The 2016 Elections, Policy Outlook & Market Implications

September 26, 2016

By Paul K. Hoffmeister

Copyright 2016

2

Preface

“If you want to make God laugh, tell him about your plans.” - Woody Allen

Woody Allen succinctly captures the uncertainty of “things.” One of those “things” is the current environment for capital allocators, who are attempting to make decisions in the face of the November elections and the prospect of significant policy changes next year.

So, in that spirit, the following is a humble attempt to understand and predict a multitude of uncertain political, economic and market variables, to share with you frameworks for how they may impact the U.S. economy and financial markets, and to highlight potentially significant investment opportunities.

Introduction

On September 9th, the S&P 5001 concluded a historic streak of 43 consecutive trading days where this equity index did not move more than 1%. The August holidays certainly played a role, but this absence of volatility is unusual even for the dog days of summer.

In my view, investors simply have not been able to meaningfully recalibrate prices in the face of the major macroeconomic policy uncertainty. With the looming November elections, how can investors and even central bankers appropriately forecast the investment and economic environment beyond year-end?

The historical data shows that the results of the upcoming elections are supremely important. Economists Alan Blinder and Mark Watson have found dramatic differences in economic (GDP2growth) and financial market performance (S&P 500) during each term, depending upon which party is in power.

Since World War II, Democratic presidents have presided over periods of faster economic growth and stronger stock market returns than have Republicans. Real GDP has grown at an average annual 4.35% rate, and the S&P 500 has risen at an annualized 8.08% rate under Democratic presidents. In contrast, under Republican presidents, real GDP growth has averaged 2.54%, and the S&P has advanced at a 2.70% annual rate3.

The past, of course, does not predict the future. But any allocator of capital would want to know these statistics, and take them into account.

So who will be the next president, and what will be the makeup of the next Congress? What will be the market-moving macroeconomic policy changes of 2017? And, how will financial markets react to them?

Obviously, no one can predict these things with certainty. But even with many important election outcomes still unclear, history and some educated guesses paint a fairly clear picture of the next

1TheS&P500Indexisawidelyrecognized,unmanagedindexconsistingoftheapproximately500largestcompaniesintheUnitedStatesasmeasuredbymarketcapitalization.Youcannotinvestdirectlyinanindex.2Grossdomesticproduct(“GDP”)isthemonetaryvalueofallthefinishedgoodsandservicesproducedwithinacountry'sbordersinaspecifictimeperiod. 3Source:"PresidentsandtheU.S.Economy:AnEconometricExploration",AlanS.BlinderandMarkW.Watson,WoodrowWilsonSchoolandDepartmentofEconomics,PrincetonUniversity,July2014

3

year, and, in turn, create a framework for thinking about the likely trajectory and behavior of financial markets during the next year.

The Race for the White House

The presidential election is, quite simply, a toss-up.

According to certain betting markets4, Secretary Clinton will become the next President of the United States. According to the Iowa Electronic Markets, her implied probability of winning reached 80% in August and has never fallen below 50% since her nomination. But those 80% odds peaked on August 17 and now stand at 64%.

Notably, August 17 is the day that Kellyanne Conway was officially announced as Donald Trump’s campaign manager, coinciding with major changes in the Republican nominee’s campaign strategy that has sparked what many call today, ‘The Trump Surge’.

Clearly, Mr. Trump has enjoyed strong momentum during the last month.

On August 17, the USC/LA Times poll showed Secretary Clinton leading by approximately 1 point; however today, Mr. Trump leads by nearly 4 points. Even more, polls in the key swing states of Ohio, Florida, and Nevada now show Mr. Trump leading by 5, 3, and 2 points respectively. In Iowa, where in 2012 President Obama beat Governor Romney 52% to 46.2%, Trump is leading by 8 percentage points, according to the latest Monmouth University polling.

Investors and prognosticators cannot rely exclusively on betting market prices today. While these prices can be extremely useful indicators, this market is vulnerable to mischaracterizations of outcomes if the size of trading bets are heavily lopsided.

For example, during on the day of the ‘Brexit’ vote in June, betting markets were implying as much as an 85% chance of the Remain camp prevailing. Johns Hopkins Professor Steve Hanke noted on Twitter, “Prediction markets were wrong because all large bets came from pro-Remain #London; ~80% of non-Londoners bet on #Brexit.”5

Even more, Mr. Trump has consistently defied betting markets since entering the political fray in the summer of 2015. Early on during the Republican (“GOP”) primaries, Jeb Bush and Marco Rubio were the frontrunners in these markets despite Mr. Trump’s virtually consistent lead in popularity polls. And in April, after Mr. Trump held a commanding lead in the GOP Convention delegate count, a bet on Ted Cruz to win the GOP nomination was trading for even money.

