It seems like each week so far in 2017 we have been looking at different variations of the Trump reflation trade, and questioning whether the evidence backs a continuation, or a reversal. Frustratingly, it’s been a bit of both and a bit of in between, depending upon the asset and the time frame. If this all sounds a bit confusing, then frankly that is how we see markets at the moment, and that is simply how markets are. Sometimes they appear to be straight forward, other times they appear to be anything but. These mixed periods usually coincide with a consolidation (sideways market with lots of churn) or a turning point. Deciphering which is a game of probabilities and we do not have a definitive answer yet.

What we would really like to see is definite fundamental and price action that the Trump trade is either set to continue or reverse. We’ll have a look at some charts and share some thoughts on the state of the economy and what we think we know about Trump’s economic policy.

First, let’s have a look at US equities. Although the trend is higher, we are beginning to see signals that are more associated with market tops than bottoms;

• Sentiment is pretty bullish as per professional investors/commentators. Retail investors are less bullish, but overall we view sentiment as pretty bullish. Of course, bullish sentiment does not have to signal a top, but tops nearly always coincides with bullish sentiment.

 

• Corporate insiders are selling more stock than they have for a number of months.

 

• Market valuations are extremely expensive; as they have been for a couple of years now; N.B. valuations are not short term market timing tools, but we do need to keep pointing out how expensive US stocks are.

 

• A widely read investment publication ran a front cover last week proclaiming next stop for the Dow Jones is 30,000. This invokes the magazine cover indicator which is a contrary indicator – in this case bearish for equities. Indeed, this particular journal has quite a record for being wrong at turning points in various markets, so the signal is quite intriguing.

 

• Speculators positions in the futures markets show that they are holding quite extended long positions, especially in the domestically focused Russel 2000 where the long position recently hit a new record by some considerable margin. Again, these speculators can be right for a long time, but they usually overstay their welcome and are positioned poorly at turning points.

 

• Volatility is at extremely low levels as we highlighted last week. This is an indication of how complacent investors are about risks which we think are more real than imaginary.

 

• We are now seeing negative divergences between price and momentum on the daily charts, as seen in chart 1 below. As with all the above signals, a negative divergence does not guarantee we are at or near a turning point in the market, but all big turning points do coincide with such divergences.

 

• Finally, a number of previous leaders are acting poorly after what were initially claimed as blowout results. Of course, there is always an exception, and Apple shares continue to trade well. However, Microsoft and Facebook have not traded so well following good results. We also point out that Amazon which was supposed to be winning market share from the bricks & mortar retailers disappointed with their revenue numbers.

 

Chart 1 – The S&P 500

Basically, we are on high alert for a move lower in equities. We did get excited earlier in the week that this may be happening, but by the end of the week, our enthusiasm was somewhat diminished as financial stocks rushed higher on news that Trump looks to tear up the Dodd Frank act, helping broad indices trade back towards the all-time highs. We need to see some downside price momentum developing to be more confident that a larger move lower is developing.

Next, a quick look at US bonds. As can be seen in chart 2, the yield on US bonds has been tracking sideways for about two months. With the speculative community having aggressively sold bonds short on the Trump election, if they don’t start to see some upside movement in yields, they may begin to reduce their bets. If yields start breaking lower, we suspect that some will be forced to cover their short positions which could add to downside momentum in yields (upside in bond prices).

Chart 2 – US Bonds

What was interesting this week was that we saw some decent US economic data; both business surveys (forward looking indicators) and employment numbers (a bit backward looking). The data announced this past week would indicate that the economy is both doing reasonably well, and that there is a degree of momentum that should carry on through the end of Q1 at least.

So, it is a little surprising that this better data and continued signs of rising inflation are not forcing US bond yields higher. Perhaps this is a case of if yields won’t rise on good economic news, then perhaps the better economic news is already discounted by bond investors? Perhaps the short covering in bond futures has started, which is what the data from the futures market is hinting at.

We would also note here that there has been some fun and games going on in overseas bond markets. EU periphery bond spreads continue to widen out, with Italy, Portugal and poor old Greece in the limelight. How can this be happening when the ECB has negative interest rates and is still pumping cash into the system at a rate of EUR80 billion per month? It feels that some of the underlying frailties of the European project are not that far away from bubbling to the surface again. Not only can we see this in peripheral bond prices; the EUR vs CHF exchange rate indicates that money continues to flow out of the Eurozone despite the Swiss Franc being overvalued on any fair value measure. No doubt, we will discuss Europe in detail soon, but we don’t have time today.

