Saying that the results of the presidential election were a shock would be an understatement. The latest polls and predictions made by poll aggregation sites all pointed to a win by Secretary Clinton. Same with equity markets, which broke a nine-day losing streak to rise over the two days leading into Tuesday’s election. Futures markets also seemed buoyant early Tuesday evening as initial exit polling suggested a Clinton victory. However, as the results kept rolling in and Mr. Trump took the lead in several swing states, equity market futures saw wild swings. At one point Dow futures were down more than 700 points. Yet, after the results appeared to be conclusive and Secretary Clinton conceded in the early AM, futures saw a dramatic reversal. By close on Wednesday, the S&P 500 had gained more than 1%, and held on to most of these gains for the remainder of the week. At the same time, bond prices fell as yields spiked.
In this post, we take a deeper look at what happened in the markets. First we take a look at what we could be looking at at the beginning of a Trump presidency.
A $5 trillion stimulus package?
President-elect Trump’s package of tax cuts, including promises to cut individual marginal tax rates and the corporate tax rate to 15% (from 35%), would cut taxes by about $10 trillion over the next decade according to the conservative-leaning Tax Foundation. This number does account for economic growth from increases in the supply of labor and capital.
On top of the tax cuts, the President-elect has also suggested significant increases in defense spending ($950 billion over 10 years) and infrastructure spending (close to $600 billion). Infrastructure would see significant support amongst opposition Democrats as well.
While the tax proposals broadly track policies proposed by members of the Republican Congress, the overall package of tax cuts and spending is likely to be trimmed significantly based on the cost. Nevertheless, we could easily be looking at a $5 trillion fiscal stimulus package that would be funded by deficit spending. For comparison, President Obama’s stimulus package, enacted at the height of the financial crisis, was about $800 billion.
Such Keynesian fiscal stimulus, advocated by economists on the left for years, could shift aggregate demand higher. This would give a sharp jolt to the economy in the short term and boost growth from the lackluster levels we have seen over the past several years. At the same time, the spending package would be enacted at a time when labor markets are clearly tightening. This could result in higher inflation and higher interest rates amid a large increase in debt.
Bond yields jump
The bond market, which is significantly larger than the stock market, can tell us a lot about what markets expect from a Trump presidency, and his package of spending proposals. Yields initially fell on Tuesday night before climbing significantly, signaling that investors believe the era of low interest rates may be over and that inflation is coming back.
Interest rates on the U.S. ten-year treasury bond jumped almost 0.30 percentage points in three days to 2.14, its highest level since January of this year. The rise in rates came came from higher inflation expectations. Ten-year breakeven inflation rates, which is the difference between the interest rate on a regular bond and an inflation protected bond – gauge of expected inflation over the next ten years – jumped 0.15 percentage points to 1.88. Inflation expectations for the next thirty years rose 0.17 percentage points to 2.07.
That the bond market expects higher inflation was amply clear from the fact term premia also climbed sharply after the election. Term premium is essentially the excess yield investors require for holding a long-term bond instead of a series of short-term ones. Usually, the term premium tends to be positive since investors want extra compensation for holding a long-term bond – so the measure tells you about the perceived riskiness of a long-term bond and the risk of inflation. The following chart shows a measure of five and ten year term premia as calculated by the Federal Reserve Bank of New York.
The term premia has been below zero since January 2016, with investors demanding no extra compensation (in fact, negative) for holding a long-term bond. The measure hit its lowest level since 1962 (when JFK was president) in the weeks after Brexit. However, as the chart shows, both five and ten year term premia saw a sharp spike after the election on November 8th, with ten-year premium almost back to zero amid rising inflation expectations.
With inflation expectations on the rise thanks to possible Keynisian deficit spending, let us next look at what equity market investors may be thinking.
Which sectors gained and which ones lost
A one percentage point gain in the S&P 500 does not seem like a big deal, but below that lies a large performance divergence amongst the various sectors that make up the index. Taking a look at which sectors performed the best and which ones performed the worst gives us a clue as to what investors expect from a Trump presidency. The next chart shows how the various sectors performed relative to the S&P 500 index (in orange). We use the select sector SPDR ETFs as proxies for measuring performance.
The out-performance of Financials, which rose more than 8% in three days, jumps out of the chart. This is not unexpected given that bond yields rose sharply and expectations are for financial industry regulations to be severely curtailed in a Trump administration.
Industrials also out-performed, rising almost 5%, which makes sense given the likelihood of infrastructure spending. This ought to give a boost to the Materials sector as well, which climbed close to 2%.
Interestingly, the Health Care sector was the third best performer, even as all of its gains came from the pharmaceutical industry (which makes up 38% of the sector). The Trump administration is expected to give a boost to pharmaceuticals and device makers by pulling back regulations, including proposals to speed up the FDA drug approval process and repeal the 2.3% medical-device tax that passed as part of the Affordable Care Act.
Energy got an initial boost as regulations favoring energy production appear to be on the horizon. At the same time, increased energy production could be a double-edged sword for this sector since this could mean a ceiling on oil prices.
Curiously, sectors which typically outperform if aggregate demand were rising – consumer goods and information technology – under-performed the index. These sectors could potentially be any hit by any changes to the existing trade regime, which would impact their supply chains, and immigration policies. The Information Technology sector in particular, which fell close to 1.5% in the three days after the election, is also unlikely to benefit greatly from potential corporate tax reductions. More that two-thirds of the sector’s negative return can be attributed to a steep drop in shares of Apple, Google and Facebook (which comprise almost 30% of the sector) – all three of whom use off-shore structures in Ireland (the double-Irish mechanism) to avoid U.S. corporate taxes.
Utilities and Real-Estate sectors were among the worst performers thanks to rising interest rates. If inflation expectations continue to rise amid major fiscal stimulus spending, sectors that benefited during the low interest rate environment of the past few years could see sharp reversals.
What does the Federal Reserve do?
Of course, another big factor in all of this is the Federal Reserve’s (Fed) reaction function to higher inflation. While they may be willing to tolerate a short period where inflation exceeds their target of 2%, it is unlikely that they will let it get too far ahead. So we may well see a much quicker pace of tightening by the Fed in the coming years, leading to potential tension between the executive branch and monetary policy authorities. Note that President-elect Trump will have to nominate two new members to the Federal Reserve board in 2017 and decide whether or not to re-nominate Janet Yellen as the Chair when her tenure ends in early 2018 (her term as a Governor runs up to 2024).
These are just initial assessments based on what we saw in markets in the immediate aftermath of the election. It is an open question as to how much of the expected policy changes President Trump, and perhaps just as important, Congress, will enact. While most of the President-elect’s policies are pointed in a similar direction as those preferred by a Republican majority Congress, we are more than likely to see grueling negotiations. So we may well see some ‘buy the rumour, sell the news‘ come Spring 2017, if not earlier.
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