There really have been some extraordinary market moves since Donald Trump became President elect a bit less than two weeks ago. According to Bloomberg, the last two weeks have seen:
- Global bonds poised for biggest two week loss in a quarter century.
- The Euro set a record 10th consecutive daily loss against the Dollar.
- The Japanese Yen fell by nearly 10% against the Dollar in 8 days.
And for good measure, US equities have scaled new all-time highs, as measured by the Dow Jones Industrials Average and Russell 2000.
The big question we are trying to answer at RMG is; just how much of a shift does the Trump victory represent? Are we looking at some sort of paradigm shift, and if so, is it mostly political or will we see a shift in economic performance and financial market valuations? Or, alternatively, have the post Trump market moves been exaggerated by a huge position adjustment, recognising that central bank price distortions (especially in bond markets) are perhaps nearing an end at a time when a cyclical increase in real growth and inflation was already in motion. The bond market adjustment has clearly favoured the US Dollar which has arguably been suppressed since January as the Fed walked back on four rate rises this year.
Of course, it is simply just far too early to know the answers to these incredibly important questions. We only know a very small number of Trump’s team and we can only extrapolate from his campaign rhetoric what his policies may be. What we are comfortable with is that the sillier campaign rhetoric is highly unlikely to become policy. So, taking into account all the uncertainties that abound, what are we thinking?
Global politics is changing because it seems a large swathe of voters want change. There are multiple reasons for voters wanting change and, so far, the incumbent political class are not able to deliver the changes demanded or even required. If this voter disenchantment had ended with Brexit, then perhaps an isolated UK would have deterred other electorates from voting for change. However, now that Trump has won, there is a distinct whiff of political change in the air. So, if there is a paradigm shift on any level, it would appear to be away from the liberal political class that has been in power for the last few decades.
What of the economy and markets? Frankly, we do not see a paradigm shift in either. Unless Trump is able to eliminate all the red tape and unleash a wave of productive investment (both government and private sector) and innovation, we simply do not see a new economic paradigm. Perhaps we’ll see a mild boost to the cyclical upswing that was already evident but no new paradigm (more on this in future commentaries, no doubt).
As for the markets, if we are right that there will be no new economic paradigm and also correct about our long term valuation concerns for both the bond and equity markets (discussed in many previous occasions), then there is no market miracle about to happen. What appears to have happened is that the bond market, already concerned with deflation risks after Brexit concerns just when inflation was shifting higher, had to adjust price rapidly as investors shift their positioning. The higher US yield environment along with other structural factors has propelled the Dollar higher, and so far, the equity market has brushed off concerns that higher rates and a stronger Dollar will tighten financial conditions too much.
Let’s focus on the bond market and specifically the US 10 year yield. Chart 1 below shows the yield back to the early 1990s. As has been widely documented by bond market followers, the yield remains within an extremely well defined bearish channel (bullish for price). The yield has risen from a low of 1.35% back in the early summer to the current level of 2.33%, which is a significant jump. First resistance at 2.50% is not that far away now, and we suspect that this level will hold for a while, or at least slow the rapid ascent. From a structural standpoint, the major chart resistance comes in around 3%, and the dominant downtrend is currently around 3.3%.
Chart 1 – The US 10 year government bond yield
Although the move upwards in yield has been rapid and may slow or pause near the 2.50% resistance area, we have to acknowledge the cyclical upswing in inflation that will last into Q1/Q2 next year. The cyclical pressure should therefore be towards higher yields for a few months yet, and we suspect that many investors have simply not made the adjustments they would like as price moved way faster than they acted.
It would appear that the move in bonds is driving the performance of the FX markets as well, with the Dollar reaching new multi-year highs on various measures. Interestingly, equity markets are broadly buying into the benign reflation story even though higher yields and a stronger Dollar represent a tightening of financial conditions. We will talk more about equities and the FX markets in the coming weeks, but as with bonds, a period of consolidation in the very short term would be more than understandable.
So, sitting back and reflecting on where we think markets stand, our thoughts are in line with what we laid out last week; that the potential for higher yields and a stronger Dollar remain in the months ahead, but after a very robust rally, some short term consolidation almost feels inevitable now. We still see the potential for an elegant reflation, however, the darker reflation path we described is a real possibility too. (SEE LAST WEEK’S REPORT)
There is no free lunch in markets, and the flexible/tactical trading style that we like to adopt should suit us well in a world where political change appears to be coming, valuations in mainstream assets still appear to be much stretched and recent moves have been quite extreme. We fully expect to have to change our tactical thoughts as new information becomes known, and central banks potentially adjust their thinking during the cyclical upswing in growth and inflation that we see evident today. Times are a-changing, and as we have been at pains to point out, a buy and hold approach to the old fashioned balanced portfolio may well need to be rethought or at least have some liquid diversification added to the mix.