Our President Elect, Donald Trump, has overcome the doubts of the media, pollsters, and political scientists to be elected as the 45th President of the United States of America. Clearly the mainstream political media strongly underestimated the depth of frustration that many Americans feel towards the Washington political elite.
By all counts Hilary Clinton was projected to be the winner of this year's presidential election. Instead voters from across the country turned out in numbers unpredicted by so called political experts to reshape the electoral map and deliver a victory to Trump. Analysis of the election results indicate that Trump won because he addressed many of the legitimate grievances of blue collar workers in swing states that establishment politicians had long ignored.
Though it was impossible to predict who would win the election, one thing that seemed certain on a very uncertain election night was that global investors would hit the panic button as soon as the world woke up to the news of President-elect Donald Trump. That is what economists, central banks, policy makers, and market analysts had been predicting for weeks.
Which is exactly what seemed to be happening during the election evening, global equities plunged as futures markets (which are open even when stock markets themselves are closed) tumbled further with each new hint of a Trump victory. At one point in the night, futures markets suggested the Dow Jones Industrial Average would start the daydown 1,000 points, worse than the worst days of the 2008 financial crisis, while the S&P 500 was down over 5%.
The following graph illustrates the reaction of the VIX index between 8pm on Nov 8th and Noon on Nov 9th Eastern Time. The VIX is an index that tracks equity market volatility. The lower equity markets fall, the higher the VIX index will rise.
As you can see, the VIX went up 55% as state after state reported numbers that unexpectedly favored a Trump victory and by noon Nov. 9th the VIX had come right back down to the point at which it began its assent.
As of today, the VIX has continued to decline and is currently at 14.3.
What can we expect going forward?
During the campaign, Trump promised to curb immigration and renegotiate trade deals, specifically focusing on China and Mexico. He also promised to cut taxes by trillions of dollars, while preserving Social Security, Medicare, and the military with $150 billion net defense spending.
He plans to boost infrastructure spending by $550 billion vowing to rebuild the nation's roads, bridges, airports, railways, and inner city development projects. To offset the cost of this development, U.S. corporations will be strongly encouraged to bring home profits currently parked overseas to avoid taxes, in exchange for a low tax rate.
He has also said he will implement a new tax deduction for child care expenses and expand the Earned Income Tax Credit. Some elements of his tax plan, such as eliminating the estate tax and lowering the corporate income tax rate, adhere to standard Republican orthodoxy, while others depart from tradition.
Some Republican critics have said this over ambitious economic plan will be either be dead on arrival in Congress, or will be significantly watered down by the legislature. The focus will instead shift to tax cuts and traditional Republican policies. We respectfully disagree.
There is no empirical evidence the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power. Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House. In contrast, with a Republican President in charge, they tend to forget their "small government" leanings.
Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some, however we anticipate that many of the above mentioned initiatives will likely be pushed through. The implementation of these policies could cause the U.S. economy to overheat, fueling inflation, and thereby forcing the Fed to raise rates more quickly that the markets anticipate.
Investment theme review: Trumponomics is a Game Changer
As a quick reminder, 5TQ began 2016 focusing our investment strategy on three main themes:
- Increasing global equity market volatility will lead to lower returns and greater investment risk than we have seen in recent years.
- The probability of currently unknown events shaping market behavior is high due to over extended financial markets and geopolitical uncertainties.
- Divergent monetary policy combined with historically unprecedented Central Bank market intervention could lead to a liquidity crisis in the bond market.
Our overarching view is that the Trump presidency is a game changer that will impact the global economy and financial markets. Perhaps it would be helpful to walk through those details, theme by theme.
Greater equity market volatility, increasing risk, and decreasing return on investment.
Since the Nov. 8th global equity markets have had a mixed performance. Emerging markets have been hit hardest falling 6.55% in fear that President-elect Trump's protectionist proclivities will crimp their exports. Of 68 emerging country stock indexes tracked by Bloomberg, 51 fell in the three days after the election.
The following bar chart illustrates the mixed equity market reaction since the election. It is interesting to note that Russia is the only emerging market that has gone up.
The stock markets in developed countries have done much better. In the U.S., the rally has been led by cyclical stocks. The S&P 500 Financials Index has soared 9.29 % to levels last seen in May 2008 (see below graph of S&P Financials Index).
