15 December, 2016
Arminius has made money for our investors in November and December by being long assets which have benefitted from the Trump rally, but we bought these assets because we expected them to rise in value regardless of Trump’s policies. Arminius makes investment decisions on the basis of long term data, not by betting on political events.
The most important factor driving markets recently is the “reflation trade”, which is the belief that inflation is rising in the US and Europe. This trade has been painfully obvious to bond investors as evidenced by the rise in the yields of long term government debt in the last five months. Since July 2016, the yield on 10-year US Treasuries has risen by 120 basis points from 1.3% to more than 2.5%, its highest level since 2014. Yields on European government debt have risen by smaller amounts. The cause is higher inflation: in the most recent statistics, EU inflation had climbed to 0.6%, UK inflation to 1.2%, and US inflation to 1.7%.
Rising inflation rates do not mean that we will see consumer prices rising by 5% or more in the near future. Ultralow or negative bond yields were only possible in a world where inflation was zero or negative. Even the modest inflation increases of 0.5% or so will bring capital losses for anyone who bought 10-year bonds in the belief that inflation would be flat for the next ten years.
As a result, many investors are fleeing the bond markets in favour of equities, on the grounds that inflation tends to lift company profits. Besides the reflation trade, US equities have been lifted by bullish economic news which is totally independent of The Donald, in particular:
* US GDP grew by +3.2% in the September quarter, the highest level for two years
* The aggregate of companies in the S&P500 recorded positive earnings growth in the September quarter after five quarters of falling profits
* US wage rates and household income have begun to accelerate in recent months, after years of below-average growth.
What little we know of the Trump administration’s policies has reinforced the reflation trade and the bullish economic news. The key features appear to be:
* Deregulation in industries such as banking, oil and gas, coal, and pharmaceuticals
* Infrastructure spending of up to USD$1 trillion
* Restoring jobs in us manufacturing
* Encouraging exports and taxing imports
* Personal and corporate tax cuts of up to USD$5 trillion.
We are (professionally) sceptical. The rollback of Obama-era regulation is meant to bring in a new age of higher profits for companies in these sectors, but there are of course many other factors besides regulation which determine company profitability. Infrastructure spending will certainly stimulate the US economy, but perhaps not immediately. Even though America’s infrastructure is in desperate need of repair, there are simply just not that many “shovel ready” projects, so the stimulus will have to be spread out over several years.
We have no idea how The Donald plans to bring back the 7 million factory jobs that have been lost since manufacturing employment peaked at 20 million in 1979, especially as the manufacturing sector produces more now than it did in 1979. Similarly, proposals for heavier taxes on imports have triggered vitriolic opposition from retailers such as Walmart, Target and Home Depot because the bulk of their sales come from imported products.
Personal and corporate tax cuts would certainly provide rapid stimulus, but Republicans in Congress have said that they want a comprehensive review and clean-up of the tax code. One policy that could be enacted immediately is a tax break to encourage companies to bring back to the US at least part of the USD$1 trillion-plus of cash which is stashed offshore to avoid paying US tax. Most of the offshore cash is owned by a handful of companies, so any legislation will have to be crafted to meet their needs. Apple leads the pack with USD$216 billion overseas, followed by Microsoft with USD$111 billion, then Cisco, Oracle and Google with USD$50 to 60 billion each.
How long will the Trump rally last? The key factor here is politics.
Markets are assuming that a Republican-controlled Congress will pass most of President Trump’s business-friendly legislation. But the Republican Party is not a tightly disciplined body. In addition to catering to the special interests of their electorates and pressure groups, members of Congress are subject to the iron law of campaign finance, which says that they have to keep their major donors happy enough to fund their next election campaign. Very few members of Congress supported Trump in 2016, and Trump campaigned for very few of them. So they owe him no favours. Trump is particularly vulnerable in the Senate, because Senators’ election campaigns are more expensive. The slim majority of 52 Republicans to 48 Democrats means that the opposition of as few as three Republican Senators could mean defeat for a bill.
A trade war with China could also end the Trump rally.
Threats about China’s unfair trading policies were a standard feature of The Donald’s campaign, and the President does not need Congressional approval to levy punitive tariffs on Chinese goods. If US imposed trade sanctions on China and China retaliated against US exports to China and US companies in China, the implications would be uncomfortable for the US but catastrophic for Chinese trading partners such as Australia.
Politics aside, the reflation trade contains the seeds of its own destruction. For example, the rise in US wage rates and household income is positive for consumer spending, but it may also impact the profits of service industries such as restaurants and retailing. As another example, the US dollar has reached its highest level since 2002, and is already making life difficult for US exporters and for US companies with overseas operations. In addition, the obvious consequence of higher bond yields is higher debt funding costs, which will put the more highly geared companies under pressure.
The Donald has shown a capacity to surprise voters, but from time to time he has chosen to backtrack very quickly. The first real test of the Trump administration will occur in March to May 2017 – what legislation will the new Congress pass? Markets could correct very quickly and very sharply if investors were to stop looking at Trump through rose-tinted glasses.