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Historical Perspective of Current Turmoil in Washington, D.C.

Given the recent controversies in Washington and nascent signs of political parallels between the Watergate era and today, we examined the market behavior and economic backdrop during the Watergate scandal years vs. today.  We do not pretend to be political pundits and the current scandal is in the very early stages and the outcome is uncertain, however we wanted to provide an analysis of the financial markets’ reaction to historical precedent and our thoughts on the current U.S. stock market.

The Watergate Era:
The Watergate scandal led to the resignation of President Nixon in August 1974, almost two years after Nixon took over 60% of the vote in his reelection in 1972.  The U.S. stock market (S&P 500) corrected over 45% during the Watergate era…an alarming number that grabbed our attention. However, the U.S. economy was in much worse shape during the early 1970’s and we argue the economic problems were the primary catalyst for the severe correction in the U.S. stock market vs. the Presidential Impeachment.

The U.S. economic problems in the early 1970’s originated from persistently high rates of inflation. Government expenditures had soared during the Vietnam war and there was no effort to reign in domestic expenditures or raise taxes in both the Johnson and Nixon administrations.  At the same time, the Federal Reserve, chaired by Arthur Burns, maintained a persistently accommodative monetary policy to facilitate Nixon’s reelection in 1972.

In August of 1971, two actions made the situation worse. 1) A 90 day freeze on wages and prices was announced, to be followed by successive phases which lasted until April 1974. Initially, these actions were politically popular and inflation (CPI) moderated. However, with the oil price shock of 1973 and the price of crude oil rising from $3.50/barrel to over $10.00/barrel in only six months, the CPI rose to over 10% by February 1974.  2) President Nixon also cancelled the direct convertibility of gold into dollars, effectively ending the Bretton Woods system of fixed exchange rates which had prevailed since 1944.  Gold rose from $40 per ounce in August 1971 to $180 per ounce by the end of 1974.  The U.S. dollar (DXY index) weakened from 120 to 90 over the same time.  These actions only exacerbated the inflation problem.

Belatedly, the Federal Reserve responded by dramatically tightening monetary policy.  The Federal Funds rate had been at 5% at the time of the 1972 Presidential Election. By July of 1974, the Federal Funds rate had risen to a peak of 13%. The tightening and the oil price shock of 1973 set the stage for a recession between November 1973 and March 1975 which was the most severe in the post- World War II to date. The U.S. inflation adjusted GDP declined by 6.8% during that time. The severity of the recession led to the severity of the stock market decline:

Tame Inflation and easing of monetary policy led stock and bond bull markets:

Source: Bloomberg, Princeton Global Asset Management

Thereafter, the U.S. stock market began a sustained uptrend in January 1975, accompanied by an easing of monetary policy.  It should be noted that the problem of inflation in the U.S. persisted through the rest of the 1970’s and into the early 1980’s. It was only under Paul Volcker as Federal Reserve Chairman that the problem of inflation was ended, with long term bull markets beginning for bonds and stocks in 1982:

Tame Inflation and easing of monetary policy led stock and bond bull markets:

​​Source: Bloomberg, Princeton Global Asset Management

Today:
There are political parallels between the Watergate era and today, particularly the naming of former FBI director Robert Mueller III as special counsel to oversee the federal investigation into Russia’s alleged interference in the 2016 presidential election.  Once again, the current scandal is in a much earlier stage and the outcome is uncertain.

Further turmoil in D.C. would lead to further market volatility (more days like 5/17), but we do not believe current U.S. stock market levels have been buoyed by a “hope trade” for success of the Trump Administration’s initiatives. We believe evidence of an improving global economy has led to higher share prices. Per Goldman Sachs, data supports that stocks set to benefit the most from the Trump agenda including companies with high tax rates, infrastructure related companies and banks have given back almost all the strong relative performance they experienced at the end of 2016/beginning of 2017:

Post-election policy expectations have mostly unwound:

Were Trump not to serve out his full term and be replaced by the current Vice President Mike Pence, the implications for U.S. financial markets could be positive.  During his prior service as a Congressman between 2001 and 2013 and Governor of Indiana beginning in January 2013, Pence proved to be a reliable member of the fiscal conservative wing of the Republican party. He would likely be a strong advocate for the pro-business aspects of the Republican agenda including tax reform for corporations (both reduction in corporate tax rates and incentives for repatriation of overseas funds), tax reform for individuals, and a reduction in regulation without the potentially negative aspects of protectionism and anti-immigration.  Without the distractions emanating from the White House, the ability to enact the Republican agenda would most likely be enhanced and would be supportive of favorable market conditions in the U.S.

The bottom line is that the current backdrop remains favorable for the U.S. stock market.  Inflation rates remaining at 2% or less should allow the Federal Reserve to normalize interest rates at a gradual pace which will not raise the risk of derailing steady growth in the U.S. economy.  Corporate earnings should remain strong, as was the case in the first quarter of 2017, providing a catalyst to higher share prices.  Outside the U.S., the pace of recovery is accelerating in Europe and Japan, with China remaining relatively robust, as well.  Our strategy is to remain overweight in sectors which benefit from a more favorable global economic environment and the initiatives of the current administration which have a higher probability of coming to fruition.  Currently the sectors of focus include Financials, Technology, And Energy.

Sincerely,

Princeton Global Asset Management LLC

Important Disclosures:
This report is for informational purposes only, and contains data based on information Princeton Global Asset Management (PGAM) believed to be accurate.  However, PGAM cannot assure the accuracy of the data. Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.

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