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Preparing For A Trump Presidency

January 18, 2017

The last time Republicans controlled more power in government was 1928. Trump’s administration stands out for having the lowest average government experience since Reagan but by far the most business experience of any administration in recent history. Trump, himself, stands out as a deal-maker. In short, this is a precedent-setting moment where Trump has the infrastructure beneath him to potentially accomplish significant policy changes.

Trump’s pro-growth policies represent a shift from monetary policy and increased regulation to fiscal policy and de-regulation. Policies includes tax reform, healthcare reform, trade, and energy infrastructure. His objective is to generate more jobs for Americans and spur economic growth.

The stage is set for reflation and the capital markets have reacted accordingly. Interest rates have spiked with the U.S. 10YR Treasury climbing 0.60% since election day. Optimism for economic growth drove U.S. equity prices to all-time highs, strengthened the dollar, and generated a spark in cyclical commodity prices.

Trump’s deal-maker character is also a major shift in how government policy is pursued…which is why we caution that uncertainty remains on when and how these policies will impact the economy and asset returns. Will Trump utilize his power to push through divisive policies? Or if Trump wants to be popular (so the GOP can maintain control and he can get re-elected in 2020), will he follow a more inclusive course? Importantly, when will the administration’s policies be passed and implemented? Tax and healthcare reform is complex and time consuming. The impact to trade policy is complex and difficult to predict. Between tweeting and spectacle press events, the next four years will be entertaining yet volatile for the financial markets…

PREPARING FOR A TRUMP PRESIDENCY

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Change in number of Democrats since 2008

Source: Washington Post

U.S. 10 Year Treasury Yield

Source: Strategas

President-elect Trump is not one thing or another. He is not an ideological Republican or Democrat. What we

do know is that he will be difficult to forecast and it will be a quick changing environment…

WE DON’T KNOW WHAT IS GOING ON!

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Wall Street Journal, January 17, 2017

Washington Post, January 15, 2017

Forbes, January 16, 2017

“One of the key

problems today is

that politics is such a

disgrace. Good

people don’t go into

government.”

“My Twitter has become

so powerful that I can

actually make my

enemies tell the truth.”

Trump’s administration stands out as having

the lowest average government experience

since Reagan but by far the most business

experience of any administration in recent

history.

Trump has also leaned heavily on

appointees with military experience to

compensate for his lack of foreign policy

experience.

BUSINESS EXPERIENCE OF TRUMP ADMINISTRATION

4Source: NPR

Types of Experience on Cabinet Members’ Resumes

Affordable Care Act

Repeal requires just 51 votes

Repeal of the 3.8% tax on capital gains/dividends and Cadillac tax ($64B estimated stimulus)

Could take 3 years to implement

De-regulation

Obamacare – could be instant

Energy projects (estimated at $48B) – could be instant

Emissions

Financial services

Labor

Trade

Withdrawal from the TPP

Renegotiations of NAFTA

Border tax proposal in conjunction with tax reform (see pages 12-13)

Cabinet Secretaries

51 votes required

Supreme Court Pick

60 votes required

Tax Reform

See pages 6-13

2017 CONGRESSIONAL AGENDA

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Corporate Tax Reform

Current rate is 35% but effective average tax rate is approximately 25%.

Trump proposal is 15% while also closing loopholes.

House Republicans have proposed 20% while also closing loopholes.

Border-Adjusted Tax could be an innovation in global tax policy – its short term impact to global currencies could be significant.

Special reduced tax rate on business income from flow-through entities like S-corps and LLCs.

Repatriation tax holiday of foreign profits for infrastructure spending ($100B).

A completed tax reform will likely happen until late 2017 – so no meaningful impact on 2017 GDP. With that said, there is historic precedent for retroactive changes.

Personal Tax Reform

Affordable Care Act repeal of 3.8% tax on investment income is likely.

Leading proposals call for a reduction in the number of tax brackets from seven to three (10%/25%/33%). Currently, the top marginal tax rate is 39.6%.

All deductions are up for elimination except mortgage interest and charitable deductions – a compromise could be a dollar cap on the total allowable deduction amount per return.

Modifying capital gains, dividend, and estate taxes.

Special reduced tax rate on business income on select pass-through entities like S-corps and LLCs. 90% of businesses in the US are pass-through entities whose income is reported on the individual’s tax return and subject to personal tax rates – could this rate end up being lower for some pass-through entities than income taxed as wages? It is possible.

TAX REFORM – RANGE OF OUTCOMES WILL BE LARGE

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While corporate tax reform is dominating the recent tax related headlines, namely for its connectivity to the

boarder adjustment proposal, any change to the treatment of pass-through entities could have a

profound impact on the small business owners across America. Combined, these entities earn

approximately 50% of all business related income and employ the majority of the private sector workforce.

