Time to Revisit Investment Opportunities Wednesday, Nov 23, 2016
The surprising Trump victory is even further evidence of the ongoing anti-establishment movement and that many underestimated the vulnerability of the status quo that Hillary represented. However, the way the markets have reacted has been completely counterintuitive following the election results. U.S. Equities moved higher, bonds collapsed decisively and the U.S. Dollar hit a multiyear high. It’s interesting how quickly the consensus around what a Trump presidency means for markets took a complete U-turn from spelling a disaster to expecting an economic expansion. All of this was predicated in Trump's victory speech in which he made a few statements aimed at calming the nervous financial markets. This suddenly saw many experts view his policies, especially those centered on fiscal stimulus, as being good for the economy.
The Trump Plan
Mr. Trump’s plan to revive the ailing economy centers around lower taxes, trade re-negotiations, massive infrastructure spending, military spending and deregulation. Many argue that several such policies resulted in higher growth in 1980s under the Regan era. The fact remains that boosting growth with these policies is going to be difficult this time. Reagan had a falling-interest-rate environment and much less debt to deal with. Also, he had a favorable demographic shift to work with as opposed to more retirees today and the onslaught of huge unfunded liabilities on account of social security, entitlements etc. Today, the market capitalization of US is 196% of GDP, versus 40% when Reagan took office, and that would not be without risk in a rising interest rate scenario.
A Trump presidency is highly inflationary because his massive $1 trillion infrastructure refurbishment plans, along with his proposal to rebuild the military, will significantly increase annual deficits. This spending binge will be on top of the already surging deficits which have increased by 34% to $587 billion this year. Trump's plans call for massive fiscal spending, deregulation and cuts to taxes. All this will increase the US budget deficit and long-term debt and put more upward pressure on bond yields.
In addition to this, Trump’s protectionist trade policies would mean higher tariffs on certain imports in order to encourage domestic production. However, this would only be possible at significantly higher costs. For example, the increase in labour costs from goods made in China would be 190% considering the federally mandated minimum wage in the United States. Hence, inflation is bound to increase.
Will the Fed play Trump’s tune?
It’s important that the Fed embarks on normalization of interest rates in order to check the massive economic imbalances that exist now. The market appears to have taken the view that a Trump presidency will be inflationary. Bonds are selling off, yields are surging higher and the market has stepped up its expectations of Fed tightening. Considering a December hike as granted, the market now has over 100 bps of hikes priced in over 2017-2019.
Investors assume central banks will counter inflationary pressures with higher interest rates. The Fed is going to struggle to deliver what the market now expects in terms of tightening. We are nearly seven years into economic recovery and we are only just approaching the second hike,yet the market expects another three hikes over the next two years.
Yellen has said that the Fed would be happy to see inflation overshoot its targets rather than tighten prematurely. Not only will the inflationary impacts of US fiscal policy take time to be reflected in the data on which the Fed’s monetary policy depends, but the Fed would be content to see inflation tick higher without tightening. We presume that there would also be added pressure from Trump if he wants to avoid starting his tenure with an economic crisis similar to that of Mr. Obama. He will need to cap long-term interest rates rather quickly and in the process will seek to convince the Fed chair to not only refrain from further interest rates hikes but also launch another round of long-term Treasury debt purchases (known as “Quantitative Easing”) if the economy loses momentum.
Ongoing uncertainty will further help gold
Gold has corrected after the US election due to surging long-term real interest rates. Until we go past the rate hike in December, gold prices are likely to remain under pressure. Post the Fed rate hike, gold prices may come under bid as markets try to ascertain the extent of further rate hikes and realize that the Fed may stay behind the curve to keep real rates negative for a much longer time.
Trump will lead to two things: inflation (as discussed above) and geopolitical chaos. Both the outcomes are positive for gold. The geo-political risk premium should increase given the change in government and its more aggressive stance on numerous issues in the Middle East. There will be reduced cooperation with the U.S. by the world in response to the US government’s reduced cooperation with the world. Gold will definitely be placed at a premium because of this.
Markets were playing the “lower for longer” theme. If yields continue to increase, it won't just be bond prices that will collapse but every asset that has been priced off that so-called "risk-free rate of return" offered by sovereign debt. The problem is that with a highly leveraged economy, elevated asset prices, rising bond yields and anticipation of further increase in rates may well cause risk premia to rise (i.e. market volatility would increase), possibly causing overvalued equity markets to correct. The associated volatility may cause financial conditions to deteriorate as the Fed likes to put it, providing it enough excuse to abandon rate hikes. The anticipation of higher real rates may fizzle out yet again, providing support for gold prices.
Trump’s policies seem to be extremely inflationary in nature but are unlikely to deliver long-term sustainable growth. There is a high probability of U.S moving towards a stagflation scenario which would be extremely beneficial for gold prices.
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