We wish everyone a happy New Year, and with the FX and rates markets entering the year with a bit of a bang, there is a lot to get through this week. We will try and keep this as concise as we can as we take brief tour of the financial market and economic landscapes and recent central bank news.
The “Trump trade” – an update
Life has been easy since the US election, right? With President elect Trump promising to completely re-energise the US economy, markets have been close to a one way bet. Equity markets, bond yields and the Dollar straight up and credit spreads down. However, the first chinks have appeared, with the Dollar struggling in the early days of 2017 as bond yields have been drifting sideways to lower. Although the fundamentals still suggest that the Dollar and bond yields can move higher in the months ahead, traders have taken on some historically large positions post the election. At some point, there is going to be a disappointment on the Trump trade and there will be a large position unwind. The question right here is whether this process has already started this week, or not.
Our best guess, for what it’s worth, is that the Trump trade can grind on for another week or two or three. That said, we do think the easy money has been made. We think that further Dollar strength should be used to exit remaining long positions. Will we probably not go from being long the Dollar to short immediately but we will take the trading evidence as it comes. We also believe that it is time to consider some fixed income trades with a modestly bullish price thesis, either outright longs or curve flatteners.
Business surveys are on fire and consumer sentiment is at cycle highs
As well as rising risk appetite in the financial markets, business leaders and consumers are also feeling much more comfortable with life. Bizarrely, this is the opposite of what we were told would happen prior to the election if Trump won, but hey, living in post Brexit Britain, we should know by now that bad news is always good news! Seriously though, we have to ask whether this burst of optimism is a signal that the economy is about to accelerate to a permanently higher growth rate due to the incoming administrations proposed policy mix. Or, and more likely in our opinion, it is more a reflection of the recent performance in financial markets.
Chart 1 below shows Consumer sentiment alongside the S&P 500. As noted, sentiment tends to rise and fall with the stock market more than other obvious indicators like the unemployment rate or wages. Clearly, there is a case to be made that some of Trump’s policies may be good for the economy, and perhaps businesses are right to be optimistic about the future. However, we think that certainly globally, and to a degree domestically, Trump’s policies are much more likely to create winners AND losers, and on net, not enough growth to support these high levels of business and consumer confidence.
Chart 1 – US Consumer Sentiment and the US equity market
The FOMC minutes
After years of downgrading expectations for both economic growth and interest rates, the Federal Reserve seems to have given a qualified “thumbs up” for the reflation theme. Minutes from their December meeting throw a bit of extra light on their decision to not only raise rates, but also their expectation of interest rate increases ahead. We’ve been here before of course. For example, a year ago when the Fed were trying to make us believe they would raise rates four times in 2016, when they only managed one. Can we really expect them to raise rates three times this year? Well, for the moment, they have every excuse to do so, given an unemployment rate of 4.7%, inflation rising in line with their target (depending on which measure of inflation), surging confidence surveys and rising financial markets.
With the Fed being so wrong in their forecasts in recent years, and flip flopping on the speed with which they remove policy accommodation, holding a high conviction view on the future path of Fed Funds is a dangerous game. Given past experience, they could row back from the current view of three rate rises at the first sign of economic disappointment (perhaps internationally inspired) or market volatility, or too strong a Dollar.
We continue to view the economy as exhibiting late cycle tendencies, and a series of rate rises coupled with a strong Dollar may well throw any Trump recovery into reverse later this year or 2018. If the Fed do deliver three rate rises this year, we may well be staring at a good old fashioned policy error – but that’s something to consider more closely in a couple of quarters or so.
Signs of curve flattening
Although Trump’s election victory was initially met with aggressive selling of Government bonds, there are signs building that not all investors are fully convinced that his policies will successfully reflate the economy. Longer dated bonds, which should be more sensitive to changes in longer term inflation expectations, have risen less in yield than shorter dated bonds in the last few weeks, resulting in a minor flattening of the yield curve (as seen in chart 2 below). Furthermore, inflation expectations themselves, which rose smartly in the initial wake of Trump’s victory, have also lost momentum in recent weeks.
