Behavioural finance: You can’t model Trump
Much of what counts as the modern study of economics consists merely of advanced mathematical modelling of financial markets, and the election of Donald Trump now renders it mostly worthless.
Confirmation bias and anchoring are two key concepts of behavioural finance. Investors select signals that appear to confirm what they already believe and often anchor decisions on messages whose content they are pre-disposed to approve, even though it is irrelevant.
The polls that promised a Clinton presidency offer two more reminders of what investors should have known: people don’t tell the truth in surveys and be wary of spurious precision in the presentation of analysis based on rubbish underlying data.
Investors are now being bombarded with research from Wall Street on what a Trump win means for markets. The short message is that Trump is the great reflation trade.
The good news is that stocks will boom: the bad news is that an inflation shock and unsustainable government borrowing might provoke rapidly rising rates and a bond market crash.
However, investors should be as wary of most of this as they ought to have been of the pre-election polls. The pointy-heads producing it have precious little to go on, given that there is no clarity yet as to Trump’s legislative agenda or priorities.
At the most simplistic level, stimulus spending and tax cuts could indeed boost growth and benefit equities, and are therefore what most banks have focused on, but imposing trade tariffs on Chinese and other exporters to the US that invite retaliation could crater growth.
How do you build economic and financial market models for a force as unmodellable as Donald Trump?
Paul Donovan, UBS
“This is the return of political economics,” says Paul Donovan, global chief economist at UBS Wealth Management. “We have to realise that random events, random shocks, will come in. “The very mathematical approach economics has taken in the past is one we must move away from in analyzing the economy in future.”
After the election, the first instinct of Michelle Meyer, head of US economics at Bank of America Merrill Lynch (BAML) – who had been expecting a Clinton win and a gridlocked Congress – was to shave 50 basis points off US growth forecasts for the first half of 2017 on the basis that businesses might delay investment in an atmosphere of heightened uncertainty.
She admits the impact of the promised tax cuts and stimulus spending is hard to work into the bank’s existing models that typically incorporate expected fiscal transfers coming due to recipients and apply a standard multiplier to calculate likely impact on growth.
As with the polls, according to Meyer: “This calls into question our reliance on the tools we have used in the past and there may be a need for a new approach.”
Equity analysts are busy picking the winners under a Trump presidency.
Pharma stocks, whose multiples had been beaten down by the threat of increased regulation under Clinton, have bounced, as have banks on the basis of likely rising rates, a steepening yield curve, volatile and active financial markets, as well as the intriguing prospect of president Trump tearing up Dodd-Frank and a slew of other regulations he says have stopped banks lending.
Sell-side analysts are focusing on this closely, even though it was hardly one of the key messages Trump thundered at his rallies, perhaps showing a little of their own confirmation bias.
Select growth sectors
If tax cuts boost consumption and stimulus promotes a broad market rally, analysts suggest some of the premium could come out of select growth sectors such as tech stocks with the rally benefiting instead classic cyclical plays such as discretionary consumer stocks.
Of course, it remains to be seen how Trump will get a budget of across-the-board corporate and personal tax cuts twinned with debt-financed infrastructure spending through a Republican Congress not minded to support such stimulus in the worst years after the financial crisis, when the US suffered much higher rates of unemployment than it does today.
When during the campaign Trump said he would consider renegotiating US debts with its leading creditors, financial market participants stuck their fingers in the ears and said they were not listening.
However, now he is president elect, the prospect of unfunded tax cuts and ambitious spending programmes that expand the budget deficit unsustainably partly prompted a big bond market sell-off in the first days after Trump’s victory.
One of his promises to keep an eye on will be the new government’s eagerness to pursue international tax reform and enforce a one-off 10% tax on overseas profits of US multinationals, much of that now parked as $2 trillion in cash on the balance sheets of big tech companies.
“If Mr Trump’s tax plan becomes law, we expect most companies will try to bring their foreign cash balances to the US and use them to fund shareholder distributions or repay debt,” suggest analysts at Citi’s financial strategy and solutions group.
“A Trump administration might require that some or all of the funds repatriated under its tax plan be invested in the US rather than distributed directly to investors.”
In that case, we might see an increase in domestic capital spending and domestic mergers and acquisitions.
However, such analysis rather pales in the run up to inauguration of a president who might lead the US into isolationism and protectionism, and provoke trade wars with China, Mexico and much of Asia.
“It is impossible to know what Donald Trump will do as president,” points out Llewellyn Consulting. “He has no experience in public office. However, he has spoken − not always consistently − about policies in many areas, and typically past presidents have at least partially enacted around 70% of their campaign pledges.
“Many of Mr Trump’s statements bear on the fundamental policy frameworks and institutions that have, by and large, served the greater part of the world well since 1945. [The only confident assertion now is simply that] many hitherto-apparent certainties are now no longer so.”
Financial and economic forecasts might be entertaining to read and even thought-provoking – but the old models aren’t worth much now.