The election of Donald Trump as the 45th President of the United States has reaccelerated a number of market forces which had been building since the middle of year, the most important of which is the global reflationary impulse driven by stronger nominal GDP growth and higher core inflation. The prospect of increased fiscal expansion, a central component of Trump’s stated economic policy, has further lifted these growth expectations, propelling risk assets higher during the month and sending U.S. bond yields to their yearly highs.
While the MSCI World gained 1.5% on the month, the U.S. 10-year Treasury shed 4.6% as yields rose by 60 basis points and currently trade at 2.38%. The move in rates has left many wondering whether we are past an important inflection point in the 30-year bull market for bonds. We tend to believe that bonds have probably seen their secular low in yields and that the reflationary dynamic at play will support risk assets going forward. Assessing whether the bull market in bonds is over seems premature at this point though we believe that the impact of monetary policy on all asset classes will be less than what it has been over the last eight years as we move into 2017.
The inability for pollsters to correctly anticipate the results of the U.S. Presidential election has been discussed at length. What receives less attention is the extent to which the investment analyst community misjudged how markets would react to a Trump victory. Whereas some analysts expected a Trump triumph would induce a decline of between 5-10% in the S&P 500, the market’s actual reaction could not have been more different, notwithstanding the initial limit-down in futures markets which quickly corrected.
Since the election, the S&P 500 has rallied 2.4%. Trump’s late-night, surprisingly conciliatory victory speech, emphasized his plans to expand fiscal policy and was interpreted constructively by the market which began to price in higher fiscal spending and stronger growth.
In the U.S., cyclical industries outperformed as a result. U.S. bank stocks recorded their strongest month since June 2009, rising 24.2% as the U.S. yield-curve steepened to its highest level in a year. Basic materials also outperformed, gaining 10.2% given their leverage to infrastructure spend. Market derived expectations for inflation also increased materially, rising to 2.1% as per the five-year inflation breakeven rate, its highest level since mid-2015.
While yields rose globally, U.S. rates led the way, widening the spread between Treasury bonds and other sovereign government bonds. The spread between the U.S. 10-year Treasury and similar maturity German Bund, which has been relatively stable, blew out to 210 basis points. These widening differentials led to a material strengthening in the U.S. Dollar on a trade weighted index, which gained 3.5% on the month and saw significant weakness in the Japanese yen (-8.42%), Mexican Peso (-8.31%) and euro (-3.57%) versus the U.S. Dollar. This is occurring against a backdrop where the Federal Reserve will almost certainly raise interest rates by 25 basis points this December.
The rate and currency moves created significant dispersion across equity markets over the month, as developed markets outperformed their emerging market counterparts given currency weakness and the prospect of greater trade protectionism in the U.S. In Japan, the Nikkei 225 gained 5%, outperforming the MSCI All-Country World Index which rose 0.6%. Japan has gained 9.2% over the last three months as the interplay of expansionary fiscal and monetary policy supports domestic demand and as the Bank of Japan’s “yield curve targeting” supports its banking sector.
Despite weakness in the euro, the Eurostoxx50 was flat on the month. This can partially be attributed to expectations that Italians would reject a referendum seeking greater centralization which markets believed would strengthen plans to recapitalize banks. The measure was eventually rejected on December 4. In addition, the market is waiting to hear from the European Central Bank on December 14, when it is likely to decide by how long its current policy of quantitative easing is extended and at what point it will begin to “taper”, or reduce the amount of bonds it buys on a monthly basis before winding the program down. The ECB currently purchases 60 billion euro in bonds on a monthly basis; plans to taper earlier than expected could lead to a further rise in bond yields and weigh on risk assets in the region. That said, we still have a constructive view on European equities given valuations which trade at a forward price-to-earnings ratio of 14.9x, a 20% discount to the U.S. At the same time, a series of recent data points demonstrate the strength of Europe’s recovery going into 2017. Eurozone manufacturing PMI data remains solid and rose to 53.5 in October 2016, its highest level since February 2014. Meanwhile, the composite PMI, which closely tracks GDP, strengthened to its highest level since January 2016.
Emerging markets posted their weakest performance, with the MSCI Emerging Markets Index down 4.6% on the month given the stronger U.S. Dollar and concerns over the implementation of tariffs that would restrict trade and weigh on growth. Foreign investors withdrew $24.2 billion from emerging markets in November, $8.1 billion of which were equities, the largest outflows since the June 2013 “Taper Tantrum.” While the medium-term case for emerging market equity remains solid given the massive currency and current account adjustments that the area has undergone over the last five-years, the current setup favours a more cautious approach until the market obtains greater clarity on the specifics of Trump’s trade policies.
Notwithstanding the move in rates, credit spreads remained fairly stable, though total returns suffered. U.S. investment grade credit shed 2.7%, its largest monthly loss since the “Taper Tantrum.” The asset class is still up 5.6% on the year and we continue to be constructive given the still strong technical dynamic at play and spreads which at 143 basis points can still compress further. U.S. high-yield was far more resilient during the month give its lower exposure to interest rates, shedding 0.4%. The decision by OPEC to cut production by around 1.2 million barrels per day, its first cut since 2008, helped support crude oil prices and by extension, U.S high-yield where energy makes up around 15% of the index.
While the election of Donald Trump has shifted market sentiment markedly, and in a very short period of time, we expect to see an eventual deceleration in momentum as the market turns its focus to fundamentals and away from mere expectations of policy. Notwithstanding a Republican-majority in Congress, many of the pro-growth policies which the President-elect has proposed will require significant clarification and trade-offs, all of which take time. For one, how will fiscal expansion be financed without running up an even larger deficit? On this basis, we think the market will focus on the viability of Trump’s proposals along with the transition from monetary to fiscal policy, and Europe’s packed political calendar, all of which we discuss at length in our upcoming 2017 Outlook . The interplay of these market drivers should give rise to higher volatility and new opportunities. On this basis, we continue to assume a more tactical approach to our equity allocation while maintaining a strategic long allocation in credit. In our view, generating positive returns requires increased flexibility and the ability to look through periods of higher volatility. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.