Also, in Japan the bond market has been testing the resolve of the central bank. Last Autumn, the Bank of Japan moved on to what is known as “yield curve control” or YCC, where they not only set the overnight interest rate but they also target the 10 year government bond yield. At the outset, they told us that they would target a zero yield for the 10 year JGB and the markets have come to accept since then that this would mean a range of minus -0.1% to +0.1%.

So, when the yield approached minus -0.1% the BoJ would reduce their bond purchases (less QE) and when the yield approached +0.1% they would buy more bonds (more QE). Late last week, the yield was hovering just above 0.1% and the BoJ seemed a bit conspicuous by its absence. As market worries intensified and yields moved to nearly 0.15%, the BoJ did step in and yields settled back to 0.09% by Friday’s close.

The point here is that the market had to force the hand of the central bank and it makes their action appear a bit ham-fisted at best. At worst, some are questioning their commitment to the zero target for 10 year yields as global yields have already risen smartly since YCC was introduced last Autumn. Simply put, if the BoJ do not regain full control, the market will test their resolve again which could lead to increased volatility, not just in Japanese Government bond prices, but also in the Yen exchange rate and perhaps other asset classes as well.

Which brings us on to the FX market. In chart 3 below, we show how the US Dollar broke out of a 20 month trading range late last year. We found it quite reasonable to be bullish of the US Dollar in early 2017. The structural case was that the world is at risk of being short US Dollars (we have written about this structural Dollar short before) and so with the Fed set to become marginally more aggressive in removing accommodation (potentially both rate rises and balance sheet reduction) and Trump’s proposed protectionist policies hurting global trading partners more than the US, we felt the Dollar breakout was the real deal and the new bullish trend would be our friend.

Chart 3 – US Dollar

It turns out that Trump is no friend of the Dollar at the moment, and already there are some concerns that the Fed will fail to deliver on promised rate rises which is exactly what happened in 2016.

So Trump has been out telling us that the Dollar is too strong, and pointing the finger at Germany, Japan and China for keeping their currency values supressed. Some may argue that this verbal intervention has worked like a dream for Trump in a world where nobody wants a strong currency. However, history suggests that verbal intervention has a somewhat limited shelf-life, and at some point, we will need to focus on the detail of Trump’s economic plan and the actions of the Fed (which will be dependent upon the performance of the economy).

Our fundamental view remains that the Dollar should be strong if Trump can articulate a plan that is actually good for America and the economy continues to accelerate and the Fed removes accommodation at their suggested rate. But we have to remain alert for a less bullish Dollar outlook, in which the Fed disappoint like last year and Trump’s reflation rhetoric fails to deliver faster growth, at least in 2017.

Can we spot any clues in the Fed? Well we know that the voters on the committee, especially Chair Yellen, are tilted on the dovish side. Frankly, we were a little disappointed that the Fed was not more hawkish at their meeting last week by hinting that March was a “live” meeting. If they truly want to deliver three rate rises this year why not get off to a fast start by raising rates in March? With the economy doing reasonably well, their dual mandate basically met and equity markets at all-time highs, they should be removing accommodation (yes, we still do believe a hawkish Fed could lead to a policy error later this year, but keeping rates too low is already leading to financial imbalances that could cause greater damage if left to fester – this is a different debate we will cover in the future).

We are also worried that the real economy is not quite as strong as some of the recent survey data would indicate. We think inflation will stop accelerating in Q1 as the low base effect from a year ago drops out and we doubt whether Trump’s policies will deliver a quick success. In short, the risks of a disappointment in Q2 or Q3 are greater than zero, and it may not take much to throw the Fed off course, which probably dampens the bullish Dollar thesis.

So as far as we can see, market correlations are breaking down as the equity market remains true to the Trump reflation trade, the bond market seems more undecided and the Dollar has moved to the sceptics camp. Of course, things can change quickly and market correlations could increase at any time and with markets moving in either direction. Or put another way, markets could be quite erratic and realised volatility could be higher.

We continue to believe that active managers need to be more tactical than usual and be as flexible as is reasonably possible in their thinking. In the portfolios we manage, we are erring on the side of fading the Trump reflation trade. Our net exposure to the Dollar is close to zero, we are modestly long of US Government bonds and have bought some put options in US and European equities. Where we hold positions via options, we will be looking to add value by trading some of the associated hedge on those trades, and overall we are looking to manage risk to a low level until we see a degree of clarity returning.

 

Stewart Richardson

RMG Wealth Management