Welcome to a brave new world (or not, as the case may be)

It is tempting to give the blame (or the credit) to The Donald, but the market shift in sentiment away from deflation towards inflation, away from bonds and toward equities and away from ‘expensive’ defensives and yield plays toward cyclical and recovery stories can be traced back to a different ballot – 24 June and the EU referendum result in the UK.

Market leadership within equities, as measured by sector performance, had already begun to change very clearly at that point and the shift has become even clearer since.

Cyclical and economy-sensitive sectors lead the way in the UK in 2016

Source: Thomson Reuters Datastream

Bond yields began to rise only a little later, despite the relaunch of QE and an interest cut from the Bank of England and ongoing QE schemes in Europe and Japan. The US 10-year Treasury yield bottomed within a week of the UK referendum, the UK 10-year Gilt within two months.

UK 10-year Gilt sell-off also illustrates the shift in sentiment

Source: Thomson Reuters Datastream

This is presumably due to the view that monetary policy is reaching its limits - unless physical cash is banned, as this would render negative interest rates unavoidable (although India’s experiences with changing its banknotes look like unhappy ones).

In addition, there is a gathering view that politicians – either sensing an opportunity or fearing the loss of power or their own gainful employment – are embracing fiscal policy as a means of tackling clear voter discontent. The combination of fiscal austerity plus central banks’ attempts to fuel growth by relying on driving financial assets higher and more cheap debt to support consumption does not appear to have created enough growth, or enough of a trickle-down effect, to satisfy enough of the electorate, especially baby boomers, to whom promises have been made (pensions, healthcare) which are proving increasingly difficult for Governments to afford.

Justin Trudeau of Canada won an election on the back of an expansionary fiscal mandate, as did Shinzo Abe of Japan. Neither has yet made a profound difference to growth or inflation, but Theresa May of the UK and Matteo Renzi of Italy had begun to bang the same drum before President-Elect Trump prevailed in the USA, with a $1 trillion-plus infrastructure investment plan a key plank of his programme.

Meet the new boss

Donald Trump’s victory raises the following short-term issues:

• Following on from the UK’s referendum vote in June, the US result potentially reinforces the presence of political risk that has been absent from developed markets for most of the last two decades – especially as we have the Italian constitutional reform vote to come in December and then elections in the Netherlands and France in spring 2017 and all three countries have “protest” parties which are already gathering momentum.
• Investors will also be aware of the historical patterns which show the Dow Jones Industrials has fallen by an average of 1.2% the first year of a Republican President since 1945. In addition, the US benchmark has fallen on all four occasions in the 12 months after the White House has passed from Democratic to Republican control. That said, Trump hardly looks like a classically fiscally austere Republican so history may be less inclined to repeat itself this time.

US stocks have traditionally fought shy of a switch from a Democrat to a Republican

Source: Thomson Reuters Datastream

• The relatively calm (equity market) response to the Trump win may see the US Federal Reserve screw up its courage and raise interest rates at its next meeting on 14 December – the central bank had previously cited financial market ructions as an reason for standing pat on more than one occasion this year. This remains a potential cloud. Last December the Fed convinced itself that a rate rise had been well communicated and all hell broke loose for two months as gold soared, bonds did well and stocks fell, only bottoming in mid-February.

December 2015 Fed rate hike was followed by substantial volatility

Source: Thomson Reuters Datastream

Same as the old boss?

In the long term, markets will start to ponder Trump’s agenda of corporation tax cuts and a substantial (if still vague) infrastructure investment programme which is currently being welcomed as pro-growth and pro-inflation, at a time when the world is crying out for both as a means of shedding the burden of its massive (and still-growing) sovereign debts (and for that matter corporate pension deficits). The US economy has not achieved annual GDP growth in excess of 3% for more than a decade. If this is the end result then the switch from bonds to stocks makes sense, but there are three caveats to this view:

• Trump needs to get support for his fiscally expansionist policies from both the House of Representatives and the Senate. He is by no means a classical Republican and seems to have a poor relationship with House leader Paul Ryan so such heavy spending plans are by no means guaranteed to receive a warm welcome, given their likely impact would be to substantially increase the aggregate deficit, at least initially. The Republicans are home to the Tea Party, after all.
• The highly-respected strategist David Rosenberg of Gluskin Sheff reminds us that President Obama launched an $860 billion ‘shovel-ready’ infrastructure programme in 2009, the effects of which upon US economic growth were transitory at best. In addition, Rosenberg notes that Eisenhower spent more on roads than any modern US President, yet in the 1950s America suffered a pair of recessions (as defined by two consecutive quarters of economic decline), despite this infrastructure splurge.

