As Wall Street traders departed for Thanksgiving this week, they could celebrate a rare achievement. On Monday and Tuesday, the four most widely cited indices of US stocks — the S&P 500, the Dow Jones Industrial Average, the Nasdaq Composite and the Russell 2000 — hit all-time highs simultaneously. The last time a “grand slam” happened was on New Year’s Eve 1999, at the height of the tech bubble.
The breakthrough for stocks, which had moved sideways for two years since the Federal Reserve stopped its quantitative easing programme, seemed to confirm a regime change. Prompted by Donald Trump’s victory in the presidential election, the narrative has changed to preparing for an era of tax cuts, deregulation and fiscal stimulus, after eight years of markets being guided by the Fed’s historically low interest rates.
“My sense is that investors are exuberant to have a new theme, any theme, other than watching the Federal Reserve,” says John Hussman, a fund manager.
This fresh exuberance has prompted a shift from bonds to stocks. About $500bn had gushed from equity funds and into bonds this year but last week the flows reversed, with investors yanking more than $18bn from fixed-income vehicles and pouring $27.5bn into stocks, according to EPFR Global, a data provider. And the financial media are already discussing when the Dow Industrials will reach 20,000 — almost 18 years after the index first passed 10,000.
Why the excitement? As Jean Ergas, head strategist at Tigress Partners in New York, puts it: “The US market has opted for Keynes over 1930s pre-New Deal economics as a breakout from subpar growth, better a temporary surge than permanent stagnation.”
Wall Streeters tend to be sceptical of Keynesianism, but are excited that Mr Trump could “out-Keynes Keynes” with Democrats in Congress supporting his infrastructure plans over the objections of small-government conservatives. Hopes are high for deregulation, in sectors from banking through healthcare to mining and energy.
The administration itself has stoked such talk. “The conservatives are going to go crazy,” Stephen Bannon, Mr Trump’s adviser, told the Hollywood Reporter. “With negative interest rates throughout the world, it’s the greatest opportunity to rebuild everything. Shipyards, ironworks, get them all jacked up.”
Bond investors have taken note. Ten-year US Treasury yields hit a postwar low in July, then started to nudge higher ahead of the election, and have shot up to 2.4 per cent this week. Many analysts think that the three-decade bond bull run is now over.
“I would say the secular [long-term] trend is going to be upwards now,” says Henry Kaufman, an economist who predicted the last bond bear market in the 1970s. “Secular swings are hard to forecast, but the secular sweep downwards in interest rates is over, and we are about to have a gentle swing upwards.”
Futures markets signal certainty that the Fed will raise rates next month, normally bad news for stocks. But the tectonic shifts had started in the US equity markets in the summer, in readiness for a new regime.
In the QE period, the stock market was dominated by “bond surrogate” stocks that pay a reliably high dividend yield and by shares that were economically defensive. Cyclical stocks were out of favour, as were financials. But in midsummer, these trends began to turn, and after the election these out-of-favour stocks received a huge boost.
David Donabedian, chief investment officer at Atlantic Trust, noted that as soon as the election results were clear, the Trump team put out a pro-growth economic message. “Coming right out of the block in the first 12 hours they hit all the right notes: the need to boost economic growth, the need for corporate tax reform, the importance of boosting infrastructure spending,” he says.
That turned a fear of a visceral sell-off into an environment where “animal spirits” were restored — and upward momentum took hold.
The shift left clear winners and losers in its wake. Banks are the biggest victors, with investors hoping that Mr Trump will repeal parts of the post-crisis Dodd-Frank legislation. The KBW index of big US banks is up 15.4 per cent since election night. Even if Wall Street regulations are not relaxed as much as the banks hope, rising bond yields should still boost their profit margins.
Among other prominent winners are healthcare stocks, which have shown relief that the threat of price controls under a Clinton administration has been lifted. Oil and mining companies have also enjoyed a rally thanks to the Trump administration’s likely change of emphasis on the environment.
Smaller companies have outperformed dramatically, as they often do in the final stage of an economic expansion. There are clear reasons why. “They tend to pay taxes [unlike many multinationals] so they will benefit more proportionately from any tax cuts,” says Peter Sidoti, of the Sidoti & Company research group. “They benefit more from looser regulations, which are a bigger cost for them. And they’re focused domestically. A stronger dollar does them no harm.”
Melting up?
Plenty of dangers lie ahead. One obvious risk to the “Trumpflation” rally is that a strengthening dollar — it is now its highest since 2003, having rallied 43 per cent since the global financial crisis — will choke off the profits of large companies and damage exporters. Wage growth will also crimp profits.
“Our longstanding view was stocks would grind higher, capped by dollar strength and rising wages,” says John Higgins, chief markets economist of Capital Economics. “I still think those forces are in play after the election — it’s just become a little exaggerated.”
Higher bond yields could spell trouble for equities by drawing investors back to fixed income. They could also raise companies’ borrowing costs and make debt-financed share buybacks less attractive. “At some point this isn’t going to help equities,” says Michael Roberge, chief investment officer at MFS, an asset manager.
There is also the possibility, as happened during the last period when the four main indices set records together in the late 1990s, that the market reaches a heady stage and “melts up” — a process that could last a year or two but would set it up for a 2000-style crash. Stocks already look more expensive than they did at their peak before the 2007 crisis.
“This could be the final flurry higher in equity markets,” says Harry Colvin, a senior economist at Longview Economics. “It’s late in the cycle and there’s a lot to be worried about in the US, but this could prolong the cycle higher, and maybe give us a last melt-up.”
With so much money in bonds that will need a new home if inflation rises, investors would likely continue the shift into stocks. “I’d be nervous about trying to be clever,” he says. “It’s probably the beginning of a period of strength in equities.”
Another risk is that Mr Trump fails to stimulate the economy as hoped. After all, he must deal with a Republican majority in Congress that in 2011 threatened to default on Treasury debt rather than allow any increase in federal borrowing. And there is overwhelming dislike on Wall Street for Mr Trump’s protectionist policies, such as ending the North American Free Trade Agreement and imposing tariffs on China.
My sense is that investors are exuberant to have a new theme, any theme, other than watching the Federal Reserve
Any such policies, which might have opposition from pro-business Republicans but support from rust-belt Democrats, are viewed as unambiguously negative for the rest of the world. Stocks outside the US are down since the election, most severely in emerging markets, showing that markets regard a new protectionism as a real possibility. There are fears that tariffs would slow down the US economy and stoke inflation in the longer term.
Another risk is that the sheer divisiveness of the political landscape could drive sharp market swings. Tom Porcelli, chief economist of RBC, polled clients and found that “people were having a hard time separating their economic/market view from their political view”. Emotions will probably run high, bringing volatility in their wake, as Mr Trump rolls out an agenda.
“Those folks that were negative on Trump continuously brought up two triggers for why he will be net negative for the backdrop: trade wars and his social policies,” Mr Porcelli says. “The people that thought he would be net positive highlighted taxes and reducing bank regulation. There was no middle ground.”
So there is every reason to fear volatility ahead. But with all major indices at record highs, the momentum is plainly upward. Even if stocks on a fundamental basis look expensive, Vinny Catalano, president of Blue Marble Research, warned that money managers would feel obliged to keep buying. “On a technical basis, the music is playing, there are no negative signals and people are dancing,” he said. “It’s career suicide if you’re not in the market.”