The highly regarded pollster Larry Sabato, from the Center for Politics at the University of Virginia, argues that the “Trump Surge” is due to a confluence of factors: Hillary Clinton’s disappearance from the campaign trail before Labor Day, the “basket of deplorables” comment, the controversy surrounding the campaign’s handling of her pneumonia condition on September 11th, increased discipline within the Trump campaign, and the increased use of likely voters in polling rather than registered voters.

Without question, the presidential contest is shaping up to be a heated dogfight that should go down to the wire.

4AsofSeptember26,2016,PredictIt.org68%probability;IowaElectronicMarkets67%5https://twitter.com/steve_hanke/status/747847809852858369

4

The Race for Control of Congress

Equally unclear is the outlook for which party will control the Senate next year. Democrats, who presently control 46 seats (including 2 independents) need a pickup of 4 in November if Hillary Clinton becomes President (the tie-breaker vote would go to Vice President Kaine), and 5 if Donald Trump wins. Betting markets currently imply a 58% probability of Democrats regaining control.

There are eleven senate races considered to be competitive: Florida, Iowa, Illinois, Indiana, Missouri, New Hampshire, Nevada, North Carolina, Ohio, Pennsylvania and Wisconsin. Recent polling shows Democrats handily leading in Illinois, Indiana and Wisconsin; Republicans are well ahead in Florida, Iowa, Missouri, North Carolina, and Ohio. This means that control for the Senate will most likely be determined by the outcomes of the Senate races in New Hampshire, Nevada, and Pennsylvania, where polling margins are within 2 points for the respective candidates.

It’s particularly noteworthy that the election prospects for Republican candidates in these states have all improved with Mr. Trump’s rise during the last month. This reflects a strong coattails effect at the top of the ticket and suggests that the presidential candidate with the most momentum heading into November 8th will decide, in large part, whether his or her party controls the Senate next year. Given the betting markets, polling, and the specifics on the ground in the key Senate races, the outlook for the Senate is virtually a coin flip.

Unlike the races for the White House and control of the Senate, however, the outlook for the 435-seat House is fairly clear to most prognosticators. Larry Sabato and Charlie Cook, of the Cook Political Report, each project Republicans to maintain their majority. Sabato currently expects Democrats will increase their seat count from 188 to 201, well short of the necessary 218. Cook currently projects 202 Republican seats to be solid, with another 23 leaning or likely for Republicans. As for betting markets, PredictIt.org is implying a 75% probability that Republicans will control the House in 2017.

Ironically, despite the uncertainty over which political party will command the White House and Senate, certain policy changes are highly likely to emerge next year: tax and trade reform.

Fiscal Reform

Around the world, the pressure from central banks and voters for legislatures to implement counter-cyclical fiscal policy is intense.

During the modern economic era, defined as the period since the Nixon Administration and the emergence of the modern monetary system, every new Administration in the White House has passed tax reform early in its first term.

President Nixon passed the Tax Reform Act of 1969; Ford, the Tax Reduction Act of 1975; Carter, the Revenue Act of 1978; Reagan, the Economic Recovery Act of 1981; George H. W., Bush the Omnibus Budget Reconciliation Act of 1990; Clinton, the Omnibus Budget Reconciliation Act of 1993; George W. Bush, the Economic Growth and Tax Relief Reconciliation Act of 2001; and Obama, the American Recovery and Reinvestment Act of 2009.

If fiscal reform does not occur in 2017 or 2018, it would be unprecedented.

5

Furthermore, officials from the Federal Reserve, European Central Bank and Bank of Japan have been consistently lamenting in recent years that monetary policy cannot exclusively support the major economies.

In March before the Economic Club of New York, Federal Reserve Chairman Janet Yellen conceded, “It certainly would be helpful to see fiscal policy play a larger role.”6

Then in August, Dallas Fed President Robert Kaplan said in a Bloomberg interview, "[Fed monetary policy] is designed to act along with structural policy and fiscal policy, and we haven't had that for seven years…I think the period of monetary policy being the main game in town probably needs to come to an end."7

Already in other countries, these calls by central banks, as well as pressure from voters, is compelling policymakers to implement fiscal policy changes. In Japan, Prime Minister Abe’s LDP Party has delayed a planned sales tax increase until 2019 at the earliest, and in August the LDP implemented $73 billion in new spending. Prime Minister Theresa May’s new government in the U.K. is contemplating corporate tax reductions as well as increased infrastructure spending. In austerian Germany, with elections looming next year and Chancellor Angela Merkel’s government in a tenuous political position, Finance Minister Schauble is promising $2 billion in tax cuts in 2017, and $17 billion in 2018. And in France, with elections also scheduled next year, President Francois Hollande is promising to reduce the corporate tax rate from 33% to 28% by 2020, as well as income taxes.

Clearly, looser fiscal policy is an emerging trend around the world in the face of seemingly exhausted monetary policy and dissatisfied voters.

So what could fiscal reform look like in the United States next year? When looking at the major power brokers on tax policy, the contours of future tax changes have already been painted.

