President Donald Trump’s election win was immediately followed by a huge run-up in equity markets, with the S&P 500 gaining close to 5% between election day and the end of 2016. As we wrote at the time, then President-elect Trump’s package of tax cuts, infrastructure spending and deregulation promised to boost aggregate demand and business investment spending, providing a sharp jolt to the economy. Economic growth was expected to pick up from the lackluster levels we have seen since the financial crisis.
A potentially massive fiscal stimulus led to bond yields climbing rapidly as inflation expectations rose, even as certain equity market sectors significantly outperforming. The following chart shows the performance of the eleven GICS sectors and the S&P 500 index between election day and the end of 2016.
Financials rose almost 17% between election day and year-end 2016, thanks to rising bond yields and expectations for a significant easing of financial industry regulations. Industrials also out-performed, rising almost 13% over the period, thanks to the promise of a huge ramp up in infrastructure spending. Similar story with Energy and Materials sectors.
Curiously, sectors like Consumer Discretionary and Technology, which would be expected to do well if aggregate demand rose, under-performed the overall index. Consumer staples actually fell during the post-election period. The concern appeared to be that these sectors could potentially be hit by the incoming Trump administration’s proposed changes to the existing trade regime, which would impact their supply chains, and immigration policies.
Suffice to say, expectations were clearly riding high as 2017 began and the Trump administration took office. On the face of it, it would appear that equity markets are continuing where they left off, with the the S&P 500 gaining close to 10% year-to-date through June 2nd. However, there has been a marked divergence between the performance of underlying sectors, not to mention other asset classes.
As Josh Brown noted recently, the non-Trump trades began to work this year, especially after investors began to realize that Washington is finding it hard to pass any meaningful legislation. We have written about the difficulty of passing big-ticket legislation as part of our Roadmap to 2017 series, including the likelihood of tax reform and health care legislation.
Trump trade sectors falter
The sectors underlying the S&P 500 have seen a complete performance reversal in 2017. The next chart shows sector performance this year.
Technology leads the way with a whopping 22% gain in just over five months. Also out-performing the S&P 500’s not too shabby 9.9% return are Consumer Discretionary, Health Care, Utilities and Consumer Staples sectors, each of which lagged in the aftermath of the election. On the other side, the Energy sector has fallen close to 13%, while Financials have gained just over 1% this year.
This stark reversal in sector performance is especially interesting, since growth sectors – like Tech and Consumer Discretionary – have risen sharply alongside the defensive sectors – like Consumer Staples and Utilities. As we described above, these are sectors that under-performed the S&P 500 index in the aftermath of the election.
Along with expectations for a fiscal boost, concerns that the Trump administration would quickly overturn the existing trade regime have also faded. The expectation was that the incoming Trump administration’s “America First” policies, especially in the area of trade, would promote U.S.-based export sectors at the expense of those sectors that rely on imports (mostly in the consumer goods space).
The impact of revamped expectations is even more clear when you look at the trajectory of the U.S. dollar since election day.
The U.S. dollar reverses
As the next chart illustrates, the U.S. dollar index, a benchmark of the dollar against major currencies, surged after the election. The U.S. dollar index rose 4.4% between election day and year-end, hitting a 14-year high on December 28th 2016.
With the Fed continuing to raise rates, inflation expectations surging amid a promise of fiscal expansion, topped off by the incoming Trump administration’s trade agenda, it seemed like the dollar would only continue its upward march in 2017. Instead, we have seen the opposite.
As the chart shows, the dollar has completely reversed over the first five months of this year, falling 5.4% year-to-date through June 2nd. It is now back to levels last seen in October, prior to the election.
Wall street was widely predicting euro-dollar parity at the beginning of 2017 but has had to recalibrate expectations as the year progressed. A starker reversal has come about in the Mexican peso. The incoming Trump administration’s promise to rewrite NAFTA led to the U.S. dollar appreciating almost 12% against the Mexican peso between election day and year-end. Mexico’s currency tumbled to an all-time low against the dollar on January 19th 2017, a few days prior to inauguration day. Since then, the currency has completely reversed and is almost back to pre-election levels.
All this suggests that investors no longer believe that the big elements of the Trump agenda will pass Congress any time soon. Even elements of the Trump agenda that could be enacted on without going through Congress, like trade, appear to have stalled.
Next we look at the bond market, which is perhaps the most important piece of the picture since the real story here is that inflation expectations have tempered.
Yield curve flattens, again
Ever since the taper tantrum in 2013, a common market meme has been that treasury yields will rise as the Federal Reserve (Fed) starts to tighten policy. Instead, in each and every year since then, the yield curve has flattened – with long-term yields falling even as the Fed was raising rates at the short end of the curve.
