There is hope and there is reality.
The current sharp rally in asset prices on the heels of Donald Trump's election victory has so far mainly been based on hopes for an economic revival based on deregulation, repatriation of US corporate profits and a huge dose of fiscal stimulus centred on infrastructure spending and tax cuts. The question on investors' minds is how sustainable this risk rally is and whether we are looking at some seismic event representing a fundamental change in the investment environment and the beginning of a new sustainable inflationary cycle.
The current rally has a striking resemblance to market action between May and September 2013 when the US Federal Reserve (the Fed) threatened to terminate the easing cycle (taper tantrum) based on the view of an improving economy. Back then the yield on the 10-year US Treasury bond soared 137 basis points. This time around, the yield backup has been 100 basis points. The S&P 500 rallied four per cent then compared to five per cent now. Small cap stocks jumped 10 per cent and by just over 16 per cent this time. Even within the equity space sector performances were similar. There was a big rotation out of the defensive rate-sensitives, such as utilities, real estate and consumer staples, and the winners back then were the same as this time around and included materials, industrials andfinancials.
As far as President-elect Trump's economic growth agenda is concerned, there is hope and there is reality. While Trump's wish list includes $1 trillion of infrastructure spending, he will have to deal with the fiscal hawks in Congress. There will be tremendous resistance to blow out the fiscal deficit by some $5 trillion (including tax cuts) over the next 10 years. Under Trump's plan public debt would grow from 76 per cent of GDP to 105 per cent.
Many observers like to compare Donald Trump to Ronald Reagan. However, when President Reagan cut taxes in the early 1980s and boosted fiscal (mainly military) spending the public debt-to-GDP ratio was 30 per cent and not 76 per cent like today. The price/ earnings ratio of the S&P 500 was at eight and not at 20 like today and long-term interest rates were at 13 per cent and not around two per cent where they are today.
The question is whether the recent rise in long-term bond yields is backed by fundamentals or whether it is just another blip and possibly a buying opportunity for bonds. It seems logical that stimulating the economy at nearly full employment will eventually lead to inflation. For now the bond market is willing to give President-elect Trump the benefit of the doubt that a relevant fiscal stimulus will be put in place. To what extent this expected rise in inflation is sustainable will depend on how fast the output gap will be closed, i.e. the structure and size of any fiscal programme is paramount. In this context let us highlight that, historically infrastructure spending has not lifted inflation (examples: FDRs "New Deal" in the 1930s, Eisenhower interstate highway spending of the 1950s) as infrastructure upgrades increase efficiency which is deflationary.
While inflation rates are bound to pick-up in coming months due to a base effect, we do not see that the necessary fundamentals are yet in place to predict the beginning of a sustainable inflation increase, even if we are seeing a "false" breakout in the short term.
The current increase in yields is built upon an expectation of a massive fiscal stimulus by the new administration. The question is how much higher rates can go with many Western governments having to serve extensive amounts of debt as a result of the Great Recession of 2008. Total debt in the global economy stands at $152 trillion (according to the IMF) which is higher than before the Great Recession. Under the circumstances it will be next to impossible for yields to rise much more without crippling the global economy.
On the other side US equities are expensive and continue to be in a consolidation phase, but remain a viable alternative to bonds in light of attractive dividend yields.
THE EFFECT ON INVESTORS
US equities are not cheap and the Trump rally has been based more on hope than reality. While we see selective investment opportunities, we are experiencing the fastest sector rotation in a long time and a more tactical approach to US equity investments will be required.
In Europe, investors' attention will increasingly focus on political risks over the next few months. Markets will be facing uncertainties from mainly political events: elections in France, Netherlands and Germany and any next steps as a result of the Italian referendum will be key. These events have the potential to produce surprises and increase market volatility as illustrated by the recent populist outcomes of votes.
While the strong US dollar is a headwind for emerging markets in the near-term, there are a number of positive drivers that favour investments in this space in the mid to longer term. The differential of growth rates between emerging and developed economies is moving back in favour of the former. Historically, this has been the main determinant of the relative performance between emerging and developed markets. In contrast to the ever more bizarre monetary experiments in developed economies, emerging economies are still conducting orthodox monetary policies which allow them to lower interest rates to spur growth.
Commodity producers should benefit from a resurgence of growth in China. Russia specifically could benefit from the prospect of better relations with the US under a Trump presidency.
After the recent surge in bond yields we believe the market will take a breather. As there is a lot of uncertainly in the months ahead we recommend investors reduce the duration of fixed income investments.
Furthermore, in this uncertain world it is prudent to have an exposure to gold which in our view is a hedge against all kinds of risks, including policy missteps by central banks.
For now the bond market is willing to give President-electTrump the benefit of the doubt that a relevant fiscal stimulus will be put in place.
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