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Authers’ Note: State of the Market

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Despite appearances to the contrary, the Trump trade may be moving into reverse as the president’s maiden State of the Union address approaches. The overall level of the stock market is, of course, at fresh records. But the pattern within it is shifting again.

The end of the week saw sharp falls for almost all equity markets except the US, with emerging markets taking a particularly sharp fall. Bond yields have fallen noticeably, and are now back at the bottom of their recent ranges. German Bunds have been particularly eye-catching, and European political risk has much to do with the move to buy Bunds again — but the recent strength of bond markets suggests at least some reappraisal of the argument for reflation. There is growing concern that the much hoped-for tax cuts will not appear in time to help markets or the economy this year.

This is how Barclays assesses the difference that could be made to economic growth, according to how the administration moves from here:

 

Without the administration delivering something on the fiscal front soon, Barclays does not expect growth to exceed 2 per cent this year. Remember that 3 per cent has been promised, and that looks implausible. Some detail on Barclays’ thoughts is interesting:

We believe that the policy focus needs to move away from immigration and health care toward fiscal policies if the administration wants to deliver on tax and spending policies that could boost economic activity in the current calendar year. Absent any re-prioritisation of policy in the very near term, we believe investors should re-orient their view on tax reform to 2018. Delays in a possible fiscal boost would make the 2017 government’s growth target of c. 3% challenging (Barclays forecast: 2.5%). For now, our policy baseline remains a combination of anti-trade policies in the form of tariffs against Mexico and China and expansionary fiscal policy that provides a boost to economic activity later this year, but we acknowledge that the probability of our baseline materialising has fallen substantially in recent weeks.

This sort of talk should be concerning for the administration and for those long the market. If we are really talking about no action on tax until next year, the risk that the administration has lost political capital by the time it tries to get its critical fiscal measures through grows much greater.

A similar but somewhat more bearish assessment comes from Mark Lapolla of Sixth Man Research:

In the last day or so, the Trump administration has clearly walked back its narrative regarding tax reform and growth. Although this shouldn’t be surprising to anyone, the capital markets remain entranced by trend lines and momentum. Specifically: 1. Treasury Secretary Mnuchin has walked back expectations regarding:

a. Deep corporate tax cuts

b. The time it will take to get legislation passed, and most saliently,

c. That it will be 2018 before the economy is materially impacted by policy changes and any infrastructure bill will be taken up by Congress

Time is of the essence when a new administration takes office. The market wants to make sure that its first 100 days are spent dealing with what matters most to investors — tax. If the opportunity is wasted, a lot of the optimistic growth forecasts on which current valuations rest begin to look suspect.

For those braced for a disappointing State of the Union (by the market’s lights), Mark provides a handy guide as to what to expect next:

Accordingly, it is reasonable to expect the following:

1. The industrial commodity complex will follow copper’s lead and begin to soften which, inexorably, will drive negative reversals in pricing and economic survey data. (e.g. PMIs).

2. The bullish dollar thesis will begin to unwind as growth expectations soften and the momentum of interest rate differentials rolls over.

3. Shorts in the Treasury market will have to cover as rates break down through this consolidation range to lower levels.

4. The reversal in relative strength between defensives and cyclicals will accelerate making all industrials vulnerable, particularly those up on air.

5. High multiple, darling stocks have NO room for error. Be forewarned; the entire market is STILL overweight AMZN.

The administration’s focus so far has understandably been on making sure that it goes through with the core promises that helped ensure support from Mr Trump’s base. That is politically almost surely correct — if Main Street benefits at the expense of Wall Street, so be it. But the strong stock market has helped him greatly so far. A significant reversal for the market would not help the administration’s hopes to deliver for the Trump base. So a lot rests on Mr Trump’s speech next week. 

Emerging currency homework

Following the Smart Money column earlier this week, in which I stated that part of the reason for EM’s recent strength was the weaker dollar, I had a charming comment from someone calling themselves Cynic in London, denying that the dollar was weakening, and telling me to do my homework.

So I will do Cynic’s homework for him, with the help of some charts from Capital Economics. The relative performance of emerging and developed currencies compared to the dollar since the election is quite startling:

For reference, OITP stands for “other important trading partners”, and it is the Federal Reserve’s index that works as a proxy for emerging market currencies. The dollar has weakened very sharply against them since the inauguration, and they are close to making up all their losses since the election. It is a surprising outcome, but that is what has happened. 

