The mighty Trump reflation trade has propelled world stock markets ever higher since Donald Trump’s surprising win in the US presidential elections.
Prices of metals and other raw materials have soared; the US dollar has gained impressive strength; US and European markets have been hitting record high after record high; US bond yields have fallen sharply; and most emerging markets and emerging-market currencies have traded to 19-month highs.
Risk appetite is most certainly back in markets, along with a hefty number of very high expectations. By the time this article is published, though, the entire game may have changed and the Trump reflation trade may already have come to an end. This doesn’t seem very helpful, especially in retrospect, although perhaps it serves as a testament to how uncertain world markets are about what to expect from the Trump administration.
A bit more on that later, though. In true Trump style, the details are not to be revealed yet.
Most of Trump’s rhetoric during his election campaign was centred on “making America great again”. Something that the market is now expecting him to deliver on. So much so that the S&P 500 has made several records, including 17 record-high closes and a rally of around 12%, adding more than $2.8tr in value to US markets since Trump’s election win.
This is truly an enormous reaction, and one that the new president is only too happy to take the credit for. But what has he really done so far?
As you may imagine, that is not as easy to answer. There have been many proposals, memorandums and executive orders that have been drawn up and put forward, but most of these still need to be passed by Congress to come into effect.
Thus far, there have been no major policy changes and in truth, it seems that the delivery of any of the promised major policy overhauls might take a little while longer than what the market might perhaps be expecting. This makes for a confusing and disjointed situation in global markets at present.
First, the gold price initially fell as indices went on a tear post the Trump victory. This would be indicative of the higher risk appetite that is being reflected in equities (indices) and bond yields, although from around 22 December, gold has recovered and is currently hovering around the same level it was before Trump was elected.
This indicates that investors are once again putting money into safe havens, although equity prices are still at all-time highs. This is the first conflicting sign of confidence. When looking at gold, you would think that risk appetite is diminishing, although when looking at equities it is clearly not so.
Second, although the dollar has strengthened impressively, bullish bets on the currency by hedge fund managers have reduced to pre-Trump levels. This might indicate to us that the smart money is expecting to be disappointed by the delivery, or the time it takes to deliver, on all the promises that Trump had made thus far.
Now we have two signals showing us that perhaps the Trump reflation trade might be coming to an end, being gold and a general reduction in bullishness on the dollar. Although, when we consider the VIX (the Chicago Board Options Exchange [CBOE] Volatility Index), widely considered the Wall Street fear index, we see that it is, and has for a rather long time been, comfortably under 15 – fully 26% under its two-year average.
This indicates to us that big funds have not been switching around their positions and that volatility in the market is incredibly low. You could be forgiven for thinking that the VIX is poised to break out above 15 and volatility should return any second now, and that is actually rather likely, although until it does, it indicates to us that there is a fair amount of comfort and perhaps even complacency in the market.
So, if gold is going up, but the VIX is staying down and the US market can’t seem to manage a decent pull-back, all should be well, right? Not exactly. Data published by policyuncertainty.com indicates that Global Economic Policy Uncertainty (GEPU) is currently at an all-time high. Once again, this is counter-intuitive. The market is giving us a fair number of mixed signals and is proving very difficult to read.
Winners and losers
So how do we position ourselves in a market that is absolutely unsure about what is going to happen, but shows no signs of slowing down? The initial thinking was that the Trump presidency would be good for pharmaceuticals and bad for tech stocks (like the FANGs – Facebook, Apple, Netflix, Google/Alphabet), which was largely incorrect. The pharmaceutical sector in the US is flat since Trump and the FANGs have continued to rally sharply.
With regard to the banking sector, the expectation for the Trump administration to do away with the Dodd-Frank regulation persists, which has led to a sharp rally in financial stocks, particularly banks. (Dodd-Frank was passed in 2010 as a response to the 2008 financial crisis, and increases the regulatory oversight in order to reduce risks in the financial system. It includes e.g. rules on reserve requirements for banks, prevents predatory lending practices and also enforces stricter rules over derivatives such as credit default swaps.)
Another source of concern shortly after the election was the very low number of shares on the NYSE Composite Index that took part in the subsequent rally from the pre-election lows. This concern too seems to have been misplaced.
At times when declining shares outpaced advancing shares, the NYSE Composite Index moved sideways only because the bigger market cap stocks held it up. Once the rest of the market started participating in the upside again, the NYSE Composite Index would move higher. This inconsistency still indicates that the current rally is fragile, but perhaps does not indicate a sure-fire certainty that the market is about to come crashing down.
With so many conflicting signals in the market, it leads you to wonder if we’re not in fact seeing the long-term impact of the quantitative easing (QE) programmes that were engaged in, both in the US and Europe. Usually correlations between certain asset classes and indicators are very reliable, although recently these correlations have fallen away. It makes the path difficult to see.
Keeping in mind that the market is sending out a great number of mixed signals and that the once-reliable correlations of old are falling apart to some extent, how can we position ourselves to make profit during the uncertain and confusing times?
First off, we should remember that over the short term the market can be rather random, but over the medium to longer term logical positioning can be done to take advantage of some of the major themes that are present in the marketplace.
One such theme is the much-anticipated and hyped-up reform to US tax regulations. Thus far (at the time of writing on 28 February) none of the details about Trump’s promised tax reforms are yet known.
A few thoughts, though, are that higher import taxes, believed to be as much as 20% higher, will offset losses in tax revenue from lower corporate taxes. Trump’s objective is to protect American industry by promoting local US production and almost punishing importers. It is not known how the US dollar will react to higher import taxes and lower US corporate taxes and therefore it is difficult to speculate what the impact will be on exporters, retailers and, most importantly, consumers.
One worrying rumour is that Trump might scrap the deductibility of interest expenses on taxes due, which could have a calamitous impact on highly leveraged companies. However, with very little of the actual details known, it is very difficult to see through the shroud of uncertainty.
The only thing that could be said with some form of certainty is that volatility will return to the marketplace in due time, and when that time comes, it is safe to assume that it will return in a big way.
Therefore it would be wise to avoid companies with high debt-to-equity ratios. This is probably good advice even at the best of times, although the event risk here is that companies who are making large interest payments each year may see large reductions in their profits, should they lose the ability to deduct their interest payments from their taxable income.
State of the US economy
For the most part though, leading indicators are implying that the US economy is in relatively good shape and that it could be poised to grow in the coming years. The unemployment rate in the US is almost at record lows, labour force participation rates are on the rise and interest rates are expected to keep lifting, albeit gradually, going forward.
Inflation numbers have also been looking rather positive over the past few months and GDP growth rate has increased for three months in a row now.
These are all signs of a strong, growing economy. Perhaps in the short term we will see a pullback, but over the medium and longer term the economy actually looks rather solid. We can therefore continue to look at the market-leading sectors and companies as potential places to invest.
Technology stocks, although perhaps not believed in as much as they once were, have been trading really well, and with solid upward momentum toward the upside. So have industrial stocks, financial stocks and utilities. Some exposure to these types of shares in the US would therefore not be unwelcome. Perhaps trying to time your entry to coincide with a pullback should be considered, although staying with market leaders should most definitely be the game plan.
Petri Redelinghuys is the founder of Herenya Capital Advisors.
This is a shortened version of the cover story that originally appeared in the 9 March edition of finweek. You can find Petri's stock picks in the magazine, which you can buy and download here.