LEADERSHIP SERIES DECEMBER 2016

A feature article from our U.S. partners

From Low Volatility to High Growth?

The new pro-growth administration could kick-start stocks and
a stagnant U.S. economy
Jurrien Timmer l Director of Global Macro l @TimmerFidelity

Key Takeaways
The high-vol presidential candidate has won,
and with a sweep of both houses of Congress,
the Republicans now have a chance to enact a
bold, pro-growth populist agenda.
This result could be positive for growth, as
long as it is not offset by rising protectionism
and a more hawkish Federal Reserve (Fed).
The U.S. economy has reached full employment without emerging from its stagnant
growth track, so any acceleration from here
will likely be accompanied by higher inflation.
A return to growth and inflation could give the
Fed and other central banks an exit strategy
from the era of unsustainable unconventional
monetary policy.

The Republican sweep could be good

for stocks
Looking at a presidential race strictly through the lens
of the financial markets, I have always viewed elections
as a choice between a low-vol candidate who would
maintain the status quo, and a high-vol candidate who
promises massive change, which would upset the status
quo that the other candidate seeks to preserve.
Now, after a stunning upset, the high-vol candidate
is our president-elect, and the Republicans swept the
House and Senate. As a result of this outcome, many
of the claims and promises made during the campaign
may actually be implemented, which could be good
news for the stock market. Historically, in the year
following a Republican sweep of both the White House
and Congress, stocks have had a higher return (+8.2%)
than in any other election outcome (Democratic sweep,
Democratic Congress/Republican President, Democratic
President/Republican Congress).1
For now, markets are adjusting to the potential for
positive growth and rising inflation that may result
from Trumps promised combination of tax cuts, deficit

spending, deregulation, and foreign cash repatriation.

meaning the level of economic activity at which growth

The U.S. dollar has rallied sharply, U.S. bellwether stock

becomes self-sustaining (e.g., 3% to 4% GDP growth,

market indexes have soared to record highs, and the

adjusted for inflation) without aggressive intervention

10year Treasury yield has risen from 1.7% on election

bythe Fed. If the latter, the U.S. dollar could rise too

night to 2.3% (Nov 25). It has been a massive reflation

much and lead to a tightening of financial conditions like

trade, meaning investors are betting that the world

we experienced earlier this year.

economy will rebound and drive up interest rates and

commodity prices. Its not a cookie cutter reflation trade,

A return to normal for central banks?

though, because emerging-markets stocks have been left

One thing that gives me hope is that a return to more

in the dust (so far).

robust growth and higher inflation could create a path

With change comes uncertainty, and investors generally

want to be compensated for uncertainty through a
higher risk premium; e.g., a lower price-to-earnings
(P/E) ratio. Uncertainty is what we have for now, as we
wait for the president-elect to take office and announce
his cabinet and policy specifics. It doesnt help that the
market is fully valued at around 19 times trailing (past 12
months) earnings and that inflation will likely rise. Thus,
any increase in corporate earnings may be partially offset
by a compression in P/E multiples.
Two questions loom large as we wait for the new administration to take control. First, to what degree will this
pro-growth agenda be offset by increased protectionism
(economic policies designed to limit often-unfair foreign
competition)? Second, to what extent will the Fed lean
into the expectation of higher growth by raising interest
rates by more than it otherwise would have?
The latter question is critical, because its a potential
double-edged sword. With the odds of a December
interest-rate hike at 95%, it seems almost certain that
the Fed will raise rates at its next meeting on Dec. 1314.
But, will the Fed allow the economy to run hot for a while,
until it sees the whites of inflations eyes? Or will it seek
to move pre-emptively and give more hawkish forward
guidance for 2017 and beyond? If the former, the U.S.
economy may finally reach what we call escape velocity,

