“Phase one is the hope phase,” Stephen Cucchiaro, chief investment officer at 3 Edge Asset Management, says of the reaction in financial markets to president-elect Donald Trump. “As it is a while until he’s president, you can hope for fiscal stimulus getting growth going and reawakening animal spirits.”
Evidence of exuberance is not hard to find. S&P 500 financials and heathcare stocks are flying; US 10-year Treasury yields have jumped to a high for the year and the dollar has strengthened appreciably. Shares of US steel makers have been in a particularly sweet spot, soaring more than 30 per cent, as investors bet they will benefit from both Mr Trump’s protectionism and his pledge to overhaul America’s infrastructure.
Analysts at Morgan Stanley breathlessly declare that under Mr Trump there is now “a credible long-term investment case for steel equities” for the first time in a decade.
‘Hope phase’ draws concerns
There is no dispute that a historic US presidential race has delivered an unusually sharp response in markets, with many believing a Trump presidency will spell the end for the bond bull market, a rotation into equities and a stronger dollar as faster economic growth and higher inflation are cultivated.
Just a week on from Mr Trump’s triumph, though, some are asking whether markets are getting carried away with the ‘hope phase’, which has been dominated by the ‘Trumpflation trade’ and makes a series of optimistic assumptions about what the next president and Republican Congress can get done.
If Mr Trump can act on his agenda, US gross domestic product may pick up as much as 1 to 2 percentage points over the current annual growth rate of about 1.5 per cent, according to Michael Underhill, chief investment officer of Capital Innovations.
However, “Trump isn’t really a traditional Republican president, as it remains to be seen how well he can work with Congress,” he adds.
Even if there is a faster economic expansion, some worry whether other risks are being ignored in the near euphoria. For many, the clearest is the potential drag on the economy and asset prices from higher interest rates, particularly if the Federal Reserve tightens policy at a faster pace in 2017.
Anthony Karydakis, chief economic strategist at Miller Tabak, points to “the sharp divergence between the thinking of the Treasury (bond) and US equity markets” over how events may unfold.
“The former is driven by fears of higher inflation and the Fed’s likely reaction to it,“ Mr Karydakis argues, “while the latter has chosen to disregard those risks focusing instead on an impossibly benign growth outlook that will not be disrupted by a significantly more vigilant Fed.”
Corporate America under profit pressure
Higher long-term interest rates also put pressure on corporate America to generate higher profits to justify valuations.
Long-term rates are a key component of one of the simplest ways to price financial assets: taking the present value of the future stream of earnings or cash flow of a business and discounting by a certain rate. That is usually the risk-free rate, or the yield on the 10-year US Treasury plus a risk premium to account for the risk of buying stocks versus bonds.
“We can live in this hope phase — where reality doesn’t hit — for some time, “ adds Mr Cucchiaro of 3 Edge Asset Management. “But if the growth doesn’t follow then we’re in trouble. Then we’ll have higher deficits, higher rates and higher rates, in a low-growth environment.”
An increase in rates could also restrain demand for housing, autos and other consumer products that Americans buy with credit. The prospect of higher rates has already pushed the dollar to its highest level of the year, which is likely to prove a headwind for export-oriented industries, including the manufacturing sector, over the next 12-18 months.
It is the dynamic between rates and currencies that helps explain why the Russell 2000, home to America’s small-cap stocks, is making new highs, but the S&P 500 so far has not. Smaller companies tend to generate more revenues inside the US, making them more of a pure play on a stronger domestic economy.
“A stronger dollar will have much more of an impact on the multinationals than domestic companies,” says Ash Alankar, global head of asset allocation and risk management at Janus Capital. “It will impact corporate earnings. We see more attractiveness currently in the Russell 2000 versus the S&P 500.”
Although not matching the giddy rise in shares of steel producers, US banks have rallied more than 10 per cent since the election on expectations both of higher rates, which boost banks’ margins, and hope that post-crisis regulatory oversight will be rolled back.
For Nicholas Colas, chief market strategist at Convergex, there is a danger that “markets get too far ahead of the facts”. He says: “Any investor in the financial services sector has had to become an expert in regulatory issues in the last decade and they understand this is not a snap your fingers solution.”
Then there is uncertainty over how aggressively Mr Trump will pursue protectionist policies. The modern auto sector, for example, has been built around current trade policies, including the North American Free Trade Agreement (Nafta), and ripping it up would prompt a broad reassessment of the companies stock market valuations.
A survey of money managers by Bank of America Merrill Lynch just after the election showed just 5 per cent expect a change in trade policies, suggesting investors will have to rapidly recalibrate if Mr Trump tries to follow through on protectionism.
But perhaps the biggest risk for investors who believe Mr Trump is a game-changer is the president-elect himself. The week since his election has been marked a shift from the divisiveness and impulsiveness that characterised the campaign, but concern remains about a sudden change of direction or an outburst.
“If the man who governs is different from the man who ran, then this is a buying opportunity,” says John Linehan, portfolio manager of T Rowe Price’s equity income fund. “If you don’t believe this to be the case then it’s a selling opportunity.”