Chart 2 – Yield curve and inflation expectations
What really has our interest in the treasury market is the record net short positions held by speculators in both the 10 year (shown in chart 3 below) and 5 year futures market. What we do know is that once a futures position has been opened, it has to be closed, and so these record short positions represent pent up buying power, which could be triggered by some type of disappointing news event, either economic or political. When this buying power kicks in, yields will fall, it just depends from what level. If from today’s 2.50% level down to say 2%, then that would be a strong indication from the bond market that the reflationary Trump trade is not quite working out how it should.
Chart 3 – US 10 year yield with speculators net position (which is at a record short)
The US employment report
The US employment report last week illustrates several things. First, unemployment at 4.7% is already very low, indicating a lack of under-utilised resources for Trump to tap into. Furthermore, the year on year rate of growth in the number of employed has been slowing for months, and this always occurs before unemployment turns higher.
So, aside from any new reflationary policies, there are signs via the employment market that the economy is entering the late stages of the post 2009 cycle. Perhaps Trump can extend this cycle moderately, but unless he can do so without causing too much inflation resulting in a more aggressive Fed, we expect the late stage thesis to gain credibility in the months ahead.
Chart 4 – The unemployment rate with the rate of employment growth
Complacency in the equity market
Almost oblivious to the very choppy trading in FX and rates last week, the equity markets have been dancing to their own bullish tune. We have discussed many times the valuation measures that we believe actually matter in terms of having predictive value for buy and hold returns, and these are all at or near record over valuation extremes. The US equity market is extremely expensive, but we did say post the election that we can understand why traders would jump on the reflation story. And jump they did. Speculators now hold quite large bullish positions in the S&P 500 and record bullish positions in the domestically orientated Russell 2000. At the same time, measures of volatility have dropped to near the lowest point since the end of the Fed’s QE programme. Active investment managers are very close to a record bullish position as measured by the NAAIM index, and small traders are basically the most bullish they have been since the end of QE.
All told, the picture in the US equity market is one of extreme complacency. Historically, this level of complacency coupled with extremely expensive valuations and rising interest rates, is consistent with poor future returns, not just for buy and hold investors as measured by multi-year returns, but also over shorter periods. For the moment however, these concerns seem mis-placed to the majority, and the direction of travel remains upwards.
But this is why the performance of the bond and FX markets are so important. We have seen several times in recent years that a Dollar that becomes too strong becomes a problem for global economic and financial markets performance. Yet at the same time, if bond yields start to decline, would this not bring into question the underpinnings of the whole Trump trade?
The potential reflationary policies promised by the new administration have been fully embraced by the financial markets. Business leaders and consumers now seem fully on board, and even the Fed seem inclined to go along for the ride. We will have to wait and see whether Trump can work his magic and somehow lift the potential growth rate of the economy towards 4%. We will no doubt have many opportunities throughout the year to discuss this, but one of our preferred roadmaps is the Fed reacting to the current improved economic outcome and burst of enthusiasm (as measured by surveys and the markets) with a more aggressive tightening than seen so far. Historically, a too aggressive Fed has been the trigger that ended expansions and ushered in recessions, and this may well be evident in a few quarters.
Back to the markets, there is already some evidence in the bond markets that not everyone believes in power of the new administration. If markets are nearly priced for perfection, any disappointment could lead to a retracement of recent market moves and perhaps a period of reflection on any new policies. What this may mean in practice is that markets will enter a period of more two way activity and a higher level of realised volatility, in equities especially.
As noted above, we think that the buy the rumour sell the fact modus operandi may apply here, whereby markets buy the election of Trump but fade the inauguration on 20th January. As such, we should be very sensitive in the next few weeks for signs that current trends have become exhausted and therefore vulnerable to a pullback.
Perhaps we will end on a final note that despite all the noise/news around the market at the moment, it is ultimately price that makes the news. And so it is that we are listening more to the news from market pricing than we are to the economic and political news, especially when it comes to our tactical positioning. So far in 2017, the market news is hinting of a potential change from the one way bet that has prevailed since election day. The hints are more apparent in the FX and rates/bond markets, but the equity market is likely to change when these do.
Good luck to all in 2017.
RMG Wealth Management