Richard Croft, president and chief investment officer at R.N. Croft Financial Group
Focus: Options and ETFs

_______________________________________________________________

MARKET OUTLOOK

Headwinds and tailwinds

I was asked in a recent interview what was the most important headwind and tailwind affecting client portfolios during the first half of 2018. My answer was the same for both: the Washington reality show that is Donald Trump.

The tailwind was the tax reform package that effectively lowered U.S. corporate tax rates to 21 per cent. The bill also allows companies to write down capital expenditures within one year which, in my mind, provides a major incentive for companies engaged in capital expansion programs. Moreover, many of these same companies have access to repatriated capital coming from offshore holdings thanks to a one-time tax incentive to reinvest those funds. That number could be as high as US$3 trillion which could provide a boost to American GDP even if Trump is unable to garner support for a federal infrastructure program that would include a border wall.

As for headwinds, Trump’s “Art-of-The-Deal” style doesn’t always resonate with countries in the same way it does with business. It’s one thing for a real estate power broker who has a firm grasp of his business to use aggressive negotiating strategies to extract a good deal. It’s quite another to use a stick-and-carrot approach in trade negotiations with a political adversary who isn’t necessarily motivated by a “business first” agenda. Mean-spirited name-calling techniques as were witnessed in the G7 meetings can have unintended consequences, not the least of which is an all-out trade war.

In the run-up to the G7 meeting, Trump talked about Canada’s unfair tariffs that impact American dairy farmers, but made no mention of the tariffs imposed on tobacco imports into the U.S. Moreover, the tariffs intended to protect Canadian farmers were removed as part of negotiations within the Trans-Pacific Partnership, which Trump refused to sign.

My point is that you can take any single issue between trading partners to send a nuanced message. There lies the rub. Trump is signaling China that, if he’s willing to throw his friends under the bus, he would be more than willing to deal aggressively with countries whose unfair dealings have put the U.S. at a distinct disadvantage. That approach has merit if his end-goal is to prevent the theft of intellectual property and break down unfair barriers of entry to the Chinese economy. But, if we’re witnessing a Trump diatribe fixated on the misguided view that trade deficits (if they exist) are bad, there’s a distinct possibility we’ll migrate towards a trade war that will lead to higher prices, nullifying the tax advantages that were intended to empower American consumers.

My concern is that Trump’s fixation on trade deficits may be underpinning a negotiation strategy intent on bringing manufacturing jobs back to the U.S. That view, despite the fact that it’s backward-looking, plays well to his base. But it does little to support a modern U.S. economy, which is grounded in services and information technology and not manufacturing.

Like it or not, anyone developing any investment thesis must take into account Trump’s propensity to disrupt. To engage in stock market predictions requires one to understand Trump’s objective. If he’s intent on bringing manufacturing jobs back to the U.S. at the expense of its neighbours, then we must accept the real possibility of a trade war.

An all-out trade war will be detrimental to high-flying companies like Boeing and Caterpillar. It will also have implications for giant tech companies that get much of their revenue from foreign countries, notably Apple and Amazon.

It may benefit domestic companies like major U.S. banks such as Bank of America, Citigroup and JPMorgan. It could also benefit profitable small-cap companies that are directly impacted by changes to the tax code.  

If his end-goal is to open China’s borders and stop it from stealing intellectual property, then his approach might work, “might” being the key word. Unfortunately, the problem is that it’s hard to know, as there are strong arguments on both sides. Personally, I’m of the view that cooler heads will prevail as an all-out trade war benefits no one. Given that position, I’ve opted to build an investment thesis on the back of what we know.

We know that changes to the tax code will benefit U.S. companies and probably cause some of the multinationals to rethink their position on setting up shop in foreign countries. But it clearly benefits smaller profitable companies with a domestic business.

TOP PICKS

BMO EQUAL WEIGHTED BANK ETF (ZEB.TO)

O’SHARES FTSE RUSSELL 2000 SMALL CAP QUALITY DIVIDEND ETF (OUSM.N)

FIRST TRUST DOWN JONES INTERNET ETF (FDN.N)