Market Update

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Market Update

Week of November 11, 2016

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Wipe Out! What a week. We started out with all bets on a Hillary Clinton win. The odds looked good as Election Day ended and the early votes were counted which seemed to suggest the predicted result. Then, in one hour, the earth shifted. At 10:40 pm, Donald Trump won the swing state of Ohio, where voters have correctly picked each President since 1964. Just before 11 pm, he won Florida and, a few minutes later, North Carolina, Iowa, and Utah. From that point on, it was up to Hillary Clinton to run the table and win the remaining states. As those hopes faded, the whole world seemed to flip upside-down. The Dow “fell” 800 points in the overnight futures market as Trump pulled ahead, and interest rates dipped with the yield on the 5-year Treasury falling 15 basis points (0.15%).

No one, the markets included, knew what to expect. The economy, fiscal policy, taxes, health care, and defense were now subject to a new administration. The experts and political elite were shocked. The French Ambassador to the US said, “A world is collapsing…,” and the Chinese state media claimed that the US democracy is in crisis compared to stable Authoritarian China.

That changed once the President-elect gave his victory speech. Gone was the sometimes bombastic campaign rhetoric and in its place was a gracious, Presidential oration. The markets took notice and soon reversed course. If the new administration were to follow through on its proposed cuts in taxes and regulations (and the federal government), they could be seeing more economic growth than the 2% GDP to which they have become accustomed.

Now that the election is behind us, one has to hope that the incoming administration will continue to foster the United States’ historic role in providing leadership to the world economy. Without that economic leadership, there exists the real risk that, in today’s troubled global economy, the protectionist forces that are pushing to the fore all around the globe will gather strength in a manner that could undermine world economic prosperity.

The international economy will demand considerable attention in the first year of the next US administration. After many years of highly unorthodox monetary policy across the globe, the world economy is drowning in debt and global financial markets are characterized by the serious mispricing of risk. Meanwhile, bank balance sheets (especially in Europe) have been impacted by years of relatively poor economic performance, and trade protectionism is becoming pervasive around the world.

On trade, neither candidate seemed to have a handle on the subject during the campaign. Mr. Trump wants to scrap the TPP (Trans-Pacific Partnership), the new trade bill negotiated with Asia. He also wants to scrap NAFTA (North American Free Trade Agreement), the free trade agreement with Canada and Mexico signed in 1994.

Eliminating free trade deals, if it ends up boosting tariffs (which are nothing more than taxes), is a negative for the economy. Still, the US economy performed well from the 1950’s through the 90’s (OK – the 1970’s weren’t so great), which was before NAFTA was passed. Tossing aside NAFTA would create chaos in the global production chain, but may not be as much of a negative as the Smoot-Hawley Tariff Act of 1930. In the end, Mr. Trump might have better results in courting companies to the US by cutting tax rates and reducing the regulatory burden instead of charging tariffs on foreign goods.

No one knows for sure what the new administration will prioritize. It didn’t help Hillary Clinton’s cause when announced spikes in medical premiums for 2017 were announced in the weeks leading up to the election. Then there’s immigration.

Still, the markets got over their “Brexit-like” swoon in short order and the Dow enjoyed its first record close in three months. Financial stocks rose as they were perceived to be beneficiaries of threats to dismantle the Dodd-Frank Act. Industrial and materials stocks rose in anticipation of infrastructure spending. Technology shares were hurt, along with high-dividend industries like household product makers, utilities and phone companies as bond yields surged.

The Dow broke through its August 15 high to close at 18,848. Long-term interest rates spiked as well, with the yield on the 5-year Treasury up 33 basis points (0.33%) from last Friday’s close. More than $1 trillion was wiped off the value of bonds around the world this week as President-elect Trump’s policies are seen boosting spending and quickening inflation.

The capitalization of a global bonds slid by over $1 trillion for only the second time in two decades (the other came after the Fed announced the winding-down of their QE programs in 2013 – the “Taper Tantrum”). At the same time, global stocks gained $1.3 trillion.

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There is little doubt that the election results are a game-changer. The markets see the real possibility of fiscal expansion and higher inflation, in stark contrast to the malaise of recent years. The rally in stocks (instead of a crash) keeps the door open for the Fed rate hike in December and increases the likelihood of more hikes in 2017 and 2018 than previously expected.

It doesn’t hurt, either, that the GOP has retained power in both the House and the Senate, which allows for the passage of tax cuts, regulatory reform and the like without too much negotiating with the Democrats. The prospect of lower taxes on individuals and corporations that will be pushed by House Speaker Paul Ryan (if he holds on to his speakership this coming week) and Trump’s economic gurus who favor freer markets will nurture economic growth.

You have to be somewhat amazed at the market turnaround. Especially, because of the markets’ certainty of a Hillary Clinton win, resulting in a continuation of the tepid GDP growth that has characterized the past eight years and, as a result, a Fed that would be slow to nudge short-term rates higher. In the end, the belief that economic growth would improve “trumped” all other concerns.

It also shows that “complacency” eventually comes back to bite you. We had become used to the low interest rate environment resulting from a risk-averse investment community who feared that the next recession was always just a few months away. The markets now have opened their eyes to the possibility that things may begin to pick up and, along with core inflation already trending above 2% for some time, interest rates are too low. The 10-year Treasury rose from 1.78% a week ago to 2.15% at week’s end. A year ago it was 2.33%. As we’ve mentioned before, historically, the yield on the 10-year Treasury has run about 1.50% above inflation. With inflation at 2%, the 10-year should be closer to 3.50% instead of 2.15%. If investors become less risk-averse and shift assets from the safe-haven of Treasuries into “riskier” assets like stocks, commodities, and corporate bonds, the rise in rates could accelerate.

Right now. nothing is set in stone. The transition team is just being formed, and the markets will continue to react to the economic agenda as it presents itself. However, the run-up in interest rates which began last summer could have legs if the markets continue to accept the transition in Washington as they have this week. The markets are marching to a different drummer.

Last, but certainly not least, we offer our thanks and gratitude to our Veterans, past and present, for their duty and sacrifice.