In the below graph we point out what we think of as a Shakespearean set of U.S. equity market happenstances. As you can see, from Nov. 7th to Nov. 8th the S&P 500 rallied 2.93% (the two days following FBI Director James Comey closing the Clinton email investigation, again). Keep in mind, this is after the market had been going down for 7 days in a row as a reaction to Comey reopening the investigation on Oct. 28th. So, clearly the market was happy (up 2.93%) when it thought Clinton would win the election.
Well, the punchline is clear..... Trump wins and the S&P 500 goes up! What the heck?
Bottom line, the U.S. equity markets are still over valued on a fundamental basis. In our view, the rally we have seen in the last 3 days has only added to this imbalance. Nevertheless, we are watching closely to see which of 2 possible outcomes will prevail.
- The combination of tax cuts, infrastructure spending, and the repeal of financial regulation will drive the bull market in equities to new all-time highs.
- The market rally of the last 3 days will be short lived as the potential for unknown consequences of Trump policy implementation begins to play a strong role in the market reaction function.
We have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market.
Overall we are of the view that the current market rally will be short lived and that the Trump presidency will lead to greater equity volatilely as markets adjust to yet unknown outcomes of this unprecedented time in U.S. political history.
The probability of currently unknown events shaping market behavior is high due to over extended markets and geopolitical uncertainties.
The combination of BREXIT and the election of Trump marks 2016 as a year that will go down as a major inflection point in economic and geopolitical history.
BREXIT + Trump = a flip from deflation to inflation.
We anticipate the dominant inflection points to be the following:
- Peak Liquidity: Expectations for central bank liquidity are peaking. Both the Bank of Japan and the European Central Bank are "walking back" their decision to introduce more negative interest rate policies. The Fed is likely to raise interest rates in coming quarters. Central banks are starting to feel political backlash for fueling inequality. In addition, "Quantitative Failure" (671 rate cuts since Lehman bankruptcy has fostered neither robust economic recovery nor "animal spirits" as corporations and households continue to hoard cash) means that the era of excess liquidity and Quantitative Easing is now largely behind us.
- Peak Globalization: The 1981-2015 era of free trade, capital and labor mobility is also coming to an end. Electorates are shifting in an anti-immigration direction. Anti-trade populism is on the rise. A recent survey showed 65% of Americans say trade policies have led to a loss of U.S. jobs, versus 13% who believe trade policies created jobs. Events show nations are becoming less willing to cooperate, more willing to contest. Global trade growth in 2016 (+1.7%) will fall below GDP growth (+2.2%), a rare event without a recession, and before a true move toward protectionism has even occurred.
- Peak Inequality: Electorates are demanding a "War on Inequality" via fiscal stimulus making it more likely that the developed economies spend less money on bonds (monetary stimulus) and more money on people (fiscal stimulus). Fiscal stimulus is already underway in Japan (5% of GDP), Europe (+1% to GDP growth), and widely expected in the U.S. in 2017. We believe a shift toward fiscal stimulus is likely to raise growth, interest rates, and inflation expectations.
- Peak Returns: Peak liquidity + peak globalization + peak inequality = peak returns. Excess liquidity and globalization have been bullish forces for Wall Street, but far less bullish for Main Street. A reversal of these trends together with a shift toward fiscal stimulus and higher interest rates strongly indicates that the excess returns from stocks and bonds in the past 8 years are also likely to reverse.
Bottom line: If these inflection points hold true, it will lead to increasingly high inflationary pressure which in turn will speed up the transition out of what has been a 35 year bull market in bonds. As of Nov. 1st there is an estimated $13 trillion in outstanding global bonds that are paying negative interest rates according to the Fitch ratings agency (That's right, investors are paying to hold bonds).
As a result of this, the financial system has become even more leveraged than it was in 2007 at the beginning of the last debt crisis. The global bond market has grown by more than $20 trillion since 2008. Today, the global bond market is north of $100 trillion, with an additional $555+ trillion in derivatives currently trading. Yes, $555 TRILLION, more than seven times the global GDP, and more than 10 times the Credit Default Swap market ($50 trillion), which triggered the 2008 Crisis.
