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Investors embrace Trump and great rotation thesis

On Wall Street the S&P 500 has surged to within touching distance of a record high, with the US equity market electrified by Donald Trump’s capture of the White House and the Republican party unexpectedly keeping control of Congress in Tuesday’s US election result.

As an historic week ends, investors believe that a macro economic regime change looms, upending the policy mix that has dominated in Washington since the financial crisis with lasting consequences for markets inside the US and beyond, notably for the emerging world.

After several false dawns, the sell-off in bonds and rally in US equities, led by those sectors most closely tied to economic growth such as banks, suggest money managers believe the catalyst for a great rotation out of fixed income assets has finally arrived as fiscal policy begins to oust monetary policy as the key driver of markets.

Rising equities have been accompanied by surging Treasury yields, which have had their steepest jump since the taper tantrum of 2013. From a low of 1.71 per cent as votes were still being counted early on Wednesday, the 10-year Treasury yield closed the week at 2.15 per cent.

The fear among investors that had prevailed about a Trump presidency was quickly replaced by a burst of optimism that the reality TV star and property mogul would galvanise a US economy that had rarely grown above 2 per cent since the financial crisis with a mix of infrastructure spending, tax cuts and less onerous regulation.

“The only thing that has mattered has been central bank policy,” says Rick Rieder, BlackRock’s fixed income chief investment officer. “You are seeing an evolution take place with fiscal, corporate and maybe banking/lending enthusiasm coming to the fore. This transition is a big deal.”

As it is for emerging markets which, in sharp contrast to the performance of US equities, have endured a brutal sell-off this week on fears the Federal Reserve would be forced to raise interest rates faster next year and the antitrade rhetoric that helped propel Mr Trump to the White House would result in tariffs.

The biggest policy risk for investors is the new administration’s trade policy, and beneath the broad rally in US stocks this week signs of that fear surfaced. Technology shares, for example, have lagged behind given their dependence on global supply chains.

Ramin Arani, a portfolio manager at Fidelity Investments, says: “If we were to enact measures that would scale back that globalisation, we would have a profit problem and therefore a dampening effect on the market.”

The threat that protectionist policies pose to US equities is echoed by Bob Doll, chief equity strategist at Nuveen Asset Management.

“We have a lot of uncertainty about which Donald Trump will show up,” he says ”We will have moments where we say, ‘I thought I was getting the pro-growth Trump but I am getting the protectionist Trump’ and that is not good for growth.”

The buoyant reaction of US equities also risks overlooking the unpredictability of Mr Trump himself, who has never held public office and, during the divisive election campaign, veered widely from attacking Fed chair Janet Yellen to praising Russian president Vladimir Putin. That is why Russian stocks escaped this week’s broad emerging markets sell-off on hopes he may ease US sanctions against the country.

The surge in inflation expectations — with 10-year break-evens climbing to the highest level since July 2015 — spurred a dramatic steepening of the Treasury yield curve, another reason US banks have led the rally in stocks.

Indeed, under the surface of this week’s equity gains on Wall Street, investors have changed sector bets significantly as they pick winners and losers from a Trump presidency. Bond proxies, such as utilities, had led the equity market for most of the year, but were sold off as high-yielding stocks become less attractive in an environment of rising rates.

While Mrs Yellen has talked about the benefits of running a “high-pressure economy”, investors say there are limits to the levels of inflation the Fed will tolerate, hence the steepening yield curve.

A consensus is building that interest rates have likely bottomed out, with Mr Trump’s agenda only one of the reasons. The fallout from the election has intensified what had been a slow march upwards in bond market yields as central banks globally have been indicating that the age of monetary stimulus may be in its twilight.

Some, though, expect US rates will not shoot up anytime soon thanks to a combination of factors, including demand for income from an ageing population and an increasingly risk-averse pension sector.

Fickle global markets could also gyrate uncontrollably if the Fed tightens policy too rapidly, adds Ashish Shah, AllianceBernstein’s head of fixed income. A December rise is still widely expected.

“The US exists in a global environment and you cannot manage monetary policy completely independently from the rest of the world,” he says. “Markets are so closely connected. If you run monetary policy too tight in the US, you could break things globally.”

The almost euphoric reaction in the US stock market this week is a jarring contrast to the anxiety in the run-up to polling day. Beginning with Mr Trump’s acceptance speech — which sounded a conciliatory note, followed by a signal from Paul Ryan, the Republican speaker of the House, that he would work with the president-elect and a concession speech from Hillary Clinton urging her supporters to give Mr Trump a chance to lead — fears of a contested election and disorderly exchange of power have faded.

“Clearly, both sides have said the right things so far, creating hope you could see meaningful positive change in Washington,” says Dan Ivascyn, Pimco’s chief investment officer. “Investors have to be very respectful of the uncertainty as they adjust to this new paradigm. [Markets are] … tied to this concept of growth and policy divergence.”

The pronounced shifts in both equities and fixed income assets also reflects investors’ confidence that Mr Trump, with the help of a Republican-controlled Congress, will be able to pass a spending package and ease regulations.

“The bar has been raised here for when Mr Trump gets into the White House in January,” says Don Ellenberger, head of multi sector strategies at Federated Investors. “The market is looking at Trump — now that we have a Republican president, Republican House and Republican Senate — as being able to get things done and most of these being pro-growth.”

Billionaire investor Carl Icahn is a believer, revealing this week that after he left Mr Trump’s victory celebration, he bet $1bn on US stocks. By contrast, emerging markets were not invited to the party in the first place.

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