Last week in “Peering past the election”, we outlined a potential reflationary period ahead that could either be elegant or disorderly. Clearly the market views Trump as more reflationary than Clinton would have been, judging by the reaction in bonds last week. We think that the Trump victory is a potentially very important event for financial markets and by extension the global economy. For the record, we are making no comment about the man himself, we’ll leave that for others to thrash out. Our comments below are focused on the global financial markets and economic trends.
We said last week that with US growth and inflation nudging higher, bond yields were set to rise (a theme we have been discussing for some time). From a pure policy perspective, Trump is rightly seen as reflationary by the markets, and this should exaggerate the moves in bond markets in the period ahead; let’s call that 3 to 6 months for the moment. Trump has told us that he will increase spending on infrastructure (by issuing new debt) and will cut taxes quite aggressively. Furthermore, there is talk of reversing recent financial regulation and paving the way for the repatriation of trillions of Dollars held abroad by US companies. If Trump is serious about these policies, and able to make them happen, then this really should be quite inflationary.
We have noted several times of late (including last week) that after months and months of investors reaching for yield, sometimes employing leverage to do so, the exit was getting much smaller. The action last week seems to be following that script. Chart 1 below shows US ten year yields alongside the 5s/30s yield curve and 5 year 5 year forward inflation rates. They all jumped very smartly post the Trump win, illustrating not only the inflationary policies that Trump is likely to pursue, but also the lack of bids in a market where far too many are looking to sell at the same time.
Chart 1 – US Yields and market based inflation expectations all jumped smartly post the Trump win
Now, for a short period of time in the hours after the Trump victory was declared, the “elegant reflation” narrative seemed to be at work, whereby bond yields, US equities and the US Dollar rose on the prospect of stronger economic growth. However, and as noted last week, it is very difficult to predict whether markets follow the elegant reflation path or a “darker” reflation path. This darker path is towards rising yields, a stronger Dollar and a disorderly exit from those yield assets that have been bid up to extremely expensive valuations in the pervasive reach for yield. For most of Thursday and Friday, the darker reflation was the order of the day, as yield sensitive assets such Emerging Market assets, sold off quite aggressively. In fact, this darker reflation puts at risk any asset which is over-owned, as the wobble in Nasdaq and recent high flying tech stocks late last week illustrates.
Chart 2 below shows the performance of an Emerging Market Bond ETF (in white) that tracks the performance of an index of bonds priced in US Dollars. As can be seen, the share price has fallen rapidly in the last few days. We show this chart to illustrate how quickly popular trades can come unstuck. The red line on the chart shows the number of shares outstanding which rose rapidly from the low in February as risk assets rose generally post the China wobble seen at the time. The worry here is that the selling has barely begun and the selling that has taken place has hammered the share price.
Chart 2 – Emerging Market (US$) Bond ETF with shares outstanding
We also chose to illustrate an Emerging Market asset, as Emerging Markets would appear to be the most vulnerable in a Trump world. Not only will higher US bond yields and a stronger Dollar make life more difficult for Emerging Markets, but Trump’s focus on doing what’s right for America and forget about the rest of the world is a new policy. Reneging on trade deals and imposing trade tariffs are poor policies from a global growth perspective, and with some of these policies aimed directly at selected Emerging Markets, we have to think that EM assets will generally underperform. A look at chart 3 below shows that Emerging Market equities have turned lower from a formidable zone of resistance, and have broken a well-defined uptrend that has been in place since earlier this year.
Chart 3 – Emerging Market Equity ETF
Another intriguing aspect of the Trump victory and the reflation policies that are now being discussed is that this is very different from the current European landscape. Not only will French and German elections dictate that big decisions on any important European matter will be delayed, but the ECB’s Negative Interest Rate Policy (NIRP) is at risk of being seen as deflationary. Surely a successful reflation story goes hand in hand with rising interest rates, both short term and long term. This was certainly the case between 2003 and 2007, as can be seen in chart 4 below showing the US equity market and the Fed Funds Rate.
Chart 4 – The US Equity Market and the Fed Funds Rate 1999 to 2009
Unfortunately, the ECB has a potentially huge problem in this cycle now. NIRP is not working, and yet they cannot (or will not) raise interest rates until well after the end of QE. Currently, QE is scheduled to end in March next year, but Draghi told us at the last meeting that QE would not end abruptly. It would appear that his plan is to extend QE, which only delays the normalisation of interest rates, which is so desperately required for a true reflationary process to begin. Frankly, we doubt that the ECB will get anywhere close to raising interest rates for a long time to come, and any illusion of an inflationary pulse will be just that; an illusion. Indeed, the inability of European equities to overcome well established resistance, as seen in chart 5 below, is a worry and may well be indicative that Europe simply cannot unshackle itself from structural problems whereas the US is now focused on reflating its economy, and may well have some success, at least in the next couple of quarters or so.
Chart 5 – The European Equity Market continues to respect well defined resistance
So, if European and Emerging Market equities are set to underperform, or even decline, what of the US. Can we really see the elegant reflation noted at the beginning whereby bond yields, interest rates, the US Dollar and equities all rise together? At this particular juncture, we simply don’t have a strong opinion. We think that US equities in aggregate are extremely expensive (as they have been for two or three years), but we can see the logic of the reflation narrative and broad equity indices remain near the top end of recent ranges. That said, underneath the surface, we suspect there will be some quite violent sector shifts with money fleeing defensive income type stocks and looking to buy cyclical stocks including Banking stocks if the yield curve continues to steepen.
So, to try and wrap up for this week. What do we have highest conviction in? Well, as we have been saying for some time, bond yields appear to be heading higher as growth and inflation nudge higher. This reflation impulse will gather momentum if Trump follows through on some of the policies he has outlined. We are therefore comfortable in looking for higher bond yields and a stronger Dollar. Also, given Trump’s insular view of let’s do what’s best for America, we think that Emerging Market assets are vulnerable. For the time being, we are somewhat ambivalent on US equities, but we will be avoiding anything too defensive or income oriented as well as anything that has massively outperformed in recent months.
We end on a familiar note, but one which we think is only strengthened by Trump’s victory. We strongly feel that buy and hold strategies will be disappointing over the next 5 to 10 years, and may well generate close to zero returns. The US is set to follow a very different course now, and one that may well disadvantage many emerging markets, and even illustrate the structural problems that continue to afflict Europe. In a world of very low returns from mainstream assets, and a world of political divergence (perhaps even central bank divergence as well), we believe that trading/active strategies will offer not only the chance of positive returns but also a level of diversification that is so hard to find today in any mainstream asset.
RMG Wealth Management