Fed may have the biggest say if third year of Trump Presidency is to live up to historical averages

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It is two years since Donald Trump was sworn in as the forty-fifth President of the United States and investors in US equities will be hoping that history is on their side, as the third year of a President’s term has, on average, been the best one for returns from American stocks. Since 1945, the Dow Jones Industrials have fallen just three times in the third year of 17 different Presidential third terms, defined as running from the inauguration date of 20 January, and generated an average capital return of 12.6%. That easily beats the average single-digit percentage annual return from years one, three and four of a Presidency.

The third year of a US Presidential term has, on average, provided the best equity returns

Source: Refinitiv data. Each year given runs from 20 January rather than calendar year.
* John F. Kennedy assassinated in November 1963 and replaced by Lyndon B. Johnson
** Richard M. Nixon resigned August 1974 and replaced by Gerald R. Ford

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

It is hard to say quite why the third year of a Presidency should the best one from the perspective of stock markets, but it may simply be that the prior year’s mid-term elections fire the starting gun on the next race to the White House. As such the incumbent President will be starting to think in terms of polls and voter-friendly policies and may therefore be inclined to run more growth-oriented policies.

As someone who seems to at least partly measure the success of his Presidency by how the US stock market does, Mr Trump will be watching the major indices particularly keenly. The Dow Jones is up 6.5% so far but to maintain this momentum President Trump may have work to do.

US Federal Reserve officials are starting to hint that US GDP growth could start to suffer if the ongoing Government shutdown runs for too much longer, while the benefits of the President’s trade policies and tariffs on imports, especially from China, are still hard to quantify, especially as Washington’s trade deficit with Beijing is getting worse and not better.

Investors can therefore expect more promises of deals and compromise with both the Democrats on Capitol Hill and Beijing’s diplomats, as such talk does seem to goose the US stock indices quite nicely, but talk is cheap and firm agreements will be required at some stage to reassure nervous investors.

The second half of 2018 showed a marked drop in the amount of US stock trading that was done on margin – using money borrowed from brokers against the security of assets in portfolios.

According to the latest data from the Financial Industry Regulatory Authority (Finra) the debt balance in traders’ securities margin accounts fell from a peak (and new record high) of $688.5 billion in May to $554 billion in December.

There has been a sharp drop in US equity trading on margin

Source: FINRA, Refinitiv data

That left December down by some $89 billion year-on-year, the biggest such drop since the fourth quarter of 2008 when Lehman Brothers went bust at the height of the financial crisis.

This loss of confidence and either voluntary or forced liquidation of margined positions could well have contributed to the sell-off that hit US stocks in late 2018. Which is the chicken and which the egg and which comes first – the market drop or the margin calls – is hard to divine but it looks like stock market rises and margin debt feed each other and stock market declines and margin debt declines serve to starve each other.

Margin trading trends and the S&P 500 do seem to have correlated in the past

Source: FINRA, Refinitiv data

Investors will be looking to the Trump administration for a resolution to their tariff and shutdown concerns, but the biggest issue that faces US stocks may be beyond the President’s control (despite his public blustering to the contrary) – the US Federal Reserve’s monetary policy.

Financial markets now believe there is a 74% chance of no change in US interest rates this year, according to the CME Fedwatch service, but the US central bank continues to reduce Quantitative Easing (QE) according to a pre-set policy that was laid out in summer 2017 when Janet Yellen was chair. That began with a reduction of $10 billion a month that has now reached $50 billion a month, or $600 billion a year, equivalent to around a sixth of the Fed’s total QE stimulus.

The switch from QE to Quantitative Tightening (QT) may have been the biggest factor in the retreat not just in US stocks but risk assets more generally in the second half of 2018.

US Federal Reserve continues to withdraw the QE stimulus

Source: FRED, St Louis Federal Reserve database, Refinitiv data

Investors will therefore look to the President for succour when it comes to trade sanctions and Government shutdowns but it may be Fed chair Jay Powell who calls the shots when it comes to whether the third year of Mr Trump’s (first? only?) term can live up to the historical averages and provide positive returns for 2019 as a whole.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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