Today, the six most important policymakers or ‘influencers’ to closely observe are: Hillary Clinton and Donald Trump (naturally, because one of them will be President); Senator Chuck Schumer (who will be the leading Democrat in the upper chamber of Congress); Larry Summers (the economic thought-leader for Democrats); House Speaker Paul Ryan (perceived by many to be the leader of the GOP of recent years); and Republican Congressman Kevin Brady (who by virtue of being Chairman of the House Ways and Means Committee, is in charge of U.S. tax code legislation).

6https://mninews.marketnews.com/content/fed-chair-yellen-qa-transcript-part-2-text7http://www.usnews.com/news/articles/2016-08-26/janet-yellen-at-jackson-hole-says-case-for-rate-hike-strengthened

6

Sources: Tax Policy Center, HillaryClinton.com, DonaldJTrump.com, KevinBrady.House.gov as of September 1, 2016

Hillary Clinton and Donald Trump have already drawn the outlines of their ideas for tax reform as illustrated in the table above. Specifically, Clinton is seeking surcharges on the highest income earners, including the implementation of the so-called Buffett Rule, increases to the tax rate on shorter-term capital gains to encourage more ‘patient’ capital investment, tax increases on estates, and a continuation of the Obama Administration’s efforts to discourage corporate inversions. Her plan is rooted in the Balanced Budget Hypothesis (the view that higher taxes and spending increase real GDP), raises taxes primarily on the 1% with little tax relief for the 99%, and is estimated to increase government revenue by $1.1 trillion over the next decade.

Mr. Trump is looking to reduce tax rates on marginal income, capital gains, and corporate earnings, as well as eliminate the AMT and estate tax, and install a low, temporary tax rate on repatriated earnings of U.S. companies. The plan, a supply-side stimulus package, is estimated to cost $4.4 trillion during the subsequent decade.

As for leaders in Congress, Speaker Ryan and Senator Schumer reportedly engaged in serious discussions in 2015 to increase infrastructure spending and entice U.S. earnings abroad to be reinvested back into the United States.8 While those negotiations did not conclude in a deal, both issues are high on the priority list in Washington: infrastructure spending to rebuild deteriorating roads and bridges, and comprehensive corporate tax reform to improve American competitiveness and reduce the wave of U.S. companies re-domiciling outside the United States.

No matter who becomes the next President of the United States and the priorities of Messrs. Ryan and Schumer, the most likely scenario next year is that everything will need to be negotiated with Ways & Means Chairman Kevin Brady, who has also drawn lines in the sand for what he believes are the best changes to the tax code.

8http://www.politico.com/story/2015/09/charles-schumer-paul-ryan-tax-infrastruture-moderate-214167

7

Compared to the Democratic and Republican presidential candidates, Brady’s plans are more similar to Mr. Trump’s, albeit he would reduce the taxes on capital gains and repatriated earnings a little more, and reduce the corporate tax rate a little less.

Certainly, given the common ground, the negotiations between Trump and Brady would be the easiest. But for as partisan as Washington seems today and for as different the Clinton and Brady tax plans are, there is plenty of room for those two to negotiate and find agreement.

Of particular importance is Larry Summers, the former Director of the National Economic Council under President Obama and Treasury Secretary in 1999-2000 under President Clinton. He recently called for $1-2 trillion in infrastructure investment to support the economy and opportunistically leverage historically low interest rates.

As Summers recently opined, “The case for infrastructure investment has been strong for a long time, but it gets stronger with each passing year, as government borrowing costs decline and ongoing neglect raises the return on incremental spending. As it becomes clearer that growth will not return to pre-financial-crisis levels on its own, the urgency of policy action rises.”9

Importantly, Summers’ position puts him squarely in line with Senator Schumer’s fiscal reform aims in 2015. It is reasonable to expect that a Democratic contingent (possibly a Democratic Administration and/or Senate Majority/Minority) seeking new infrastructure spending and Republican House Leadership insisting on corporate tax reductions and reforms will reach a compromise.

Of course, there is always the possibility that should Democrats win the White House and Senate, they will seek enough defections in the Republican House and support in the Senate to pass their own bill without any negotiation with and input from Chairman Brady. This scenario, however, has a low probability.

The political winds are more fluid than they have ever been in recent history. The current election cycle is extremely close, and thus will not necessarily produce a strong, obvious political mandate—with the exception of the anti-Establishment trend. Furthermore, any Democratic majority in the Senate will be extremely narrow, and Democrats are at a disadvantage in the 2018 Senate election races where they will be defending 25 seats (including 2 independents) and Republicans only 8. Add to this context the fact that central banks are clamoring for fiscal support from legislatures, the path of least resistance would be for a bipartisan fiscal agreement next year.

The Impact to GDP from a Negotiated Tax Deal

It is therefore reasonable to assume that a negotiated tax deal will fall somewhere in between no significant change in tax policy on the one hand (highly unlikely) and Chairman Brady’s proposal, on the other hand. If so, the impact upon GDP growth would range between zero and meaningfully positive.