PASS-THROUGH ENTITY TAX REFORM RELEVANCE

7Source: Tax Foundation, IRS

Recent Growth In Pass-Through Entities over C-Corps Pass-Through Businesses Net Income now exceeds C-Corps

US CORPORATE TAX RATE COMPETITIVENESS

8Source: Strategas, Tax Foundation, and Organization for Economic Cooperation and Development

Statutory Corporate Tax RatesCombined Federal + Subnational Tax Rates

OECD International Tax CompetitivenessCorporate Tax Score

US tax rates are relatively high and uncompetitive compared to the rest of the world…

The effective US corporate tax rate is ~25%.

Looking at the S&P 500 sectors by their effective tax

rates, more sectors than not benefit from the GOP tax

rate proposal.

HIGHER TAX RATE SECTORS

9Source: Strategas, Tax Foundation, and RBC Capital Markets

Top US Corporate Income Tax Rate &

Effective US Corporate Tax Rate

S&P 500 Sector Effective Tax Rate

Companies with high tax rates are outperforming since the election.

Companies with domestic-only sales exposure are outperforming (particularly small caps).

MARKET REACTION TO TAX POLICY SINCE ELECTION

10Source: Strategas

S&P 500 Companies with High Tax Rates vs.

S&P 500 Companies with Low Tax Rates

S&P 500 Companies with 100% US Revenue Exposure

Relative to the S&P 500

Presidential Election

President-elect Trump’s Treasury Secretary nominee explicitly said that income tax rates could

be lowered with no additional benefit for the wealthy as they would lose significant deductions.

This could also include taxing municipal bond interest which is currently exempt from

federal income tax.

Municipals have been hit hard since the election for several reasons:

Interest rates are moving higher

Real possibility of federal income tax rate cuts that make munis less attractive all else being

equal

Potential for increased supply from new highway spending – including public/private

partnership funding sources

The threat to the municipal bond interest exemption from income

TAX REFORM MAY CONTINUE TO PRESSURE MUNICIPALS

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12/13/2015 12/13/2016

Index YTW YTW

Barclays Agg 2.60% 2.60%

Barclays Municipal 2.20% 2.70%

0.50% change in spread

Unusual for Taxable Yields

> Tax Exempt Yields

Source: Bloomberg

Unusual for Taxable Yields to

be less than Tax Exempt

Yields

Congress is proposing tax reform, not tax cuts.

The goal is for “deficit neutral” tax reform that lowers tax rates while removing tax deductions and credits.

The Border Adjusted Tax system is a destination cash flow tax proposal and includes:

Capital expenditures receive an immediate write-off – no depreciation.

No more deductions of net interest expense (although financial services would get treated differently).

Eliminates the tax deduction for expenses incurred overseas while excluding revenues generated overseas.

Theoretically, it incentivizes businesses to reduce debt and encourages more equity in the capital structure. It

also incentivizes companies to increase capital expenditures in the US and move manufacturing operations or

other profitable divisions out of lower tax jurisdictions overseas.

Example of impact on a US retailer that sells imported goods in the US:

Taxes would be paid on the full sale price of imported goods rather than the profit of the transaction.

It should also reduce the trade deficit (estimates are $1.2T) and theoretically strengthen the dollar.

If the tax package increases the deficit over the 10-year window, the provisions are temporary and defeats the

purpose of reforming the tax code.

BORDER ADJUSTED TAX PROPOSAL

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The Border Adjusted Tax system eliminates the tax deduction of expenses incurred by importing

goods…

Taxes would be paid on the full sale price of imported goods rather than the profit of the transaction.

SAMPLE BORDER ADJUSTED TAX IMPACT ON RETAILERS

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Current Corporate Tax Border-Adjusted (All Imported Goods) Border-Adjusted (All Domestic Goods)

Net Income Margin = 20% Net Income Margin = 12% Net Income Margin = 24%

Source: RBC Capital Markets

Fiscal policies should lead to higher inflation in the US…

US bond yields spiked substantially more than Germany and Japan.

Federal Reserve is projecting for ~200bps increase in the Fed Funds Rate over the next 3 years.

POLICY SHIFT IS REFLATIONARY

14Source: Federal Reserve and RBC

Change in 10YR Government Bonds Since June Lows

A US Phenomenon

Federal Funds Rate

Federal Reserve Projections (December 2016)

Wages are due to accelerate…

US is currently long in the economic cycle.

US unemployment rate is low.

REFLATION – WAGE INFLATION

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Unemployment Rate (RHS) vs. Wage Increase (LHS)

Closing the Gap

Yearly Wage Increases

Creeping Towards > 2%

Source: RBC

US Inflation expectations have spiked…

REFLATION - INFLATION

16Source: Federal Reserve and Statista

Projected Annual Inflation Rate Personal Consumption Expenditure Inflation Rate

Under the Border Tax Proposal, companies relying on imports would see higher

taxes and lower net incomes – resulting in higher prices for those goods…

REFLATION – HIGHER RETAIL PRICES

17Source: Wall Street Journal

Non-defense discretionary spending by the US government has fallen to historic lows – at the expense

of public infrastructure…

REFLATION – GROWTH IN INFRASTRUCTURE

18Source: Center on Budget and Policy Priorities

Non-Defense Discretionary Spending

(spending as a % of GDP)

Public Infrastructure Has Been Neglected

(infrastructure needs, funded and unfunded, 2013-2020)

The last repatriation tax holiday of 2004

resulted in $300B or roughly half of foreign

earnings repatriated back to the US.