for central banks to return to conventional monetary

policy and, in the process, undo the distortions that have
infected financial markets. I have long worried about
what the end game might be for all this unconventional
monetary policy. Wouldnt it be great if the central banks
were bailed out by growth? A return to growth and
inflation could put an end to the low-vol, high dividend
phenomenon that turned the markets upside down. Also,
given that many active managers have underperformed
the markets directly as a result of this distorted sector
leadership, a return to growth and inflation could mark a
return to favor for active management more broadly.
As weve seen since the financial crisis, monetary policy
reaches its limits when rates decline to the zero lower
bound (ZLB). Yes, there is quantitative easing (QE) as a
means to create the effects of additional rate cuts, and
theres even negative interest-rate policy (NIRP). But, as
central banks around the world have discovered, the
benefits of some unconventional monetary policies are
far from clear, while the unintended consequences are
very real.
After years of fiscal austerity, it now appears the baton is
being passed from monetary policy accommodation to
fiscal policy stimulus. Just in time, too. Its ironic that the
Fed has been talking about the day when the economy
would finally get out of its funk of 1% to 2% real growth
and reach escape velocity. It hasnt happened so far, but

FROM LOW VOLATILITY TO HIGH GROWTH?

that didnt prevent the unemployment rate from falling

Potential investment regime scenarios

from 10% in 2009 to 4.9% today.

Ive spoken in the past about which investment regimes

In other words, the U.S. economy has reached full

are more or less likely to occur, and Ive used a bell-

employment (i.e., the limit of how fast the economy can

shaped distribution curve as an illustration. Prior to the

grow without creating inflation) without ever accelerat-

election, it seemed wed be stuck in the current secular

ing out of its stagnant growth track. Now, just when the

stagnation regime for the foreseeable future (the mid-

economy has reached its inflation threshold, we may fi-

dle of the bell curve in Exhibit 1). It was a grind-higher

nally get the escape velocity thats been missing. But it is

market in which interest rates would remain low to offset

happening at a time of full employment, so when escape

weak earnings growth. I perceived that a left-tail event

velocity meets full employment, it is likely that inflation

(deflation bust) and a right-tail event (inflation boom)

will follow.

were very unlikely, and that if we had any kind of regime

This is why it seems very likely that a positive growth

shift it would be either toward stagflation (as the econo-

shock will be accompanied by rising inflation. This sug-

my reaches its inflation threshold without reaching escape

gests potentially better earnings growth, but the resulting

velocity), or a bond bubble (as the effects of increasingly

price gains may be at least partially offset by a decline

unconventional monetary policy caused more and more

in P/E multiples. And history shows that the markets P/E

disruptions in every asset class around the world).

ratio is inversely correlated to the inflation rate (higher

Now, with a pro-growth administration taking shape, I

inflation leads to lower P/Es and vice versa).

need to rethink that bell curve. The left tail is still small,
but with rates resetting higher the bond bubble scenario

EXHIBIT 1: Higher inflation is more likely now than it was

before the election
Investment Regimes

now seems less likely than before. Meanwhile, the righttail scenario of an inflation boom (or boomlet) is not so
easily dismissed any more. And that could be a good
thing for investors in stocks.

Secular
Stagnation

Authors
Jurrien Timmer l Director of Global Macro, Fidelity Global
Asset Allocation Division
Jurrien Timmer is the director of Global Macro for the Global
Asset Allocation Division of Fidelity Investments, specializing in
global macro strategy and tactical asset allocation. He joined
Fidelity in 1995 as a technical research analyst.
Deflation
Bust

Bond
Proxy
Bubble

Stagflation

Inflation
Boom

Fidelity Thought Leadership Vice President Matt Bennett provided editorial direction for this article.

For illustrative purposes only.

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1

Dow Jones data, Haver Analytics, Fidelity Investments, as of Nov. 18, 2016.

Bloomberg Finance L.P., as of Nov. 21, 2016.

Bureau of Labor Statistics, as of Nov. 4, 2016.

Index definitions
Standard & Poors 500 (S&P 500 ) Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry
group representation to represent U.S. equity performance. S&P 500 is a registered service mark of The McGraw-Hill Companies, Inc., and has been
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US: 780796.1.0

CAN: 782986.1.0

61.111252E