As I noted in my And the Field Goal is Good! blog post, the outcome of the US presidential election shouldn't have been too surprising. However, I think that the markets' reaction to it was the real surprise. After making the point that a Trump victory was a reasonable possibility, my blog post focused on what would be the likely market reaction should Trump win. Going into the election, global equity markets frequently reacted positively to events that improved chances of a Clinton victory, and frequently reacted negatively to events that improved chances of a Trump victory. The conventional wisdom was that Clinton provided continuity of the status quo, while Trump provided a somewhat unknown outcome due to his lack of concrete policies, with the possibility of serious downside risk if Trump's anti-trade rhetoric was followed-up with action.
Following conventional wisdom before election day, global equity markets did initially react negatively when it became apparent that Trump would win Tuesday evening (S&P futures, which trade around the clock, hit the -5% circuit breaker). But within 30 minutes after the US market opening Wednesday morning, the S&P 500^a had already crossed into positive territory. By the end of the week, the S&P 500 finished up a modest 1.1% from Tuesday night's close. This was significantly better than what was expected for the US market reaction to a Trump presidency, and more inline with what was expected had Clinton won. But hiding within this modest 1.1% US market performance were widely divergent industry outcomes. Financials, healthcare, industrials, and energy sectors gained strongly, while more stable dividend-paying sectors, like REITs, consumer staples, and utilities suffered.
US Equity Winners2
US Equity Losers
Also defying expectations, fixed income markets sold off aggressively—wiping off over $1 trillion in value from global bond holdings. The Barclays US Aggregate Bond index,b which we use within AlphaGlider's composite benchmarks, fell 1.5%. The yield on the US 10-year Treasury stood at 2.15% at the end of the week, up 30 basis points (0.30 percentage points) since Tuesday's close, and up a significant 78 basis points since early July (Brexit fear). Measures of risk, such as gold and the VIX,c also fell aggressively.
Fixed Income Losers
However, there were some financial assets that did act as expected. Nearly all emerging markets assets were clobbered. Since Tuesday's close, emerging market equities (as measured by VWO) were off nearly 8%, and emerging market government bonds (as measured by VWOB) were off over 4%. Most emerging market currencies sold off against the dollar, but none as much as the Mexican peso, which was off over 13%. The Mexican equity market was down a staggering 18% (in dollar terms, as measured by EWW).
Emerging Market Losers
So What Are the Markets Telling Us?
In our opinion, the markets expect Trump, with the aid of the Republican controlled Congress, to carry through on most of the market friendly promises that he made during the campaign. Namely the following items, most of which are from the traditional Republican playbook:
- increase infrastructure spending
- lower corporate tax rates
- lower personal marginal, capital gains tax, and estate tax rates
- dismantle some financial regulation, specifically large elements of the 2010 Dodd-Frank financial reform act
- dismantle some environmental regulation, specifically the recent Paris Agreement
- dismantle some health care regulation, specifically large elements of the Affordable Care Act and FDA reviews of drugs and devices
The damage to global bond markets signal an expectation of higher inflation and higher interest rates, fueled by an increase in fiscal stimulus (primarily infrastructure spending) in a relatively tight labor market, and rising federal government deficits (spending more while tax revenues fall from lower corporate and personal tax revenue). It would appear that markets expect the Republican controlled Congress to approve Trump's higher infrastructure spending programs even though they consistently blocked Obama's own infrastructure spending efforts in the name of budgetary discipline.
The 13% fall in the peso and the 18% fall in the Mexican equity market since Tuesday indicate that investors take Trump's threats to apply tariffs and/or renegotiate terms of the North American Free Trade Agreement (NAFTA) at face value. But given the strength in US equities this week, the market does not expect Trump's pressure on Mexico to begin a trade war, nor spread to other major trading partners such as China. For example, Boeing, a major US exporter of passenger jets and a likely target for Chinese retaliation should Trump apply tariffs on Chinese imports, was up 4.4% since Tuesday. Likewise, markets appear to downplay the possibility that Trump will follow through on his campaign rhetoric to pull back from long-standing alliance partners in Europe, Asia, and the Middle East if they don't contribute more to mutual defense, to renegotiate the Iran nuclear deal, and to take a more conciliatory stance toward Russia.
In summary, the markets had been viewing the prospect of a Trump presidency as a glass half empty, or even worse, going into last Tuesday, but now view the actual Trump presidency as a glass half full, or better. The markets consider the likelihood of and the value of Trump's pro-growth agenda to more than offset the likelihood of and the downside risks presented by his anti-trade and isolationist positions during the campaign.
Where to Now?
For the last several years, AlphaGlider strategies have been underweight assets we consider overvalued, namely US equities, longer duration fixed income, and interest-rate sensitive sectors like real estate. This positioning served us well in the three trading days since the election as the benefits of being underweight longer duration fixed income overcame missing some of the upside provided by the US equity market.
We appreciate what the markets see in the near-term benefits to US companies as a result of higher fiscal stimulus, lower taxes, and reduced regulation. However, we are less convinced of their longer-term net benefits as all of these actions tend to come with negative, longer-term side effects, such as higher government debt, irreversible environmental damage, and increased risk to the global banking system.
We sincerely hope that the market is correct in pricing in little incremental risk that Trump may initiate a trade war with one of the US's major trading partners, or add to geopolitical tensions. However, we are more conservative in our assessment in this area, given the severity of Trump's rhetoric in these areas, and the magnitude of damage to asset values should such a negative scenario(s) occur. Sitting on a cyclically adjusted price to earnings ratio of 26.8x, the US market is not paying us sufficiently to take on such risks as those mentioned above. This is even more true with the increase in inflation expectations and bond yields since Tuesday. The value of a company, after all, is the value of cashflows it generates into eternity, discounted back to today. The discount rate on all company cashflows went up 30 basis points since Trump was elected.
We remain comfortable with the positioning of our strategies, but as always, we remain vigilant in analyzing valuations relative to expected returns from our investments. While we have been presented over the last week with many new facts about how the US will be governed over the next four years, there is still so much that we don't know from a campaign season that was so light on policy specifics from Trump.