US suffered recessions in the 1950s despite a big road-building programme

Source: FRED, St. Louis Federal Reserve Database, Gluskin Sheff

• We have been here before. Japan has tried a combination of weak currency, zero rates, QE and fiscal stimulus over the past 27 years to no great avail, in the face of the same deflationary demographic and debt forces which now burden the West. The Nikkei index still stands at less than half its 1989 high (despite half a dozen very substantial rallies) and Japanese Government Bonds have become known as ‘the widow-makers’ for their ability to confound bears and see their yields go lower once more as the initial effects of any stimulus have worn off.

Japan is the fiscal spending model no-one wishes to emulate

Source: Thomson Reuters Datastream

Back to the 1930s

In addition, Trump’s calls for tariffs and isolationist stance are also seen as inflationary as it could potentially roll back the disinflation prompted by two decades of global supply chain management. This again would spook bond markets but present equities with a challenge in that central banks could find themselves behind the curve and taking interest rates higher more quickly than expected, removing the loose money crutch which has done so much to support equity and bond valuations since 2009.

It is to be hoped that GDP growth and increases in corporate earnings and dividends could then take up the slack but this then encounters the biggest long-term downside risk posed by Trump’s protectionist, even isolationist stance – namely the risk posed to growth by tariffs.

Economists agree on very few things but one point of consensus seems to be that the introduction of tariffs in the 1930s (via legislation such as Smoot-Hawley in the USA) made a difficult situation an awful lot worse than it would have been otherwise. There is already clear evidence of slowing international trade flows and tariffs would be a further burden on this front.

This explains why Emerging Markets are already taking a hammering on the bond, currency and equity front. In addition, regular readers of this column will be well aware of the historic inverse correlation between the dollar and emerging market equities.

Trump’s pro-growth stance is leading investors to price in a rate hike from the US Federal Reserve on 14 December and possibly further increases to headline borrowing costs in 2017. That is driving the dollar up and EM stocks down, in the view a stronger dollar can be bad for commodities demand and emerging nations’ ability to service their greenback-denominated debts, as both become more expensive.

A strong dollar has historically hobbled emerging market equities

Source: Thomson Reuters Datastream

The one-week moves in 10-year Government bond yields shown where (whereby an increase means bond prices fell and vice-versa) show a rout in EM government bonds, too. Higher yields on US Government bonds (and a higher dollar) mean investors can potentially get improved returns on US assets and not feel obliged to take on the risks associated with yield-hunting in emerging arenas.

Emerging market bonds have generally seen big yield increases (and therefore price drops) post Trump’s win

Source: Thomson Reuters Datastream

Violent switch

These long-term trends will only play out with time and the sheer violence of the switch from bonds to stocks, emerging assets to developed ones and defensive stocks to cyclicals suggests a lot of the market action is the result of positions being closed and opened by hot-running hedge fund money than any profound underlying shift.

As the wise owls at strategy research boutique Avalon Capital Partners argues, long-duration bonds and dependable yield-generating stocks had all become very expensive relative to historic norms. By contrast, volatility was near historic lows, as measured by benchmarks such as the VIX.

Volatility remains subdued, according to the VIX

Source: Thomson Reuters Datastream

As such some degree of market violence was overdue anyway and only time will tell whether the trends which began in late spring/summer and were then augmented by Trump’s win prove durable or not. Three final points are worth bearing in mind.

• First, if markets were really buying into the inflation narrative with maximum conviction, it would have been logical to expect gold and silver to advance post-Trump’s win, not drop. The gold/silver ratio has also risen above 70, whereas real faith in growth and inflation would tend to favour silver over gold and see the ratio fall toward or below the post-1970 average around 56.

Gold/silver ratio

Source: Thomson Reuters Datastream

• Second, America’s Dow Jones Industrials has set a new all-time high but the S&P 500 is making heavier weather of it and the broader NYSE Composite is still some 5% below prior peaks. In the UK, the FTSE 100 is still trading below 7,000 and levels seen just before the General Election in 2015, some 18 months ago. This suggests conviction in the sustainability of growth and inflation has yet to truly build.

Equity markets are struggling to forge a decisive break higher

Source: Thomson Reuters Datastream

• Third, the turnaround in the bond market has been stunning but it needs to be kept in context. The 1.40% yield on the UK 10-year Gilt does compare to a summer low of barely 0.50% - but it only takes us back to where we were in June and is still well below the 1.95% on offer last December. The same picture is evident in the USA, where a 2.2% 10-year Treasury yield only takes us back to January of this year.

Government bond yields are still below where they were a year ago

Source: Thomson Reuters Datastream

All three suggest conviction in the sustainability of growth and inflation has yet to truly build – though this is not to say they will not do so, as Trump fleshes out his policies, the May-Hammond administration in the UK outlines its plans more clearly and the elections in Italy, the Netherlands and France tell the authorities in Europe what the voters want to see (which may or may not be austerity and supra-national neo-liberalism).

Russ Mould, AJ Bell Investment Director