This year could continue to show an acceleration of global growth, or it could be the apex of protectionist policies leading into a trade war. True that at any point in time extreme scenarios are possible, but we believe that now the probabilities have shifted from the middle to the sides. That is what probability theory calls ‘fat tails’, as in the sides of a distribution having more mass than the usual bell shaped distribution. Trump is not the reason but a catalyst, that accelerates and accentuates trends that were emerging before the election, which presumably he read better than others. Growth had been showing marginal improvements of its pace before the elections in the US, while populism and nationalism was also emerging in many places around the world before the US elections. On both dimensions, the good and the bad, the elections results seems to work as an accelerator, bringing the issues to the top of the list of drivers.

Though it is usually the case that what happens and gets decided in Washington DC matters around the world, at the moment it is not only critical but also fairly uncertain. The campaign rhetoric contained some fairly extreme views and proposals, and President Trump continued to discuss those until very recently, if not since getting sworn in. At the same time, most of the people being nominated are fairly strong people, taking into consideration this is a republican president that won with a fairly populist rhetoric. Moreover, during many of the senate confirmation hearings for the nominated cabinet members, senators from his same party asked tough questions that put the nominees on the record with positions fairly inconsistent with what President Trump had said. This is clearly augmenting the uncertainty on policy, given that some of the extreme pledges are inconsistent with the people nominated for key positions. Additionally, the cabinet itself is maybe more diverse than usual, with some people that would otherwise be very difficult to find together or in the same project, especially in economic positions.

On the positive side, deregulation and tax reform can improve investment incentives and eliminate barriers that lead to efficiency gains. Some observers compare this dimension and its promise to what happened under Ronald Reagan, which is a bit of an exaggeration, given that in the early 1980s marginal tax rates were significantly higher, and most sectors were much more regulated. But we believe there are efficiency gains that can be produced by tax reform and deregulation that can on the margin add to growth prospects, which can mean 3+% growth rates for the US, as opposed to 2-3%. But these reforms take some time to legislate, and then to take effect. Obviously, markets bring those potential benefits to the present, to some extent, and there is nothing wrong with that.

Additionally, on the upside part of the distribution, the tail is somewhat fatter than a few months ago, because fundamentals have been showing improvement globally. Economic data points to a slight acceleration of growth, from mediocre rates almost everywhere. Whether that can continue, with higher investment leading to higher productivity growth (the key driver of sustainable growth) is a relevant question.

On the negative side there are a few different issues, that could happen individually or jointly, providing for worrisome scenarios. Trade is the obvious issue to mention, and it is where some concerning action has already taken place. The nomination of Peter Navarro to be the first director of the National Trade Council is concerning, and interestingly inconsistent with most other economic policy nomination (as the Secretary of the Treasury and that of the new Director of the Economic Council). Only by googling Peter Navarro and checking out his site (named deathbychina) one can clearly appreciate its protectionist nationalistic populist bend, which is apparently inconsistent with the rest of the more centrist nominations, as well as that of Secretary of State. Besides one person (which can be quickly made irrelevant or replaced), the inauguration speech and some of the first executive decisions point to an apparent mercantilistic approach to trade, which can potentially trigger a trade war, reducing global trade, leading to significantly lower global growth. Again, this is not totally new and due to Mr. Trump, since there have been other political events in the world that point to a more broad reaction to globalization, which is most likely rooted in the lack of general wage growth during the last 2 decades. But in practical terms, if the US government takes actions (like imposing tariffs or banning some country’s or sector’s imports), it can push other countries to retaliate, and if that chain of events is not quickly reversed, it could spiral out of control.

The third leg of this economic policy tripod is the possibility of fiscal deficits as a consequence of tax cuts and a non-trivial infrastructure program. Obviously, well planned and designed improvements on infrastructure help productivity and improve the attractiveness of private investment, at the margin, and over a long period of time. In the short-run what would be observed is an increase in the fiscal deficit, at the same time that tax cuts also increase the deficit. This is relevant as it would both push interest rates higher faster, and start to plant seeds of concern about the fiscal sustainability of a large debt stock. Higher interest rates as the result of cyclical growth is different than higher interest rates as the result of higher fiscal deficits, while the debt stock pushes close to 80-90% of GDP.

On the political front, and to a large extent tied to the trade and mercantilistic approach to economic policy, there are some risks that the rhetoric leads to similarly toned policies and reactions. So far, the US centric rhetoric is bound to isolate the US from the relevant debates and global policy initiatives, giving room for other countries to fill in (which is not in itself bad), but also undermining some of the positive elements of the global order. For example, NATO or the EU, are stabilizing institutions. Mr. Trump has been explicitly dismissive of both. Despite the fact that some of his statements might have an element of truth (like the possible disintegration of the EU), a US President cannot be on the side of cheering for it, when it would clearly be a shock to the global economy.

This is clearly a fairly bipolar set of risks, and it all depends on what the US government does and persistently pursues over the next 12-18 months. Clearly, there is always room for changing course, for reversing policies, and for walking back previous statements. Moreover, the first few weeks and months of a new administration tend to have a large percentage of mistakes and faux-pas, of learning by doing. But, given today’s information, in today’s market context, the distribution of potential returns clearly has fatter tails. Equity valuations, especially in the US, are not cheap, and would only have sustainable upside if growth accelerates, producing earnings growth. Valuations in other parts of the world clearly depend on whether globalization is dialed back and by how much. Additionally, there is the whole issue of inflation and interest rates, and the impact of that phenomenon in equity valuations and the dollar.

There are moments in which one can elaborate a clear view and have a high degree of confidence on it, drawing asset pricing implications across asset classes. Then there are times in which one has more questions than answers, and those are times in which it is not wise to push the analysis beyond what can be elaborated with an acceptable degree of confidence. We have a cautiously optimistic approach to portfolio design, with an open mind eager to answer the questions that emerge from thinking through issues like the ones mentioned above, and others. What happens in Washington DC over the next 2-3 months is key, and it should provide some indication of what is ahead.

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