Today there is over $2T of foreign earnings

that could come back to the US.

If enforced, another repatriation tax holiday

could be earmarked for activities like hiring

workers or capital expenditures in the US…

REFLATION – FOREIGN EARNINGS REPATRIATION

19Source: Strategas

De-regulation should be a tailwind for the economy, particularly in certain sectors…

Energy

Financial Services

Healthcare

REFLATION – DE-REGULATION

20Source: JP Morgan

Increase in Government Regulation

Thousands of pages in the Code of Federal Regulation

Cumulative number of economically significant regulations

published during equivalent periods in office

Small business optimism rocketed to tis highest level since 2004…small businesses make up

approximately half of U.S. private-sector employment and output…

REFLATION – SMALL BUSINESS CONFIDENCE BOOMING

21Source: National Federation of Independent Business

Small Business Optimism Index

(indexed to 100)

Small Business Single Most Important Problem

(Regulation continues to dominate small business issues)

S&P 500 revenues and earnings are still less than where they were two years ago. Unemployment is

already low and the administration’s policies should lead to more jobs, greater capex, infrastructure spend,

wage growth, and consumption. It is estimated that for each 0.10% incremental gain in GDP should lead

to a 0.50% pick up in S&P earnings.

REFLATION – EARNINGS GROWTH

22Source: Standard & Poors and RBC

S&P 500 Sales & Earnings Growth Since Q3-14

(indexed to 100)

Potential EPS Growth From Change In GDP

(EPS increase per each 0.10% incremental gain in GDP)

0.70

0.80

0.90

1.00

1.10

1.20Quarterly EARNINGS

Quarterly EARNINGS - Estimated

Quarterly SALES

US budget deficit could continue to increase with lower revenues, higher spending, and increasing

interest rates…

TRUMP AGENDA SHOULD LEAD TO MORE TREASURIES

23Source: Strategas

MAJOR DEBT BURDENS FOR TRUMP

24Source: Strategas

LOOKING FORWARD THROUGH A HISTORICAL LENS

25Source: Strategas

LOOKING FORWARD THROUGH A HISTORICAL LENS

26Source: Strategas

U.S. 10 Year Yield

The potential changes in tax and spending policies can ignite animal spirits such that consumers spend more and businesses

increase investments. The degree to which improving sentiment will flow through to actual behavior along with the

timing and magnitude of actual policy execution are the big questions. The early days of the Trump Administration will

likely determine how successful they will be.

ANIMAL SPIRITS ARE HIGH…BUT TRUMP CONFIDENCE IS LOW…

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U.S. Economic Confidence

Source: GALLUP

Americans’ Spending – Monthly Averages

Americans’ Approval of Congress

Pre-Inauguration Favorable Ratings

DISCLOSURES

This material is being provided to demonstrate the general thought process and methodology used by Edge when constructing a portfolio for an individual client. This material should not be

interpreted as a representative sample of the portfolio performance achieved by all Edge clients and there can be no assurance that any client is likely to achieve the results shown.

Since each portfolio will be tailored to the specific client’s unique investment objectives and tolerance for risk, a client's actual portfolio and investment objective(s) for accounts managed by

Edge Advisors, LLC may look significantly different from this or other models, as appropriate. Investors are strongly urged to consult with their own advisors regarding any potential strategy or

investment.

This material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. Past

performance is no guarantee of future results.

Index information reflects the reinvestment of dividends and is included merely to show the general trend in the equity markets for the periods indicated. You cannot invest directly in an index.

The opinions expressed herein are those of Edge Capital Partners (“Edge”) and the report is not meant as legal, tax or financial advice. You should consult your own professional advisors as

to the legal, tax, or other matters relevant to the suitability of potential investments.

The external data presented in this report have been obtained from independent sources (as noted) and are believed to be accurate, but no independent verification has been made and

accuracy is not guaranteed.

The information contained in this report is not intended to address the needs of any particular investor. This presentation is solely for the recipient. By accepting this report, the recipient

acknowledges that distribution to any other person is unauthorized, and any reproduction of this report, in whole or in part, without the prior consent of Edge Capital Partners is strictly

prohibited.

This communication is not to be construed as an offer to sell or the solicitation of an offer to buy any security such as an offer can only be made through receipt of an offering memorandum

which will explain all risks.

All figures are estimated and unaudited. The case studies shown are meant to demonstrate Edge’s investment process and are not meant as an indication of investment performance. Past

performance is not necessarily indicative of future results.

Copyright © 2017 Edge Capital.

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