Does this mean a meltdown in the global bond market is imminent? No, it does not. It does however mean that we continue to be very defensive in our investment recommendations.
Divergent monetary policy combined with historically unprecedented Central Bank market intervention could lead to a crisis in the global bond market.
Since the middle of 2015 our concern has been that the reactionary function of the Fed will be too little too late. They risk setting a dynamic into motion in which interest rates will be forced higher much faster than the market anticipates. The outcome of this dynamic could potentially trigger a liquidity crisis in the bond market.
In the last three days, U.S. treasury bonds have plunged with 30-year bond yields climbing the most since at least 1977 amid concern that a Trump administration and a Republican-led U.S. Congress will unleash a wave of spending to boost the U.S. economy, thus triggering a surge in inflation.
Since Trump was elected we have seen this dynamic pick up pace with unnerving speed as more than $1 trillion of global bond value has been wiped out in the last 3 days. This is only the second time in two decades that the bond market has suffered such a huge loss in such a short time.
This loss has been driven by a spike in yields on U.S. 30-year bonds, which are more sensitive than shorter maturities to the outlook for inflation. U.S. 30-year bonds have jumped almost 40 basis points since last Friday, heading for the biggest weekly increase since January 2009.
This bond market reaction has caught many investors off guard as it is the opposite of what was expected if Trump won. It is also the opposite of what we saw as a reaction to BREXIT.
This week the bond market gauge of inflation expectations climbed to the highest level since July 2013 amid speculation that a Trump administration and a Republican U.S. Congress will ramp up spending and drive up inflation.
Bottom line: These conditions continue to reinforce our conviction that the bond market currently holds much more risk than it does upside potential. We do not know if the Fed and other central banks will be successful in their attempt to engineer a new credit upcycle.
If the past bubbles are any guide, even as this reflation is happening, and the outlook is getting more and grimmer for the sustainability of the bond bubble, investors will be dismissing signs of a turn and sticking to their guns. So even as inflation starts to return, don't expect mainstream market commentary to recognize it. Nevertheless, in our current market conditions dictate that we focus on capital preservation and maintain our defensive positioning across all portfolios.
In our view, Trumponomics is a game changer for global financial markets. The combination of BREXIT and the election of Trump marks 2016 as a year that will go down as a major inflection point in economic and geopolitical history.
BREXIT + Trump = a flip from deflation to inflation and from Wall Street to Main Street. The key inflection points that will impact the next four years are Peak Liquidity, Peak Globalization, Peak Inequality, and Peak Returns.
We have stated many times that the model of growth that has driven equity markets to the second longest Bull Run and historically unprecedented $ 5.6 billion new issuance of U.S. corporate bonds at all time low interest rates can only be maintained while there is little to no inflationary pressure in the economic system.
At this point the market expectation for higher and faster inflation is being driven by potential economic pressure created by Trump's stated economic policies. We do not yet have any clarity as to the resolution of the dramatic forces which have impacted the bond market over the last three days.
The pumping of cash into the financial system by central banks has lifted nearly all financial assets, a bond shock could force a dramatic repricing of assets across the board. If overpriced bonds and stocks get repriced more quickly than market expectation, investors could dash for the exits in an attempt to lock in any gains in both stocks and bonds before year end.
As we have been pointing out, although there are many, we will continue to actively monitor events in the coming weeks and will communicate any changes in our outlook and portfolio positioning as they occur. In the meantime, please feel free to call us any time or come by the office to have a conversation.
All the best,
GOVINDA QUISH, PAUL KRSEK, JEFF ROUSH,
THE INVESTMENT POLICY COMMITTEE
5TQ CAPITAL, LLC
595 Coombs Street, Napa, Ca, 94559
(707) 224-1340 Main
Disclosure and Disclaimer - Updated last on July 17, 2016, 2016 by Paul Krsek:
ELLUMINATION is the proprietary newsletter written for clients, friends, and affiliates of 5TQ CAPITAL, LLC .
FROM JUNE 1998 to January 1, 2016 Paul Krsek was the sole author of ELLUMINATION. While the views and representations found in the newsletter generally reflect the attitudes and opinions of the 5TQ CAPITAL, LLC members and staff, Krsek wrote without editing was therefore is solely responsible for the content and opinions contained in ELLUMINATION.
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