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The Reflationary Presidency?

Friday, November 18, 2016

Last Tuesday night the un-politician was elected and the career politician gave a next-morning concession speech. Post BREXIT, and with regard to still-rising nationalistic movements in many developed countries, it seems clear that whatever status quo existed between the political ruling class and their constituents is almost substantially breaking down. Witness Jeb Bush/Marco Rubio/Ted Cruz and Donald Trump, and Hillary Clinton and Bernie Sanders. It seems, around the world, we’ve entered uncharted waters, and are leaving behind our maps and trusty compass. The thoughts outlined below will provide perspective on how we read the changing economic and fiscal landscape in the wake of the election. It’s not our place to comment on the emotional resonance of any political figure unless it begins to impact the forces that drive the markets.

Contrary to a great deal of nonsense written pre-election regarding the need for bomb shelters and bottled water were Mr. Trump elected, risk markets around the world, after a brief early-morning bout of indigestion, rose substantially. For the week the:

  • S&P 500rose 1.61%
  • S&P Mid cap 400 rose 3.57%
  • S&P Small Cap 600 rose 7.98%

The substantial rise in mid caps and small caps indicates a return to a risk-taking attitude. Further evidence is the massive sector rotation that took place:

  • Utilities, Consumer Staples, REITS, and Telecommunications – safer, dividend-paying sectors –stocks sold off
  • Industrials, Materials, and Consumer Discretionary stocks rose
  • Financials rose 11.33% driven by the probability of a Fed rate hike, which increased from 76% preelection to 88% post-election. Higher rates would allow banks to record higher earnings and returns on assets. As well, the new Administration promises repeal or at least a major overhaul of the Dodd-Frank Act
  • The Health Care sector rose 5.82%, probably driven by the overhanging threat of a pharmaceutical pricing investigation being removed with the election results

Interest rates also responded with regards to a more inflationary economic outlook, as the yield curve

steepened sharply:

  • 2-year Treasury yield rose from 0.82% to 0.92%,
  • 10-year Treasury from 1.83% to 2.15%,
  • 20-year Treasury from 2.6% to 2.94%

As a result, the dollar strengthened significantly, as nominal and real yield (inflation adjusted) differentials between the U.S. and other countries rose, which should create a stronger demand for Treasuries and other dollar-denominated assets over time.

Inflation expectations also rose; the 2-year breakeven yield (an indication of what Treasury investors believe inflation will average over a given time period) rose to 1.29%, the 5-year breakeven to 1.73%, and the 10-year 1.91%. In short, a major part of President Trump’s platform was tax reform and government Market Commentary November 2016 stimulation of the economy via infrastructure projects. History shows these actions would tend to be inflationary over time.

However, the change in stance and tone from the White House does present downside risks worth monitoring. The rise in the dollar, as has happened every time the Fed firms their stance towards normalizing interest rates, caused commodity prices to decline, along with emerging market debt and equity valuations. Crude now trades back at $43.00+ (also due to a chronic oversupply problem), and copper, after rallying for fifteen straight days, also dropped. From November 7 through November 11, the Mexican Peso lost 11.8%, the South African Rand 6.79%, and the Brazilian Real 5.80%. Looking at Asian currencies in terms of Japanese Yen, the Chinese Offshore Yuan rose 1.67%, something that Chinese officials will not be pleased with, and may not tolerate for long.

All of this results from a new administration which promised both personal and corporate tax reform (including possible repatriation of corporate cash balances held overseas), increased infrastructure spending, a concerted effort towards deregulation, a repeal or massive overhaul of Obamacare, and of course, negotiation of more fair trade pacts with our global economic partners. Any effort, and certainly any success, toward these goals will be business friendly, which hopefully translates to jobs and increasing personal incomes. President-elect Trump and Vice President-elect Pence and team managed to accomplish, overnight, what the Fed and the outgoing Administration were not able to do in eight years, and that is to shape some expectation that business activity would pick up enough so as to be prospectively inflationary, and wrest us back from the cusp of deflation. There is a very good chance of successful legislative outcomes, at least from the incoming Administration’s point-of-view. Republicans maintained majorities in both the Senate and the House, and won key Senate races in Indiana, Pennsylvania, and Wisconsin, each of which had been predicted to go to Democrats.

We think it’s important to note that it’s quite possible the market rise Wednesday-Friday might have been a substantial short-covering rally, and that the tough hoeing is still to come (the rally in the Dow Jones Industrials, a price-weighted index, and the S&P 500, a market-cap weighted index, was completely disproportionate; only a handful of high-priced stocks drove the Dow, primarily Goldman-Sachs). There were numerous articles written, many by prominent people who should have known better, that there would be a massive market selloff were Donald Trump elected. Indeed, in the early-morning hours Wednesday the S&P 500 was down more than 5% at one point. Our belief, and as written by my colleague Terry Blaker in his “Today’s Markets” note November 9, was that there is no one person, or branch of government who can make ad-hoc decisions and overcome the checks and balances established in our Constitution. “Whether it’s trade agreements or other matters, our democracy is designed to limit the ability of one person snapping their fingers and changing something overnight. Because of this, we advise against knee-jerk reactions with regards to investments.” It sounded wise when Terry wrote it, and rings true today.

Given the markets positive reaction in the wake of the election, there is reason to believe the legislative landscape has changed in a positive sense. No matter the children’s reactions in Portland and other cities, in general, it can’t be denied that there will exist, on Friday January 20, a far more pro-business climate in our nation’s capital than has existed in years. The prospect of being governed by people who understand that the best social equalizer is a job, not necessarily the fairness or equality of that job, is enough for the assumption of risk.

As well, we are now coming up on corporate earnings that will be easier to beat. The upside to falling earnings is that at some point comparisons become easier. If the economy were to pick up, even slightly, Market Commentary November 2016 there could be a healthy earnings rally that would lower the historically high price-earnings ratio for the S&P 500. The market could grow into its currently very high P/E ratio. That will, however, have to be in the face of a rising dollar, a bane to any company incurring costs in dollars and selling products overseas.

The same risks that existed pre-election exist today, and they are major:

  • Continued strength in the dollar - The yield differential mentioned above will make our Treasury market, at some point, more attractive to foreign buyers, and this will serve to keep the dollar strong or make it even stronger. This will have damaging side-effects to emerging markets, who acted as they were financially incented to do via artificially low interest rates and borrowed a great deal of money denominated in U.S. Dollars. A rising dollar only makes it more difficult to pay that back, at a time when commodity prices are depressed by a lack of demand and a rising dollar.
  • Global currency uncertainty - Global currency issues have not gone away. Because China continues to fight a migration from the Yuan to the dollar, it’s not out of question they might feel a need to initiate a “bail-in,” and devalue their currency by a significant amount at one fell swoop. As we have mentioned before, what keeps us up at night is not equity or fixed income risk per se, it’s the outsized amount of money that continues to be excessively volatile in currency markets. The Fed is walking a very high tight-wire.

In short, we are heartened that there is a more pro-business environment, and will use that as a backdrop for making the tactical portfolio decisions of accepting or shedding risk. While headwinds still exist, there has been a positive change in the economic environment, which typically provides a healthier climate for taking risk and getting paid to do so.

We appreciate your business, a great deal. Please call us with any questions or concerns. Best regards…

Jamie D. Wright, CFA
First Merchants Private Wealth Advisors
November 13, 2016


This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this email are solely those of the author and do not necessarily represent those of the organization.