As the WSJ puts it, “so much for Wall Street hating uncertainty.”
Ever since the Republican sweep of Washington, investors have snapped up stocks and sold bonds, anticipating a future in which President-elect Donald Trump and Republicans in Congress cut taxes, slash regulation and push through a large fiscal stimulus. Investors’ embrace of the reflation narrative is evident in the scramble out of assets that benefit from low rates and into those deemed likely to gain from higher rates.
S&P 500 financials climbed 4.1% that day, as investors bet banks will benefit from rising long-term interest rates that tend to fatten their lending profits and potentially from deregulation that will open new lending opportunities. Utilities sank 3.7%, reflecting a bet that rising rates will diminish the sector’s appeal. It was the sectors’ largest daily gap since 2009 per the WSJ.
The capital reallocation move has been a veritable flood: as pointed out on Saturday, $22 billion poured into US equity ETFs over the past three days, which is not only three times larger than the outflow seen in the previous week before the election, but it presents the strongest 3-day buying streak since last January.
Additionally, dispersion, measuring the standard deviation of one-day returns for S&P 500 industry groups, surged on Wednesday to the highest since 2008, according to Macro Risk Advisors.
However, as we – and others, notably Deutsche Bank – cautioned, while the market moves seem to point to a future in which stronger growth will finally put ultralow interest rates behind us, the “reflation trade” in which stocks rise and bonds fall amounts to a roll of the dice. “That is because investors are betting that the full Trump economic agenda will accomplish what the investment world likes, such as tax relief and deregulation, while largely ignoring the potentially growth-reducing impact of other campaign promises, such as much tougher stances on trade and immigration.”
As a result, the rapid, dramatic rush out of long-term Treasurys and into industrial stocks might already have gone too far, portfolio managers warn, even as many are hopeful that this latest sign of the that the end of the “New Normal” era of low rates is finally over, even before a stronger recovery takes root.
So what does the near-term trading environment look like?
Trades based on rising growth and inflation are “probably going to work through inauguration day, but then we have to start dealing with the reality,” said Scott Minerd, global chief investment officer at Guggenheim Partners LLC, an asset manager with $250 billion under management.
Price declines in the U.S. long bond, whose yield rose the most last week in seven years to 2.928%, have pushed the 30-year yield near its likely level when the Federal Reserve completes its current tightening cycle in two to three years, Mr. Minerd said. “Rates are not going to continue to go straight up,” he said.
Stephen Cucchiaro, chief investment officer at 3EDGE Asset Management, said his firm sold emerging-market equity exchange-traded funds and gold after the election jostled both markets. “It’s a race against time,” Mr. Cucchiaro said. “Will the economic piece kick in before the deficit rises and inflation spikes up?”
Alas, this won’t be the first time the market may have gotten ahead of itself in dumping bonds, and buying financials – these are trades that investors have been trying for years with only occasional success, most notably during the 2013 Tamper Tantrum, which however was quickly squashed when a substantial capital flight out in emerging markets quickly put a damper on global reflation hopes.
To be sure, sharp rises in U.S. bond yields in the spring of 2010 and the second half of 2013 were quickly reversed, reflecting the persistence of soft global growth, aging populations that limit consumption and rising debt loads that constrain spending.
It is likely that after the initial bout of euphoria, pessimism will again return: “over the longer term, the secular forces on the global economy don’t change,” said Brian Levitt, senior investment strategist at OppenheimerFunds. Levitt said that likely means that even after Mr. Trump’s election, ” inflation doesn’t actually go up substantially.”
Still, the Trump’s forming agenda will provide a steady stream of good news for stock investors – if only for the next few weeks – at a time of stretched valuations and soft growth. Lower taxes could boost earnings at a time they have been in decline. Cutting the effective corporate tax rate to 20% from the current 26% stands to double the 2017 earnings growth rate of S&P 500 companies, Goldman Sachs estimates.
The relief would be welcome. Third-quarter earnings are on track to rise 2.9% from a year earlier, snapping a string of five quarterly declines. Still, some analysts warn that the volatile trading after the election surprise might have led to gains that aren’t sustainable. Then there are concerns about the surge in debt will likely pressure bond prices even lower, keeping a lid on equity valuations, absent a total disconnect between (discount) rates and PE multiples.
In other words, while for now optimism about Trump policies is keeping pessimism about a potential negative outcome in check, that may change.
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Perhaps the best summary of this tension was laid out by Bloomberg’s Daniel Kruger, who in a Sunday afternoon note wrote that “It’s Trump Versus New Normal In Play For US Growth.”
Here are his thoughts:
Count this among the ways that Donald Trump’s election has rocked the financial world: monetary policy is no longer in charge. The president-elect’s proposals for significant commitments to spending and tax cuts have shifted the burden of stimulating growth from central banks, for the moment at least.
“The market’s been looking for the fiscal theme to take over,” said Deutsche Bank’s Alan Ruskin. “The burden of responsibility has shifted,” with those who doubt the market’s recalibration being the ones who need to prove their case.
That accounts, in part, for the enthusiasm for equities and commodities. Expectations of faster U.S. inflation are also spreading to Europe and Japan as seen in rising breakeven rates.
Trump may get some of the spending and, especially, the tax cuts he wants from Congress. Whether these will have the effect the market is now betting on remains to be seen.
Trump will be pushing against an economy that is on a lower long-term growth trend in what many economists call “the new normal.” As a candidate, he promised an expansion of 3.5% or faster. If it doesn’t materialize, will he double-down on his policies?
The upward surge in bond yields across the curve, inflation expectations and the dollar may complicate Trump’s plans. Futures show traders are locking in bets on a December rate increase. It’s possible that tightening financial conditions may slow the Fed from further moves until stimulus bears fruit.
But monetary policy is no longer what’s driving these moves. Increasingly, central banks may see themselves in a defensive role, reacting to events rather than dictating trends. The greenback’s rally is already forcing Asian and Latin American central banks to protect their currencies. More such moves may be in the offing if dollar gains continue.
Will Europe and Japan turn to the Trump model in an attempt to boost growth and inflation in ways monetary policy hasn’t? Europe may have a limited ability to increase spending, while Japan has essentially exhausted that growth channel, too, said Robert Tipp of Prudential.
But for now, after growing weary of monetary-led slow growth, markets are grasping at Trump’s answer to the New Normal.
Every previous time the market was certain it had found a way out of the New Normal’s liquidity trap, it was proven wrong in a matter of months if not weeks. Perhaps this time will be different.
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