At long last markets were not preoccupied with central banks over the last month. They had something entirely different to obsess over instead: the US election.
November was a great example of how fickle financial markets can be. Earlier in the month the US’s S&P500 suffered its longest run of consecutive down days in 35 years: 10 days for a total loss of 3.1%, so death by a thousand cuts. Then the day before the US election the stock market rose by 2.2% in one hit (see the chart below).
When the election result became clear, which was night time in the US, traders despaired so much at the prospect of a Trump victory that the S&P500 futures were trading ‘limit down’, that is, they fell about 5% and the market was closed. People on our side of the world went to bed fearing the worst, then woke to find US shares had finished the trading day more than 1% higher. Only two weeks later the three major U.S. stock indices (the Dow Jones, S&P500 and NASDAQ) all hit a new all time high on the same day. That’s what I mean by fickle.
The US’s S&P500
So what’s going on and does it make sense? As always markets are looking ahead and trying to position for what the collective wisdom sees is coming down the pipeline, but as always, there is no crystal ball so at least some of the market’s momentum is based on conjecture at best and guessing at worst.
Reasons to be cheerful
The financial markets figure Trump’s economic plan has two big positives: tax cuts and infrastructure spending.
He’s talked about cutting income tax rates across the board, from the wealthiest to the poorest individuals as well as for companies. That would leave more money in peoples’ hands and the theory is they will spend some of it and so increase economic activity. How likely is it those cuts will get through? Well, the Republicans have wanted to reform the US tax system for years and years and finally they control both the senate and the house, so aside from some internecine wrangling over vested interests, you’d think it has a good chance of happening.
Trump has also talked about spending $1tn over 10 years on infrastructure. This has really excited some people who reason that it’s an awful lot of money for the government to inject into the economy in the first place, and if done properly infrastructure spending can have knock on benefits from improving productivity. The thing is if you read the fine print the Trump team is not talking about massive fiscal spending in the form of the government writing a bunch of very large cheques, rather, they want to marshal private sector resources and incentivize them by offering tax concessions. It will still be a lot of spending but it’s not clear how it will be structured or how the private sector will respond and it’s far from clear it’s what the market thinks it is.
Does the market response make sense?
There have been some extraordinary moves across different markets since the US election, the most profound of which have been in the bond markets, where yields have shot up. As we wrote last month, US 10 year bond yields had already started moving upwards since July when signs of inflation started showing up, rising just under 50bp in four months to 1.82%. Since the election they have risen the same amount in just three weeks, to 2.35% (see the chart below). The reason is because the markets are anticipating that if tax cuts and infrastructure spending come through it will add to the already rising US inflationary pressures.
The 10 year US bond yield
The thing is though, even if the tax cuts are passed and the infrastructure program is pursued, the changes probably won’t be enacted for up to 12-18 months and then you’d have to wait for the spending effects to be felt in the economy after that. In other words, the markets are doing their best to factor in changes that are not only still some way off yet, but we have no idea what they’ll look like.
Another extraordinary move is in the commodities. For example, the copper price has risen almost 20% since the US election (see the chart below) allegedly on the prospects of a rise in US demand, yet the US accounts for less than 10% of global consumption, whereas China is more than 40%.
Another has been the iron ore price, which has all but doubled since the start of the year and has added more than 40% since the U.S. election.
Iron ore price
Here again, the U.S. consumes about 7% of the world’s iron ore production whereas China accounts for about 66%. In that light it’s hard to see how those recent price rises makes sense. It’s also worth bearing in mind that, according to Bloomberg, there’s an additional 250 million tonnes per annum of supply coming on over the next three years.
Reagonomics Mk II?
Optimists have spoken almost reverentially about Trumponomics being the second iteration of the stimulatory policies enacted by Ronald Reagan in the early 1980s, where tax cuts and fiscal spending ushered in one of the best economic booms the U.S. has ever known. While it’s possible that could happen again, it’s worth noting there are some significant differences in the current economic environment compared with then. For a start, interest rates in the early 1980s were at record highs because inflation was running above 10% p.a. and debt levels were very, very low.
U.S. Federal funds rate – interest rates in the early 1980s were at record highs…
…because U.S. inflation was at multi decade highs…
…but U.S. government debt to GDP was at all time lows.
That’s pretty much the opposite to the current situation, so it’s a stretch to presume the outcomes will be the same. The debt levels might help explain why Team Trump is trying to get the private sector involved. Overall, it seems very early to be banking on a fiscal stimulus just yet.
A new era
This is not to say the election of Donald Trump is not a game changer, it is and it will have implications for investors. However, as usual the markets’ initial reaction could well be an overreaction. As one fixed income fund manager said “rates markets are about the fashion of the narrative”. It wasn’t so long ago all the talk was about the inevitability of demographic decline and near zero natural rates of interest and bond yields were very low (arguably too low) and now the focus has turned on the proverbial dime to reflation and yields across the world are rising (meaning the price is going down) and equities are going up. The chart below shows just how sharp the reaction has been since Trump’s election.
The short-term market reaction could well be an overreaction
– equities and bonds since the US election
If dissatisfaction about economic inequality and the status quo was one of the reasons Trump got elected, that alone could have far reaching implications. Much has been written about Trump being elected by sexists, racists and anti-immigrants, but as one commentator noted surely there can’t be that many more of those types than there were four years ago when Obama got elected. The chart below is perhaps a better explanation of Trump’s success:
Clearly Trump’s reading of the zeitgeist during the campaign was better than his opponent’s and he was prepared to say anything that would get him elected. One wonderful summary of Trump is that his critics took him literally but not seriously whereas his supporters took him seriously but literally. That will be tested as he backs away from some of his more outlandish ‘promises’, like building the wall and prosecuting Hillary Clinton.
The biggest issue for Trump is his promise to “bring the jobs back home”, to restore the manufacturing heart of America’s mid-west. According to Professor Michael Hicks, the director of business research at Ball State University in Indiana, academic consensus is that offshoring was responsible for at most 10-20% of the 7.5m manufacturing jobs lost in the U.S. since the 1970s, with technology and machines accounting for the balance. The typical U.S. factory now employs 20-30% the number of workers that their Chinese counterparts do.
If Trump fails to address the inequality gap and is seen as just another politician, what will the disenfranchised who voted him in do next?