Tuesday, December 20, 2016

Trump rally to continue lifting markets next year 2017

I wanted to wait until the new POTUS was in office before giving an update and combining with a year-ahead-type note. The planned delay was because I wanted more certainty on what Donald Trump is actually going to do rather than focus on current headlines and assumptions, but the pressure to write has been growing hence this note with a planned follow-up one early in Q1 next year.

The first thing to say is that Donald Trump's victory is not a massive surprise if one considers the anger and inequality created by central-bank-driven policies since the GFC for those not in the winning camp – the top 1-10% of our societies in the West. And the second key point is that Mr Trump's win is a big deal, in particular because he will enjoy a Republican congress (for now) and he will also have the power to shape the US Supreme Court for a generation. Make no mistake Washington will now shape our future much more than the tired old central bank story which is exhausted and lacking credibility when looking society-wide and in the context of markets. This outcome was not factored in at all by the Fed pre-election.

Looking ahead, we know Mr Trump's “known unknowns”. We expect attempts to deregulate (not just but notably in the areas of energy policy and financial sector rules), tax cuts, infrastructure spending, a re-working of Obama-care, and an anti-globalisation push particularly focused on trade, on-shoring and defence.

To use his own words, we all know that the new POTUS will be attempting to make America great again in the face of some extremely powerful long-term global forces. Not just the US, but the West in general, and now also many of the so-called Emerging Markets are facing the same very prevalent long-term challenges: 

-    deteriorating demographics, with a lack of young workers butting up against a rapidly aging population and where the anti-immigration trend in the West is hugely unhelpful;
-    dangerous levels of debt and deficits – since the GFC debt and leverage levels have risen almost universally, with most big economies either already at or close to the 100% debt/GDP level which many see as a tipping point from when debt can be helpful for growth to when additional debt and deficits become a drag on growth;
-    technology and globalization, which are here for good and which are very powerful when it comes to generating deflation by lowering wages and by crushing the production cost of virtually everything; and global regulations covering many if not most parts of our lives, including energy policy (climate change, for example) and financial sector regulation (the BIS for example).

With all this in mind, what does it mean for markets and asset allocation into 2017?

It looks to me like we have come (thankfully) to the end of the phase where central bank utterances dominate. Central policy options are widely considered to be exhausted and lacking credibility. Going forward, I expect eventually some form of normalisation of monetary policy, not just at the Fed, which should trigger the next long-overdue recession. In the interim I think markets need to assume that further central bank easing, notably in the US, the UK, the eurozone and Japan, is now off the table and instead we will need to cope with de facto tighter monetary policy.

Further, there is a portfolio shock in place. After eight+ years of central bank cajoling, many funds are now long the wrong assets at the wrong price – not just portfolios that own DM government bonds, but also most obviously portfolios heavy in credit assets, especially in hard currencies, especially in the IG sphere. As such, I think the possibility of a liquidity shock hitting markets in 2017 is material as the portfolio shock will require a level of risk and portfolio transformation that the sell-side will likely struggle to provide in any kind of smooth and reliable manner.

Going forward, alpha should dominate beta. Markets and investors have ridden the central bank “beta-wave” for eight years. Markets are currently trying to change course towards riding some form of “Trump reflation and deregulation” beta-wave. I don't think this will last very long, but it has been powerful since Donald Trump's victory and I think has legs into 2017. Eventually, however, I expect generating alpha to be the name of the game.

In essence it comes down to the ability primarily of the US (other parts of the world still follow) to generate a sustainable increase in trend real GDP growth that outstrips the sustained increase in the cost of capital which we are seeing already most notably in USDs (through the rising USD, higher yields and now a hawkish Fed). If President Trump and the US can pull this off then it should generally benefit much of society. Unfortunately, I think Donald Trump is probably the wrong man at the wrong time. The world needed Trump reflation and Trumpian deregulation back in 2008-09 when unemployment, slack and output gaps were high. In 2017 I think Trumponomics is most likely to lead to a short-term boost to nominal GDP (which will be very tradable) giving way to serious inflationary concerns, which in turn will mean that the sustained increase in the cost of capital in USDs will ultimately trigger the next recession. And yes, I do not doubt that this Yellen Fed will be very active, even if it means that Mr Trump ends up as a single-term president. As Bill Clinton once said, “It's the economy stupid!” And in today's world Mr Trump has made promises that he will find very difficult to deliver to his voter base, as we now live in a multi-polar world which the US can no longer control and drive, and where the issues around demographics, globalisation, technology, over-indebtedness and global regulation cannot simply be brushed aside and ignored.