To measure the potential economic upside, the Woodhill Equation is a useful method to measure the potential GDP stimulus of a given change in the tax code. Economist Louis

9BuildingtheCaseforGreaterInfrastructureInvestment,byLarrySummers,September12,2016,http://larrysummers.com/2016/09/12/building-the-case-for-greater-infrastructure-investment/

8

Woodhill has discerned a simple, yet elegant relationship from the 1951-2015 GDP and “produced assets” data published by the Bureau of Economic Analysis (BEA):

GDP = 0.08 (residential assets) + 0.44 (nonresidential assets)

The Woodhill Equation posits that GDP is driven by capital investment in real assets. Over the past 66 years, the GDP return on $1 of new residential assets has averaged 8 cents per year, while the GDP return on $1 of new nonresidential assets has averaged 44 cents per year.

While the Woodhill Equation is highly simplified, it suggests a methodology to assess the GDP impact of tax changes. We can assume that increases and reductions in taxes on savings and investment flow dollar for dollar into non-residential investment. This is conservative, because it ignores the incentive effects on the investment flows into and out of the United States.

Based on the Woodhill Equation, the Brady tax reform proposal would permanently increase annual real GDP by 1.9 percentage points. The federal deficit would increase during the first 1-3 years, but if monetary and regulatory policy cooperated and the higher growth were sustained, the deficit would quickly decline.

As such, a reasonable, conservative estimate of fiscal reform in 2017-2018 is that it will add up to 2 percentage points to U.S. real GDP growth.

Trade Reform

Next year, the United States will be entering the first innings of a new era of trade policy. Current policy, in place since World War II, has been significantly undermined by the 2016 election season, as each of the four leading candidates for President – Hillary Clinton, Donald Trump, Bernie Sanders and Ted Cruz – has rejected the Trans Pacific Partnership trade deal.

Indeed, the American electorate across the political spectrum finds more common ground against current U.S. trade policy than most other issues. Polling conducted in March 2016 by Selzer & Co. found strong majorities of Americans view NAFTA10 negatively and favor more protectionist policies in general. Ann Selzer told Bloomberg News, “Virtually every question of policy has a Republican-Democrat split. On trade, there is unity.”11

Between the founding of the United States and the early part of the Great Depression, the country was, for the most part, protectionist and mercantilist. But, as Clyde Prestowitz, President of the Economic Strategy Institute and former U.S. trade negotiator, has explained, three major factors conspired to shift American trade policy: a) the belief that the Smoot Hawley Tariff Act triggered the Great Depression, b) the fact that post-World War II supremacy of American industry meant it no longer needed protective barriers, and c) American geopolitical objectives to contain the expansion of Soviet influence.

According to Prestowitz, U.S. trade representatives during the Cold War sought trade deals primarily to open foreign markets for U.S. companies, encourage political-military alliances, and develop emerging markets. For almost 25 years, the strategy was seemingly a smashing

10TheNorthAmericanFreeTradeAgreementisathree-countryaccordnegotiatedbythegovernmentsofCanada,Mexico,andtheUnitedStatesthatenteredintoforceinJanuary1994.11http://www.bloomberg.com/politics/articles/2016-03-24/free-trade-opposition-unites-political-parties-in-bloomberg-poll

9

success for the United States, as it enjoyed full employment, strong economic growth, trade surpluses, a check on Soviet expansion, and economic recoveries in Europe and Japan.12

David Ricardo’s theory of comparative advantage, which underpinned this post-World War II free trade policy, posited that countries that specialized in their strengths would produce more, and thus both would be better off. In that regard, U.S. economists and trade negotiators pursued trade relationships where the United States utilized its skilled labor to export capital-intensive, high-technology products, while partner countries exported low-skill, labor-intensive products.

Increasingly, however, Asian countries, namely Japan, followed industrial policies that specifically sought, instead, to grow capital-intensive industries through subsidization and by limiting foreign entry into their own markets.

By the 1970’s, the United States had begun to run trade deficits that even floating exchange rates have still not been able to fix. ‘Win-win’ free trade orthodoxy seemingly began to breakdown.

The real world of trade in the late 20th century simply did not adhere to the assumptions underlying such orthodoxy. The key assumptions in free trade models that did not hold were, for example, perfectly competitive markets, fixed exchange rates, full employment, no economies of scale, no cross-border flows of capital and technology, no government subsidies and industrial policies, and constantly balanced trade.13

It appears that the offshoring phenomenon wrought by NAFTA (1994) and China’s entry into the WTO14 (2001), as well as the growing status and influence of China, were the tipping point, compelling the majority of American voters to increasingly call for changes in policy.15

The new era of trade policy will call for deeper integration of the major economic spheres and regions and, to one degree or another, greater adherence to strict interpretations of existing trade agreements. Larry Summers sees greater “trade harmonization;” Donald Trump is looking to make “better deals.”

