Donald Trump held his first press conference since the election last week. Just in case there was any doubt, we think the style and the substance tell us that change is coming; potentially big changes. In some cases, the changes will be immediate, for example the proposal to repeal and replace Obamacare. In other cases, the changes will take years to fully play out, such as his likely foreign policy and trade policies. These changes are not like turning a light switch on with immediate results. Understanding the real consequences will only be a realistic endeavour over the long term.
Rarely are things simple in financial markets, and what seems obvious may or may not happen. As well as political change in the World’s super power, we have the Federal reserve tightening policy after years of extraordinary stimulus and further significant debt accumulation since the Financial Crisis. US profit margins appear to be in a structural decline after reaching a record high level in the last couple of years and inflation is a potential threat. These and many other macro issues (technological change perhaps been one of the more important?), both in the US, and internationally, bare close analysis in the months ahead.
One fact that is reasonably consistent over time is that sentiment moves from optimism to pessimism and back again, and market narratives change accordingly. Some of above mentioned macro issues could turn out to be fairly seismic, and price can change dramatically as the facts change the prevailing narrative. Without knowing the answers to many of these issues, what we do think is likely is that market volatility is likely to be higher in the next four years than it was in the last four years. The RMG FX Strategy mandate (Managed Account and UCITS fund) would enjoy some more volatility and its track record of providing uncorrelated returns in the most liquid market should be of interest to investors in this environment.
So, with all of this said, let’s have a look at the current market narrative, and share some thoughts.
Let’s start with fixed income and the US Bond market. Here, the current narrative appears to be fairly clear. Yields hit their low point in the post Brexit deflationary scare, despite a cyclical upturn in the rate of inflation already developing, due in part to the reduction in spare resources 7 years into the current economic expansion and also the low year on year base effect induced by the collapse in the oil price.
As yields began to rise from the post Brexit scare and investors realised that growth and inflation were actually ticking higher, markets focused on the US election, realising that both candidates were advocating reflationary policies. Of course, with Trump’s victory, the reflationary narrative ramped up several gears and market expectations are now almost the mirror image of where they were 6 months ago. Chart 1 is an update from last week showing the yield on US bonds (in red) alongside the net position of speculators using the futures market (in white and inverted).
Back in July, the yield on the 10 year Treasury plunged to 1.40% and speculators were holding their second longest net futures position since the financial crisis. As the narrative changed, and became turbo charged by the Trump victory, yields surged from 1.4% to 2.5% whilst positioning has shifted from near record long to a record short (by some margin). Clearly, those buying into the deflationary post Brexit narrative were wrong.
Chart 1 – US 10 year bond yields (red line) and speculators net position in the futures market (white line & inverted)
As noted last week, the economic data, both survey and hard data, have improved from last summer. The US economy expanded at 3.5% in Q3 (that is QoQ annualised – the year on year growth was 1.7%) and is expected to have grown by a little over 2% in Q4. This is a decent pick up from the ~1% growth rate seen late 2015 and H1 2016. Perhaps more important for markets, the improving economic performance has been better than expected. Chart 2 below shows the Citigroup economic surprise index for both the US (white line) and globally (red line). As can be seen, the trend for both has been strongly positive since late October. What this tells us is that consensus was perhaps too cautious in October.
Chart 2 – Citigroup economic surprise indices
The situation today is that these indices have reached elevated levels (the global index especially). What we would suggest is that consensus has now fully caught up with the improving economic performance, and that if anything, the surprises may be on the downside.
We have seen 10 year yield forecasts from respected analysts/investors ranging from 6% on the high side to 1% on the low side (with an outlier suggesting yields could still fall below zero!). This may sound strange, but we can envisage both a surge in yields and a collapse in yields in the months ahead, as alluded to last week. We hope this doesn’t sound mad, but the uncertainty surrounding Trump, his policies and the response from the Fed, together with the extreme positioning noted above, make both outcomes possible over both the short term and the long term.
We also think that the performance of the bond market in the next few quarters is extremely important for all financial markets, and ultimately the economy. After several months of rising yields and rising inflationary pressures, it is all too easy to buy into the Trump reflationary narrative. And although this may well be the longer term outcome, the greater risk in the next few months is a period of disappointing data, leading to falling yields as investors and traders scramble to cover shorts and buy duration.
As well as watching the employment reports and business surveys, we will need to watch the inflation data carefully. As noted above, part of the upswing in the rate of inflation can be attributed to the low bas effect of oil. Now, the price of oil bottomed in January/February period last year, and we should expect the low base effect to dissipate by the end of Q1 this year and complete disappear by the end of Q2 assuming the price of oil remains in the $50 range (which we do).
Having talked about rising inflationary pressures, we just thought that we would try and put some perspective on this. Chart 3 below shows various measures of US inflation as well as a gauge of wage inflation from the Atlanta Fed. Clearly, wages are rising faster, currently at 3.9% annualised compared to 3.1% at the end of 2015. As for the various inflation measures, they are all either flat or higher compared to their end 2015 levels with the greatest increase seen in the Personal Consumption Expenditure Index. However, the PCE is only 0.25% higher than where is was nearly a year ago – hardly a surge.
Chart 3 – Various measures of US inflation
As noted above, we can understand both the bullish and bearish inflation/yields scenario. However, we do wonder just how strong the core inflation pulse is. For example, we also know that the core inflation rate is being boosted by large increases in the costs of healthcare, shelter and education. If we were to only strip out shelter from the core CPI, we get a very different picture. Chart 4 below shows that this core inflation ex. Shelter is only increasing by a little over 1% year on year. The reason this may be important is that for some, the increasing costs of healthcare and shelter are more like a tax than anything else, and therefore deflationary. If higher wage costs only go to meet rising healthcare and shelter costs, how can this be truly reflationary?
Chart 4 – Core CPI and core CPI excluding shelter
For what it’s worth, our view at the moment is that we are near the “peak reflation” narrative in the markets. Yes, the economy is doing better than the depressed expectations from a few months ago, and yes, inflation is rising as are wages. However, this may well be close to fully discounted in markets, with the bearish bond trade now very crowded. We would not be surprised if upcoming data are more in line with recently raised expectations, and there is certainly room for a downside surprise or two. We would also not be surprised if inflation peaks in the next few months.
If our narrative is near correct, the bond yields may fall quite a bit (prices rise), and this would be bad short term for the Dollar and would certainly bring into question the continued re-rating in the equity markets. Will this more cautious outcome happen immediately? The evidence appears to be building but price is not yet confirming it. However, we believe that things may change, and perhaps quite quickly, once Trump is in the White House.
Stewart Richardson
RMG Wealth Management