So, bringing this all together by focusing on markets, how to view 2017?

In the very short term risk assets are overbought, optimism rules the roost especially in the US (but where Wall Street yet again gave Main Street another reason to vilify it, by almost overnight flipping from “we love Hillary” to “we love Trump”), expectations around President Trump are high, and as discussed above, we see a liquidity mismatch likely early in 2017. So Q1 may be very difficult and we could see a repeat of the market pain of Q1 this year.

Beyond this short term, the trends over H1 [First Half] 2017 should be higher (especially US) equities and yields, steeper curves, a stronger USD, and mixed performance in credit (especially in the IG sphere) and EM. Equity markets in particular are initially likely to ignore the inflation issue and focus on the idea that Donald Trump can overnight rebuild the US economy into a “4-5% nominal GDP” limo, vs the underlying current sense of a “3% and falling fast” jalopy. So for me, most likely over the middle two quarters of 2017, I can see the S&P 500 cash index up at 2450 +/- 50 points, with the Nasdaq weakest and the Dow strongest of the big three US indices.

Eventually, this optimism must give way to reality – we can call that reality “inflation” and “inability to deliver” when it comes to President Trump and his promises. For markets, that really means that the old rule whereby long-term bond yields track trend nominal GDP over time needs to become the key focus. I think we could easily see the long bond at well over 4.5% yield levels, UST10s at 4% and the DXY index up at 120. Initially nominal assets like equities should celebrate the better outlook for reflation and higher nominal GDP. But I would expect this to give way quickly – maybe as soon as Q3 or Q4 2017 – to a realisation that we are likely to end up with either much more inflation than is currently anticipated (Trumponomics should take the US unemployment rate to 3% or lower) whereby a 4.5% nominal growth rate is made up of 3%+ inflation + only 1-2% real GDP, or a much more stagflationary outcome with even lower real growth (bar a short-term boost) and much higher core and headline inflation. Here the pain of USD strength on US corporate profits could be severe and easily outweigh the short-term boost to domestic US revenues and profits that might be seen under Trumponomics in 2017.

I worry particularly about this Fed, which at the top is ideologically as far away from Donald Trump and Team Trump as it could be. If President Trump does what I think he will attempt to do early in his tenure, this Fed will see itself as way behind the curve and will have an overwhelming flow of inflationary and credit growth data to respond to. So the idea that this Fed will hike by at least another 100bp in the next year, backloaded into H2 2017, is very much my base case.

Remembering that MV = PY, we have seen base “M” in particular explode globally over the last eight years, but this has been offset by falling “V”. Trumponomics will, in my base case, not create new demand but merely bring forward two to four years’ worth of demand into the next year or so. Money Velocity should take off. With base M now 8-10 fold larger than before 2008, I think the overall impact of Trumponomics plus what has been seen with base money will lead to much larger “PY” outcomes than currently anticipated. If I am right then the Fed will have to be super-aggressive, probably by, but not before, H1 2017.

Looking ahead, we will need to see exactly how aggressive the new POTUS is and how far a Republican congress is willing to bankroll and accommodate him. H1 should be good (overall, but a Q1 correction is overdue, as mentioned above) for risk assets and should spill over globally, especially into commodity exporters and surplus EM countries, as well as into Europe and Japan. Beyond H1, the reality of limited sustained positive impact on real GDP together with a more aggressive Fed and general tightening in financial conditions, likely in gap moves, is likely to lead to the next recession and market crash. I doubt this would play out fully in 2017, but the process could certainly begin in 2017. So keep watching for the next six months or so, or maybe for the next six quarters at an extreme – the most likely is somewhere in between. The risk hurdles are likely to come thick and fast. Aggressive China devaluations, Turkey and major political risks in the eurozone, which may well result in markets once again pricing in break-up risk, are three of many such hurdles/challenges outside of the US, alongside the US-driven ones discussed here. Stay close to the exit door and beware the complacency around inflation, the Fed and the impact of rapidly tightening financial conditions, especially in USD. Over my 25+ years in this job, the one certainty I have found is that when the cost of capital rises as quickly and aggressively as it has and as I think it will continue to do so, at a time when debt levels are so high, then nasty accidents are virtually guaranteed.

Merry Christmas and happy New Year to all.