Closer adherence to existing trade pacts will be the near-term philosophy of those changes in trade policy. As a result, major trading partners such as China, Japan, Germany, South Korea, and Mexico will be pressured to keep their trade promises, and to switch from investment and export-led growth models to consumption-led models.16

At the same time, expect to see surcharges threatened and applied on countries with large, prolonged trade surpluses, or those engaging in beggar-thy-neighbor conduct (e.g. dumping) or for providing substantial subsidies to their domestic industries (such as tax holidays, land grants, government-funded worker training, or other kinds of government cost-sharing).17

Also, the United States will likely counter foreign exchange rate manipulation with threats, penalties or even directly intervening in markets themselves.

12http://washingtonmonthly.com/magazine/junejulyaug-2016/free-trade-is-dead/13Ibid14WorldTradeOrganizationisanintergovernmentalorganizationwhichregulatesinternationaltrade.15Ibid16Ibid17Ibid

10

Market Implications of Fiscal Reform

Major fiscal reform will potentially increase quarter-over-quarter real GDP growth from its present 1-2% core trend to 3-4%. In such a positive scenario, the simulative effect would be comparable to the June 2003 tax reform spearheaded by House Ways & Means Chairman Bill Thomas, when quarter-over-quarter real GDP accelerated (despite hawkish monetary policy and a devaluing dollar) to a 3-5% growth rate range through 2006, from a 1-2% core trend following the bursting of the tech bubble.

Of course, the degree to which a tax compromise is reached next year will determine the degree to which real GDP will increase and provide the ‘escape velocity’ that the U.S. economy needs for the Federal Reserve to comfortably abandon its unprecedented, post-2008 low interest rate policy. Not coincidentally, the June 2003 tax reform created the necessary breathing room for Chairman Greenspan to shift monetary policy in June 2004.

Past Performance Does Not Guarantee Future Results.

Source: Federal Reserve Bank of New York, Bureau of Economic Analysis

In a strong tax reform scenario, the implications for financial markets are fairly clear: U.S. stocks would experience a strong rally and bonds will underperform (as interest rates would rise).

-10.00%

-7.50%

-5.00%

-2.50%

0.00%

2.50%

5.00%

7.50%

10.00%

12.50%

1990 1993 1996 1999 2002 2005 2008 2011 2014

U.S.RealGDPGrowth(QuarteroverQuarter) EffectiveFederalFundsRate

GDP lacksescapevelocity

11

To gauge the degree of the rally, consider for example, only the effects of a corporate tax rate reduction to 20% from 35%. A 15 percentage point reduction in the corporate tax rate today would increase the after-tax returns on corporate profits by 23.1%, which would translate into a comparable increase in stock prices.

To be even more granular, within 12 months of any legislation designed to reduce the corporate tax rate to this extent, one would expect in total a 23% rally in stock prices, whereby 25-50% of the rally, arguably, would occur once news of such negotiations emerged until the signing of the legislation, with the remaining 50-75% of the rally occurring subsequently.

Source: KevinBrady.House.gov, DonaldJTrump.com, WhiteHouse.gov

Of course, it is possible that next year’s tax reform will include other changes as well. Tax rate reductions to income, capital gains, and estates would significantly add to equity market returns.

Unless it is offset by liquidity expansion by the Federal Reserve, robust tax reform that increases incentives on investable capital will increase the demand for dollars, and therefore increase deflationary pressures.

As a result, the dollar would be expected to strengthen in real and relative terms. In financial markets, this will translate into downside price pressure in precious metals (particularly gold) and dollar strength in foreign exchange markets. The greatest forex dollar strength would occur in exchange rates of countries that would be pursuing expansionary monetary policies and contractionary fiscal policies (that create reduced liquidity demand for their respective currencies).

Economically-sensitive commodities will perform well, notably those that have decoupled the most vis-a-vis the real value of the dollar in recent years, notably oil, natural gas, and wheat.

Corporate Tax Reform Resultant After-tax Return on Corporate Profits to Shareholders

35% Current statutory rate -28% President Obama's offer, 2012 tax negotiations 10.8%20% Chairman Brady's current proposal 23.1%15% Donald Trump's current proposal 30.8%

12

Conversely, should fiscal stimulus not occur, the present market environment and dynamics will persist; where monetary policy will be the dominant driver of equity and fixed-income prices, and periodic bouts of risk aversion will erupt due to tail risks, notably from Europe, Asia and emerging markets.

In this scenario, Treasuries and high quality corporate bonds will remain highly attractive on a relative basis, as a Japan-style decline in yields continues, due to sub-optimal economic growth and a shackled Federal Reserve that operates with interest rates as its primary policy lever. The trajectory of dollar forex rates and precious metals would be driven primarily by the relative balance sheet expansions/contractions from the respective central banks, as well as any tail risks which emerge that create systemic risk aversion (such as the 2011-2012 panic surrounding European debt and currency union fears).