This conceals great variation between emerging markets, although the trend of weakening between the election and the inauguration and strengthening since then is widespread:

For obvious reasons, the Mexican peso has been far more affected by the election than other currencies, but the effect is plain across the range of emerging markets.

Can this last? Much depends on the Trump administration’s behaviour from here. Backing off calling China a currency manipulator reduces the risk of a sharp appreciation in the dollar. Now we need to await the Federal Reserve. Higher rates could easily put pressure on emerging market currencies again, and plainly Mexico will continue to be a special and very fraught case. 

Capital Economics also suggests that emerging markets remain vulnerable. Some specific comments are interesting:

More generally, we expect the Fed to hike interest rates further and faster than markets expect in the coming months, causing most EM currencies to weaken a little. That said, in most cases we don’t think that this tightening of policy will trigger significant falls, since EMs have generally become less reliant on capital inflows in recent years. With the exception of Turkey and South Africa, few major EMs still have worryingly large current account deficits, in contrast to the 2013 “taper tantrum”.  Finally, we expect Eastern European currencies to weaken against the dollar too, owing to their close ties to the euro. We forecast the euro to fall below parity against the US currency this year as the contrast between Fed and ECB policy proves to be starker than markets are currently discounting.

If Cynic in London is reading this, I hope this has been useful homework for him or her.

Hot streaks

The Dow’s winning streak has now, just, reached 11 days. It is closing in on its record from early 1987. How much weight should we put on streaks?

Certainly the phenomenon of momentum in markets is real, and traders make money from it. Winners tend to keep winning, and losers tend to keep losing, until they meet a sudden reversal. 

But streaks are also a classic example of our tendency to be fooled by randomness, as Nassim Taleb would put it. Streaks catch attention and they can distort perception. Random distributions naturally contain clusters.

For an example, I will turn to my first love, baseball’s Boston Red Sox. The longest hitting streak in the American League last year (meaning the longest number of consecutive games in which a player managed to get a hit that allowed him to reach at least as far as first base safely), was 29 and it belonged to Jackie Bradley Jr. of the Red Sox:

Jackie, I should hasten to add, is a wonderful player to watch — gloriously athletic in the field and blessed with genuine power with the bat. The last two times I went to see the Red Sox play live, he managed to hit a home run. So it is easy to get the impression that he is one of the best players in baseball.

The problem is that he isn’t. He is a good player, bordering on a very good one, but he is also possibly the most maddeningly inconsistent player in the game. His streak was the best of the year, but by the end of the year his batting average was .267 (he hit successfully 26.7 per cent of the times he came to bat). That ranked him 38th, way behind Jose Altuve of the Houston Astros, who hit .338.

Here is another example from two of the most famous players ever to play the game. For the uninitiated, 1941 was a great season. These two gentlemen are Joe DiMaggio of the New York Yankees (also famous for marrying Marilyn Monroe and being name-checked in a great Simon & Garfunkel song) and Ted Williams of the Boston Red Sox:

They were two of the greatest players who ever lived. In 1941, DiMaggio pushed the bounds of probability by compiling a hitting streak of 56 games.

Nobody has even come within 10 games of this since. But Williams hit for a higher average than he did while the streak was on, and by the end of the season averaged .406. Nobody has batted more than .400 for a season since. 

Yet DiMaggio was named the league’s most valuable player that year (to be fair, he was far superior as a fielder), and went on to be far more famous, largely because of his streak. By the end of his career, it was plain that Williams was the superior hitter (I admitted at the outset that I am biased). Yet he was not greatly liked even among his home fans — although his final appearance did provoke one of the greatest essays ever written on sport, by John Updike.

I derived great innocent pleasure following Jackie Bradley’s streak last year. That is what sport should be about. But it was totally misleading as to his overall strength as a player.

The same should apply to hot streaks on the market — which should be very much more of a serious business. We should not read too much into the Dow’s current hot streak, just as we should not read too much into its passing the landmark of 20,000. Try to keep focused on the underlying signs of trouble, hard though that might be, and for entertainment do something like watch sport. Spring training is under way after all. 

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