Since the announcement of the US presidential election, the financial markets have been pricing-in the positives that could be realized from President Trump’s policy proposals. This has had two immediate results: US equity indices are claiming new highs and US treasuries are declining significantly. Today, there are diverging views on whether this re-pricing of financial assets is sustainable or if they are fragile enough to reverse course in the event these policies are ineffective or slow to solidify.
In December, Gravitas implemented a historical scenario which ran PnL simulations using realized risk factor changes since November 8th to calculate the impact of President Trump’s election on client portfolios. This has helped clients assess the potential impact of what their PnL would have been if they had maintained their existing portfolios since Election Day.
While it’s much simpler (and more concrete) to calculate the realized impact retroactively based on a historical scenario, it is also important to examine the future for a better understanding of what’s to come. To calculate the ex-ante value of PnL arising from President Trump’s proposed policies and actions, we need to carefully analyze the current economic and market environments using a choice of risk factors and their expected movement.
We have created the following predictive risk scenarios, using driving risk factors based on analysis of each policy risk theme, to understand the potential ex-ante framework of the Trump Presidency:
- Tax Reform: Tax reforms are expected to be finalized and passed within the next couple of quarters with a high probability that the corporate tax rate will be reduced to the range of 15%-20% from current 35%. Corporate tax cuts along with foreign corporate profits/cash coming onshore would boost US corporate profits in the high single digit to low double digit range. The market has already priced in the current impact with a 10%-15% rally in broad US equity market indices since November 8th. However, this is also expected to have a further positive impact on corporate earnings growth FY 2018 onwards. Risk factors chosen to model this impact: Equity Indices SPX 500 (+7%) and Russell 2000 (+10%) from current level
- Deregulation: The deregulation agenda has been an ongoing discussion, specifically in relation to the energy and financial services sectors. The effect could be immediate in the energy sector. In the financial services space, however, it will take longer to materialize, and there will be uncertainty regarding how it will manifest. We believe that any benefit in the short or medium term will not be felt by the financial services sector, hence there is a moderate probability the recent sector outperformance against the overall Index may reverse. Risk factors chosen to model this impact: Energy Sector: XLE ETF (+5%) and Financial Sector: XLF ETF (-5%) relative to benchmark Equity Index
- Fiscal Initiative on Infrastructure: The proposed infrastructure expenditure is expected to lead to growth but also an uptrend in inflation. The long term interest rate could be pushed further up in near future. The current 10 Year T-bond rate of 2.5% is still well below the long term historical average across business cycles. There is a possibility for long term rates to rise if inflation continues to pick up along the fed tightening cycle. Risk factor chosen to model this impact: 10 Year T bond rate (+75 BPS)
We calculated current betas between the driving independent risk factors described above and all other dependent market factors by doing a multivariate regression using a 1 year series history of factors. This beta is used to produce expected changes in other dependent market factors. After that, we repriced the portfolio using the changes in each risk factor to get expected PnL impact on Portfolio from impending policy actions. Below, we illustrate possible PnL scenarios using three long only US-centric sample portfolios with various equity and debt allocations.
- Portfolio: 50% Equity distributed among Large, Mid and Small Cap and 50% investment grade debt (7 to 10Y maturity) | Prediction: The average PnL impact at portfolio level is +1.75%. Depending upon size, sector and duration in the portfolio, we get a range of +0.25% to +3.5%.
- Portfolio: 80% Equity distributed among Large, Mid and Small Cap and 20% investment grade debt (7-10Y) | Prediction: The average PnL impact is +6% and ranges between +4.25% to +8.5%.
- Portfolio: 25% Equity distributed among Large, Mid and Small Cap and 75% investment grade debt (7-10Y) | Prediction: The average PnL impact is -2.25%% and ranges between -3.5% to -0.5%.
Gravitas enables clients to drill down into PnL distribution by sector, asset, and position levels to confirm biggest contributors of total PnL and understand which aggregations drive it. Predictive scenarios as a tool are being used increasingly by our clients to understand the possible impact on portfolio due to future risk events.