Sectors

If Hillary Clinton is elected President, noteworthy industries to overweight would be: infrastructure, hospitals and managed care (as the Affordable Care Act is modified to adjust to recent challenges by participant insurers and healthcare providers), and solar and renewable energy (to address Democratic environmental concerns). Underweight industries would be pharmaceuticals (as Democrats seek to address drug pricing anxieties) and energy (as regulatory barriers remain in place, e.g. the Keystone Pipeline).

Strong Fiscal Reform No Fiscal Reform(including Improvements to tax incentives) (no improvements to tax incentives)

Overweight: Overweight:Equities Fixed IncomeDollar Forex High Quality Corporate BondsIndustrial Commodities (oil, natural gas, wheat) Precious Metals (gold)

Underweight: Underweight:Fixed Income EquitiesPrecious Metals (gold)

Hillary Clinton Presidency Donald Trump Presidency

Overweight: Overweight:Hospitals EnergyInfrastructure FinancialsManaged Care InfrastructureSolar/Renewable Energy Pharmaceuticals

Restaurants

Underweight: Underweight:Energy HospitalityPharmaceuticals Railroads

13

If Donald Trump is elected President, industries to overweight would be: energy, financials, infrastructure, and restaurants. Underweight industries would be hospitality and other related industries sensitive to low wages, and railroad companies and other related industries exposed to NAFTA.

Market Implications of Trade Renegotiations

Naturally, renewed trade negotiations create the potential, at the outset, for headline risk to markets, as investors price for a host of risk and uncertainty. Importantly, the strength and size of fiscal stimulus will dictate the degree to which markets buffer those risks or concerns.

When considering the market implications of changes to U.S. trade policy, an important distinction to be mindful of is the difference between risk and uncertainty, which economist Frank Knight first distinguished in 1921. Whereas risk relates to a set of known, measurable outcomes, uncertainty relates to a set of unknown outcomes that are more difficult or even impossible to measure. Given that risk is more defined, market volatility is smaller than to market movements in reaction to increased uncertainty.

In trade renegotiations, the set of outcomes or consequences are significantly less known and measurable than, for example, changes in the tax code. A multitude of questions obviously emerge. Will trading partners retaliate? To what degree? What will be the economic effects on the respective industries and communities? Will seemingly sudden economic dislocations or transformations create isolated or systemic banking risks?

Accordingly, a sound, sustainable risk-taking environment (supported by strong economic growth and non-threatening monetary policy) will be most favorable for financial markets and investors while trade agreements are renegotiated.

Caution will be warranted in long positions in currencies exposed to trade renegotiations, particularly the renminbi and Mexican peso.

Trade Renegotiations: Investment Considerations

Cautious: Peso-$ forex rate (bearish peso)Yuan-$ forex rate (bearish yuan)

Industries Vulnerable to Significant Transformation:Audio-Video EquipmentComputersFurnitureSemiconductorsTextiles and ApparelAerospaceBiotechnologyLife SciencesNuclear Technology

14

Investors – on both the long and short side – will also need to consider the potential for significant transformations of certain industries as a result of any renegotiated trade agreements. The obvious industries are those most affected by existing trade agreements, particularly within the manufacturing and advanced technology sectors.

According to the Economic Policy Institute, “Most of the jobs lost or displaced by trade with China between 2001 and 2013 were in manufacturing industries (2.4 million jobs, or 75.7 percent).” These industries include computer and electronic parts (e.g. computers, semiconductors, and audio-video equipment), textiles and apparel, and furniture.18

In 2013, the United States had a $116.9 billion deficit in advanced technology products with China, and this deficit was responsible for 36.0 percent of the total U.S.-China goods trade deficit. In contrast, the United States had a $35.6 billion surplus in advanced technology products with the rest of the world in 2013. The advanced technology products sector is comprised of industries such as, biotechnology, life sciences, aerospace, and nuclear technology.

Given Hillary Clinton’s more favorable view in the past of present U.S. trade policy, and despite her recent criticisms of the Trans Pacific Partnership, it’s more likely that the pace of change to trade policy will be slower-moving compared to a Trump Administration. As a result, the potential market impact is likely to be meaningfully muffled, on a relative basis.

Monetary Reform: Potentially the Major Policy “Surprise” of 2017

If Mr. Trump is elected President, there is another major economic policy shift that may emerge in 2017: monetary reform.

Art Laffer has said, “If regulatory policy is important by a factor of 1, then fiscal policy is important by a factor 10, and monetary policy by 100.” The considerable impact of monetary policy necessitates exploring the prospect of, and developing a framework for understanding and navigating, such a scenario.

With 45 years having passed since the breakdown of the Bretton Woods Agreement and the dawn of the modern, fiat money era, it is understandably difficult for many to contemplate the possibility of international monetary reform. But, indeed, it is possible.

Many members of Mr. Trump’s economic team are stable dollar advocates, and Ways & Means Chairman Brady has sought the establishment of a commission to explore alternatives to discretionary monetary policy, possibly in favor of a more rules-based approach. Furthermore, Speaker Ryan has long favored the Federal Reserve target a commodity basket, in keeping with Federal Reserve Governor Wayne Angel’s unofficial approach when he helped steer monetary policy between 1986 and 1994.

