Call it the “new abnormal.”
For years, an unchanging backdrop of low interest rates, steady central bank stimulus, and so-so economic growth was dubbed “the new normal” or “the new neutral” by investors. That all abruptly changed when Donald Trump was elected president, promising to cut taxes and reduce regulation at the same time as spending freely and tearing up trade deals. Investors are suddenly confronted with an environment where anything can happen.
In the short term, stock markets have rallied strongly as traders assume Trump’s aggressive fiscal plans will be a boon for business. Economists, meanwhile, warn that Trump’s protectionist trade policies make his pledge to boost long-term economic growth highly unrealistic (paywall). After only a month in office, investors must devise their strategy based on a smattering of policy proposals and the president’s Twitter account.
The strategies among traders, asset managers, and economists fall into three broad categories: short-term optimism, long-term anxiety, and blissful ignorance.
Since the election, US stock indexes have rallied to all-time highs. Shares in Goldman Sachs, Apple, and Boeing have set new records since Trump’s inauguration. The six largest US banks have seen their market value jump by more than $280 billion in the past few months, on promises of sweeping deregulation of the industry.
“Financial markets discount all the future good news onto today’s price,” says Steve Barrow, head of G10 strategy at Standard Bank. For some assets, like bank stocks, Trump’s policies are so obviously supportive that the run-up in price is almost automatic.
Or take the dollar, which within a couple of months of Trump’s victory gained more than 5% against a basket of major currencies. This is partly thanks to an acceleration of expected Federal Reserve rate hikes, on top of policy proposals from the president and legislators. The Republican-controlled Congress is considering a “border adjustment tax,” which is generally expected to strengthen the dollar by boosting exports and reducing imports (it’s complicated: here’s an explainer).
Meanwhile, Trump has mulled a one-time cut to the repatriation tax to encourage companies to move money parked overseas back to the US, further increasing the demand for dollars. To avoid the a 35% tax on repatriated funds, US companies currently have about $2.5 trillion stashed abroad (paywall).
The odds of these currency flows materializing seem better than the risks that other countries will retaliate in a negative way, according to Barrow. “We know far less about that than we do the positive aspects of the dollar,” he says. “When you’re uncertain about something, you cling onto those things where you think there is something relatively tangible to hold onto.”
That said, some of the bullishness has died down recently. Currency and fixed-income traders are waiting for more substantive information on fiscal policy before putting more money to work.
Stock investors, however, keep on buying. A survey by UBS of wealthy clients at the end of last year found that they were more optimistic about the outlook for the US stock market than the country’s economy. This suggests that they see reasons for the rally to continue, even if GDP growth doesn’t pick up. Much of this optimism is down to policy—looser laws for banks, tax breaks for exporters, higher military spending for aerospace firms, fewer environmental restrictions for energy companies, and stricter immigration enforcement for private prison companies.
“Markets and the economy are most likely enjoying a sugar high that will not last a year.” Larry Summers, the former US Treasury Secretary, wrote this on his blog at the end of last month. He questioned whether there was any fundamental reason for the rally, and offered up a more sinister reason to not trust—and fear—signals from the stock market.
“New governments with authoritarian tendencies have historically brought about bull markets even before they led to disaster,” Summers wrote. “Governments with much stronger authoritarian tendencies than anything plausible in the USA like those of Hitler or Mussolini nonetheless saw strong markets in their early years.”
President Trump has proved no more subdued than candidate Trump. A matter of days into Trump’s presidency, economists at Goldman Sachs said “the balance of risks is somewhat less positive.” Many of the president’s signature reforms won’t be passed quickly, given internal disagreements among Republicans (see the trouble repealing Obamacare) and little chance of any legislative support from Democrats. Any fiscal boost, should it materialize, won’t be until 2018. Plus, Trump’s seemingly strongest commitments, on trade and immigration, could damage the economy.
Restrictions on immigration will be particularly harmful, according to Goldman Sachs. Immigration accounts for nearly all of the growth in the US labor force, so without it economic and productivity growth will slow. What’s more, the US economy is already near full employment, so expansionary fiscal policies may do nothing more than stoke inflation and force the Federal Reserve to raise interest rates more aggressively.
Speaking of the Fed, Janet Yellen’s term as chair of the central bank ends in 2018, and Trump has already said he wants to replace her; he will also get to fill two other Fed board vacancies during his first term. Domain expertise and previous experience in a field were not requirements for some prominent appointees early in Trump’s tenure—any hint that he will similarly politicize monetary policy would unsettle markets.
In April or May, new presidents typically release their budget proposals for the following tax year. In the next few weeks, the White House is expected to send the outlines of the administration’s spending plans to Capitol Hill.
This could be the moment when the wheels come off the post-Trump stock rally, according to Alex Dryden, a global market strategist at JPMorgan Asset Management. Chatter about fiscal stimulus has sustained the rally to date, but if the draft budget isn’t as expansive as expected markets may go into retreat. For the first clues, investors will pay close attention when Trump addresses a joint session of Congress today.
Already, the dollar rally looks at risk. More than 40% of fund managers in a recent survey by Bank of America Merrill Lynch said betting on dollar strength is the most “overcrowded” trade around.
The stock market’s gravity-defying run also looks like its days could be numbered. Last week, the price-to-earnings ratio on US stocks was at a level only topped during the dot-com mania of the 1990s and the run-up to the Great Depression in the late 1920s. If corporate earnings do not keep pace with these heady valuations, investors could be in for a nasty shock.
This gloomy scenario could be good for bond investors. Yields on 10-year Treasuries have risen from 1.8% before the election to around 2.3% today (bond prices fall when yields rise). This slump wasn’t too surprising as it coincided with a cyclical rise in inflation, interest rates, and commodity prices, says Robert Tipp, the chief investment strategist at Prudential’s fixed-income business.
If the economy fails to expand as robustly as Trump projects, in the next few years the neutral rate of interest on the benchmark 10-year Treasury is probably closer to 2%. That implies a rally from current levels, but off the levels reached during the perkiest periods during the decades-long bond bull market that has lost steam recently. “We haven’t seen elements that would give the US to sustainable 4% growth, frankly not by a long shot,” Tipp says.
If the unpredictability of the Trump administration is simply too much to bear, there’s always the third option: look away.
JPM Asset Management argue that there are better investment opportunities outside of the US, particularly in European stocks, where investors are on edge about upcoming elections. With US stocks looking expensive, the European market offers decent scope for higher earnings, better dividend yields, and a potential rebound in the beaten-down euro.
Ignoring the noise from Washington and focusing on the signal of financial fundamentals is in the same vein, and allows investors to stay engaged with US markets. “As a global rule of thumb, politicians are not as important as they think they are,” says Paul Donovan, global chief economist at UBS Wealth Management.
Trump has inherited a strong economy and may not be able to enact meaningful reforms for a year or longer. In the meantime, the economy “just carries on chugging along,” Donovan says.