Covenant Weekly Market Synopsis as of November 18, 2016

November 21, 2016

Developed market equities continued to move higher last week following the election. The move was more pronounced in the U.S., ground-zero for President-elect Trump’s new policies, where large capitalization stocks moved higher by about 1%. Small capitalization stocks (which are expected to benefit from reduced regulation and a lower corporate tax rate under the new administration) moved up by 2.6% and are now up 10.5% on the month and 17.3% year-to-date. Strength of the US Dollar (+2.8% month-to-date) has yet to weigh on domestic equities, but has made its presence felt on emerging and frontier market equities, both of which fell last week, and have declined 6.7% and 4.6% month-to-date, respectively. Yields on fixed income investments continued their post-election ascent, with the yield on the 10-year US Treasury bond rising 0.2% to 2.35% (the highest level since last summer). Precious metals had another tough week, while WTI Crude gained 5.3%. As investors have revved up risk taking, the VIX Index fell another 12.8% to 12.85, and is down nearly 25% for the month.

For a detailed view of weekly, month-to-date and year-to-date asset class performance click here.

Many, many questions remain as to what President Trump’s ultimate policies will be and how quickly they can impact the real economy. There is a lot of optimism priced into markets, but investors should not lose sight of the economic reality in which we find ourselves long after the Financial Crisis. Both the optimistic view and a reality check are summarized below.

Optimistic View: President Trump is able to implement the changes he campaigned on, reducing regulations on business, “fixing” Obamacare and reducing corporate and household income taxes. These changes will usher in a new age of prosperity and a Ronald Reagan-style economic recovery. This is what the markets are currently reflecting as indicated by market action in the two weeks since the election:

  • $25.4 billion of new cash invested into equity ETFs
  • Inflation expectations have risen…
  • …causing massive outflows from bonds which resulted in the largest two-week loss in at least 26 years in the Barclays Global Aggregate Bond Index. The 10-year US Treasury yield, at 2.35%, is nearly one percent higher than its post-Brexit lows in early July.
  • The US Dollar rallied to a one-year high
  • The Dow Jones Industrial Average and the S&P 500 are within a percent or so of new highs (19,000 and 2,200, respectively).

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Sources: Bloomberg and Covenant Investment Research

 

Reality Check – President-elect Trump is still nine weeks from taking office and the market has seemingly determined that not only have the policies he campaigned on been implemented, but that they are having a similar positive impact as ‘Reaganomics’ did in the 1980’s. Of course, the market is a forward discounting mechanism, meaning that it prices assets now based on the future. But importantly, the forward discounting is determined by humans (for the most part) and humans are emotional creatures swayed by powerful feelings of greed and fear. It is these hard-wired emotions that push markets too high in good times and too low in bad times. The market’s forecasts may well prove accurate, but it is worth considering current economic conditions relative to the time when Reagan took office:

  • Reagan’s tax cuts were implemented during a time in which the Fed was slashing interest rates (rates were reduced from a peak of 19% in 1981 to 8.35% by 1985). The Fed funds rate today is 0.5% and the Fed is biased towards increasing rates – the odds of a December rate hike are nearly 100% according to Bloomberg.

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Sources: Federal Reserve Bank of St. Louis and Covenant Investment Research

  • Reagan’s tax cuts were far larger, on a relative basis, than those being discussed by Trump.
  • Fed Chairman Volcker orchestrated a major decline in the US dollar through the Plaza Accord in 1985. As noted above, the US Dollar’s strength has accelerated recently primarily because of faith in Trump’s policies – a classic “Catch-22”.
  • Non-bank debt equated to only 135% of GDP when Reagan took office, but today it stands at 251% of GDP. That is to say, the domestic balance sheet is being financed with a lot more debt today than it was when the Gipper took office.
  • The current economic expansion is more than six years old, so pent-up demand for big-ticket items (new vehicles, plant and equipment) is likely waning. Reagan inherited an economic recession when he took office and thus his pro-growth policies were implemented during a time when there was large pent-up demand.

Lacy Hunt of Hoisington Investment Management sums up the current state of the market as follows: “Markets have a pronounced tendency to rush to judgment when policy changes occur. When the Obama stimulus of 2009 was announced the presumption was that it would lead to an inflationary boom. Similarly, the unveiling of QE1 raised expectations of runaway inflation. Yet, neither happened. The economics are not different [this time].”

 

Bottom Line – With control of the three branches of government, President Trump will be able to implement a lot of the policies he wants. Yet it remains to be seen what those policies will look like once they make it through the highly-politicized Legislative Process. In a perfect world Trump’s policies to reduce regulation, lower taxes and increase fiscal stimulus will be sufficient to overcome the lingering effects of the Financial Crisis, which have yet to be wrung from the system. While they did not all cast their ballot for Trump as President, investors have clearly voted on his policies.

Be well and Godspeed,

Jp.

 

Sources: the information above was gleaned from a number of sources including Barron’s, Hoisington Investment Management, Federal Reserve Bank of St. Louis. and Bloomberg.