Also, the issue of U.S. monetary policy will surface organically. Trade renegotiations and complaints of currency manipulation will raise Fed policy as a central issue, as foreign central banks, governments, and trade negotiators inevitably lament that the dollar’s volatility is a significant factor behind, or reason for, their own currencies’ fluctuations.

18http://www.epi.org/publication/china-trade-outsourcing-and-jobs/

15

In truth, the dollar’s volatility in real terms plays a role in the foreign exchange decisions by some trading partners. When the real value of the dollar depreciates, foreign central banks will be incentivized to strengthen their currencies to maintain a more stable real value for their currencies; whereas when the real value of the dollar strengthens (as in recent years), those central banks will depreciate their currencies to create greater real currency stability.

For example, the yuan’s exchange rate vis-a-vis the dollar is traditionally inversely correlated with the dollar-denominated gold price. When the gold price has risen (dollar depreciation; more fiat currency required to purchase an ounce of gold), then the yuan has strengthened versus the dollar. When the gold price has fallen (dollar appreciation; less fiat currency required to purchase an ounce of gold), then the yuan has depreciated.

Past Performance Does Not Guarantee Future Results.

Source: Federal Reserve, Comex

It is no coincidence that the real appreciation of the dollar since late 2012 culminated with the inflection point in yuan-dollar foreign exchange policy by the People’s Bank of China, notably the major, sudden depreciation of the yuan in August 2015 from ~6.2 to 6.38.

The significance of monetary reform cannot be overstated. The last 45 years have been a unique experiment in monetary history where commerce has been conducted without any major

5.6

5.8

6

6.2

6.4

6.6

6.8

7

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

2010 2011 2012 2013 2014 2015 2016

Yuan-DollarExchangeRatevs.Gold($/oz.)

Gold($/oz.) Yuan-DollarExchangeRate

16

currencies tied to something “real.” There is a reasonable chance that we may witness the beginning of the end of this fiat monetary era.

What would this mean for investors? What framework should investors use to navigate financial markets if the beginnings of monetary reform take shape in 2017?

Financial Market Implications of Monetary Reform

The objectives and nuances of any monetary reform will mean everything. The critical, initial question is, would new monetary policy maintain the Federal Reserve’s current policy of utilizing interest rate targets as the primary policy lever? If not, what will be the new policy lever and objectives?

The likely alternatives to current Fed policy would be the Taylor Rule (or variation thereof), NGDP19-targeting, gold-price targeting or a commodity-basket target.

If the Taylor Rule becomes the expected policy reform outcome, the interest rate lever would remain the policy mechanism of choice. In this scenario, financial market volatility would erupt, with the short-end of the U.S. Treasury rising, and stocks weakening due to the prospect of a higher short-term overnight policy rate. The risk aversion would limit a rise in yields on the long end of “the curve”, causing a yield curve flattening.

If NGDP-targeting is the chosen alternative, expect significant stock and bond market volatility during the near-term -- reminiscent of 1979-1980 -- as interest rates become market determined, and monetary and economic uncertainty create significant ‘noise’ for equities.

19NominalGrossDomesticProduct.WhereasrealGDPisadjustedforinflation,nominalGDPisnot.

17

Past Performance Does Not Guarantee Future Results.

Source: St. Louis Federal Reserve Bank, the author’s opinions

If gold-price targeting or commodity-basket targeting are the chosen alternative, the policy target, its lever to achieve the target and the price of the target will mean everything. Not knowing these specifics today, the outcomes are highly unpredictable at the moment. For example, the simple question, will this translate into broad stock market strength or weakness, cannot be answered without knowing the specific policy target and its level.

However, a basic framework suggests bond yields will likely rise temporarily, in anticipation of becoming market determined. As for equities and specific industries, the trajectory of the gold price will provide important clues.

-6%

-4%

-2%

0%

2%

4%

6%

8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 2015

10-YearTreasuryYieldvs.GoldImpliedInflationRate

10-YearTreasuryYield Gold'sImpliedInflationRate

MonetaryAggregateTargeting:InterestRatesFloatFreely

18

Past Performance Does Not Guarantee Future Results.

Source: Comex

A decline in gold prices will signal investors to: overweight developed over emerging market equities, overweight technology and consumer staples and discretionaries, underweight commodities, long dollar forex, short yuan, and “speculative short” dollar-pegged currencies.

An increase in gold prices will signal investors to: overweight emerging market equities over developed markets, overweight commodities, underweight utilities, short dollar forex.

Reform of current monetary policy is certainly no small matter. It will impact virtually every economic actor in the world, as every currency and implicitly “contract” whether for products or labor is interrelated with the dollar, the world’s reserve currency. Even more, during the lead up to any formal, announced reform, speculation of such reform and decisions made on such speculation can have a profound effect on economic activity and financial markets.

