some roadblocks in Congress, where various factions disagree on key details of health care and tax reform. Moreover, the President’s ability to influence Congress may have been weakened by testimony from FBI Director James Comey that his election campaign is under investigation for coordination with Russia. This has coincided with about a 2% pullback in the S&P 500 from its March 1 peak, as well as declining long-term Treasury yields and a weakening dollar. Is the market vulnerable to a more significant correction if Trump is unable to advance his policies in Congress, beginning with the American Health Care Act?
At Roosevelt we do not anticipate a significant correction. In our view, very little of the post-election rally was due to hoped-for legislation. Instead, we believe the lion’s share of the rally was due to improvement in economic fundamentals. Most notably, industrial activity has accelerated, as measured by the widely-followed purchasing manager indexes and confirmed by regional Federal Reserve reports. Higher prices of crude oil and industrial metals are supportive, as is improving economic growth in Europe and many developing markets. Improving business conditions in the energy, industrials, and materials sectors can have an outsized impact on earnings growth in the S&P 500 because of the high operating leverage in those businesses. Thus an improving earnings outlook may be the primary driver of the rally.
Beyond earnings, some portion of the rally may be attributed to anticipated deregulation (which does not require legislation in many cases), as well as the rise of so-called “animal spirits” as measures of sentiment across consumers, small business, and large enterprises have all improved materially. In our view, some of the improved sentiment may be attributed to anticipated legislation, which suggests that gridlock in Congress could weigh on the stock market, just not to the extent feared by bears.
One final note is that Republicans control all branches of government and believe they have a mandate to deliver on their campaign promises, a prominent one being a repeal of the Affordable Care Act. Since certain groups within the party disagree on the details, they seek to influence the legislation by threatening to withhold their votes. While this is how the legislative game is often played, ultimately we expect the party to come together and repeal the ACA in some form – which we think would alleviate investor fears that gridlock will stymie the President’s plans to reduce corporate taxes, fund an infrastructure investment program, and deregulate via legislation.
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