The post-election period seemed to herald a new era, with higher inflation on the horizon. The promise of fiscal stimulus resulted in higher long-term yields and a steepening of the yield curve soon after the election. The 10-year treasury yield rose from 1.88 on election day to 2.45 by the end of 2016, reflecting a sharp rise in inflation expectations, while the 2-year yield rose from 0.87 to 1.22.
However, it seems like we have reverted back to recent norm in 2017. The 10-year yield has fallen to 2.16, as of June 2nd. Yet, the 2-year yield sits at 1.29 thanks to the Fed continuing along their path of rate hikes. The net result is a flatter yield curve.
The following chart shows the spread between the 10-year and the 3-month yield, as well as the spread between the 10-year and 2-year yield.
Spreads have more than reversed their post-election rise. The 10-year/3-month spread, which rose 49 basis points (bps) post-election, has fallen 76 bps in 2017 (as of June 2nd), and is currently sitting at levels seen last September. The 10-year/2-year spread rose 24 bps after the election, but has fallen 38 bps in 2017. The difference between the 10-year and 2-year yield is now less than 90 bps.
Inflation expectations fall
The rise, and subsequent fall, in long-term yields has clearly come about as bond investors recalibrate inflation expectations. 10-year breakeven inflation rates, which is the difference between interest rate on a regular bond and an inflation protected bond – a gauge of expected inflation over the next ten years – jumped 0.22 percentage points, from 1.73 to 1.95 by the end of 2016. However, this measure had fallen back to 1.79, as of June 2nd.
Term premia also fell this year, reversing its post-election surge. Term premium is essentially the excess yield investors require for holding a long-term bond instead of a series of short-term ones. Typically, the term premium is positive, since investors want extra compensation for holding along-term bond – so the measure tells us about the perceived riskiness of a long-term bond and the risk of inflation.
The term premium had been below zero since January 2016, with investors demanding no extra compensation (in fact, negative) for holding a long-term bond. However, as the next chart shows, term premium quickly made its way back above zero soon after the election as inflation expectations jumped.
The 10-year term premium climbed 46 bps between election day and year end, but that gain has almost completely been reversed in 2017. The term premium is back below zero, reflecting the fact that investors are not too concerned about inflation right now.
Part of the story is that current inflation measures have also softened. In fact, the numbers have gone in the opposite direction from what most investors probably expected at the beginning of the year. As the next chart shows, both core and headline (including food and energy) inflation numbers have fallen since February. Core inflation is now close to 1.5%, while headline inflation is at 1.7%. Annual wage growth has also seemingly stalled close to the 2.5% mark, despite what looks like a tight labor market with 4.3% unemployment rate.
With inflation and wage growth numbers breaking their uptrend, and falling well below the Fed’s 2% target, the obvious question is what the Fed does now.
Fed officials have carefully managed expectations over the last few months – through speeches, comments, and meeting minutes – seeking to convince investors that the March rate hike would be followed by one in June. This has been a successful effort in that Fed Funds futures currently put the probability of a rate hike in June at 95%. So the Fed may be boxed in with respect to raising rates, and maintaining their credibility, despite the case for a rate hike having weakened considerably.
Since December 2015, when the Fed embarked on their tightening cycle with the first quarter point hike in a decade, they suggested that would simply be the first of nine rate hikes by September 2017. They projected inflation to be close to the 2% mark by that time. The forecast has clearly fallen short, and the expected June rate hike would only be the fourth rate hike this cycle.
The Fed has essentially had to catch up to the bond market, which has consistently assumed that economic growth and inflation would fall short of the Fed’s optimistic projections. Hence we have seen the yield curve flatten in recent years, amid sustained downward pressure on long-term rates. The post-election period seemed to be the break of that cycle, but even that has turned out to be brief.
Where the “Trump trade” goes from here
As we have seen above, the “Trump trades” have not “worked” since the beginning of the year. In addition to vanishing expectations for a huge fiscal package, including comprehensive tax reform, it appears that investors also expect the Fed to lower their own projections for economic growth and inflation. This would result in a more gradual pace of rate hikes than the Fed currently expects.
Interestingly, the most telling comments come from Gary Cohn, President’s Trump’s chief economic advisor. When asked about the seeming disconnect between stocks rallying to all-time highs in tandem with falling yields, he replied:
“I don’t think there’s a simple answer or a simple factor here, but remember the bond market takes a longer-term view of what’s going on. I think people are taking a longer-term view on our economy, our economic growth, and where they think policy’s going.”
In other words, the bond market seems to be telling us that economic growth is going to continue along its recent trend (about 2% annually), with lackluster inflation and wage growth. This is a far cry from the administration’s own projections of 3% plus growth amid business friendly policies and tax reform. The market clearly does not believe any of these will come to pass, at least at this time.
The long and short of all this is that there has been no “Trump trade” in 2017. Instead, equity and bond markets have reverted back to recent norm, with expectations that economic growth would continue at a solid but lower pace amid lower inflation and easy monetary policy.
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