Strong underlying economic growth, of course, would support any transition to a new monetary policy era. Just as importantly, policymakers must design and implement best practices for communicating with the public (including financial markets) about reform.

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

GoldSince1971

LastPrice 12.5-yearMovingAverage

19

The following are general guidelines for policymakers:

1) The greater the degree of public understanding, the more efficient the transition in policy. 2) Communication must be integrated into the policy evolution, and articulated credibly and

proactively. 3) Policy objectives and the path to achieve those objectives must be plainly and

abundantly clear.

These guidelines provide not only a basis for policymakers, but also capital allocators to gauge, prepare, and reallocate financial assets in capital markets.

Market participants will need to ask is, to what extent are policymakers adhering to this communication strategy? Even in a scenario where monetary reforms will be beneficial for economies and markets, the degree of adherence to these guidelines will determine the ultimate scale of capital market volatility.

In Conclusion

With a shift in power looming in Washington, financial markets and macroeconomic policies are very likely at a significant inflection point. And given the enormity of the contemplated policy changes by American leaders, tectonic shifts in the complex web of capital markets and within industry in the United States and around the world may occur in the coming years.

If there is anything that is certain about the upcoming twelve to twenty-four months, it is that strong underlying economic growth can not only give central banks desperate breathing room, but buffer markets, countries, specific industries and labor from the transition, and any of its unintended consequences.

Temporary economic stimulus is rooted in counter-cyclical fiscal policy; whereas long-term, sustainable growth is predicated on deep structural fiscal, monetary, trade and regulatory policies.

As Alan Blinder and Mark Watson have discovered, different presidencies can produce immense effect on growth and financial market performance. In terms of real GDP performance,

Monetary Reform: What Alternative?Rules-based System Anchored in Interest Rates

Taylor Rule

Rules-based System Anchored in Price TargetNGDP-targetingGold Price TargetCommodity-basket Target

What target? At what level?Historical relationship of price universe with the target level?

Policymaker Adherence to Communication Best Practices?Clear ObjectivesPublic UnderstandingCommunication: Integrated, Articulated, Proactive

20

the most successful Administrations of the post-World War II were President Truman (1949-1953), Kennedy-Johnson (1961-1965), Johnson (1965-1969), Clinton (1997-2001), and Reagan (1985-1989).

Past Performance Does Not Guarantee Future Results.

Each of these Administrations, with the exception of President Truman who oversaw the end of the Second World War and the beginning of the post-war global recovery, negotiated strong counter-cyclical fiscal policy that re-ignited the U.S. economy.

After assessing the key power brokers today, there is cause to be optimistic that major fiscal reform will be reached next year, and as a result, the present economic environment and market trend will meaningfully change. The frameworks for capital market participants contained herein are a reflective attempt to navigate those shifting tides.

Average GDP Growth Rate by TermRank Term Growth Rate (%)

1 Truman (1949-1953) 6.57%2 Kennedy-Johnson (1961-1965) 5.74%3 Johnson (1965-1969) 4.95%4 Clinton (1997-2001) 4.03%5 Reagan (1985-1989) 3.89%6 Nixon (1969-1973) 3.57%7 Carter (1977-1981) 3.56%8 Clinton (1993-1997) 3.53%9 Reagan (1981-1985) 3.12%10 G.W. Bush (2001-2005) 2.78%

Source: Presidents and the U.S. Economy: An Econometric Exploration,

Alan S. Blinder and Mark W. Watson, Woodrow Wilson School and

Department of Economics, Princeton University, July 2014.

21

The views and opinions expressed in this paper represent the opinion of Quaker Funds, Inc. and are believed to be true and accurate as of the open of business on 9/26/2016 and are subject to change on the basis of subsequent developments. These views are not intended as investment advice or as a prediction of the performance of any investment.

About the author:

Paul Hoffmeister, Portfolio Manager

Paul is a Portfolio Manager and Partner at Quaker Funds. He also serves as Economic Counsel to Bretton Woods Research, a financial research firm that assesses macroeconomic variables to identify economic catalysts, investment opportunities, and risks. Paul was previously the Director of Market Strategy and Chief Economist at Polyconomics and has advised several political campaigns. He has written for Forbes.com and has been quoted by such news outlets as Bloomberg, Reuters, and National Review. In addition, Paul has appeared on Kudlow & Company and radio talk shows. He graduated Georgetown University with a concentration in accounting and finance.

He can be reached at phoffmeister@quakerfunds.com

22

Contact us: Quaker Funds, Inc. c/o U.S. Bancorp Fund Services, LLC P.O. Box 701, Milwaukee, WI 53201-0701 800.220.8888 www.quakerfunds.com

Mutual fund investing involves risk, including the possible loss of capital.

Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The Statutory and, where available, the Summary Prospectuses contain this and other important information and are available for download at www.quakerfunds.com or by calling 800.220.8888. Read carefully before investing.

©2016 Quaker® Investment Trust | The Quaker Funds are distributed by Foreside Fund Services, LLC.