MARKETS FOCUS ON GROWTH…
Taken literally, some Trump’s plans would benefit growth, particularly any tax cuts and increased infrastructure spending. However, they would also have the negative implication of higher budget deficits. The surge in yields by 40bp since the election – the largest four-day rise since the US Federal Reserve started talking about tapering its asset purchases in June 2013 – implies that increased government spending would crowd out at least some private investment. It remains to be seen by how much the plans will be watered down in Congress, where the Republican party tends to prefer prudent fiscal policy. Implementing major infrastructure spending would take time. A cut in corporate taxes and the possible repatriation of profits currently held abroad could have a more direct positive impact, though.
Financial markets are now focusing on the president-elect’s pro-growth policies. Equities have gained, the euro has dropped, the Japanese yen has weakened and the Mexican peso and the Chinese renminbi have lost ground. German yields have moved higher and Japanese yields have moved close to the Bank of Japan’s zero percent target.
Risk spreads on US dollar-denominated emerging market debt have moved to the high end of their four month-old trading range, while yields on bonds in local currency have spiked to their highest since early March. The 5-year, 5-year inflation swap rate, a common measure of longer-term inflation expectations, has spiked to 2.5% in the US and to 1.6% in the eurozone.
… WHILE DOWNSIDE RISKS REMAIN
The drop in emerging currencies and the rise in local currency emerging market debt indicate that markets have not lost sight of the possible risks that may stem from Trump’s election. The main risks are to global trade: overall weakness in economic activity, the waning pace of trade liberalisation, growing political risk, a slower pace of globalisation, the reduced availability of trade credit and a reduction in China’s competitiveness due to rising wages. Most of these are structural factors that will not change immediately by virtue of any policy initiatives employed in the US or any other country. However, we think the tendency towards greater protectionism is getting stronger. It remains to be seen how dogmatic or pragmatic president Trump will be. We think it unlikely that we will see initiatives that will hamper US business interests. Targeted approaches to certain products or sectors look more likely, but uncertainty is high.
So under the new administration, US growth and inflation may accelerate next year, but the impact of any measures might be limited and highly uncertain. It is possible that most of the effects, especially on inflation, may be seen only in 2018. The new political landscape may affect monetary policy. However, the market-implied probability of a rise in US interest rates in December has remained at above 80%. We think higher inflation expectations matter more to the Fed at this point than the rise in recent yields and as long as equity markets do not sell off, we think the Fed will hike next month.
In the eurozone the ECB may be struggling with the rise in yields, particularly the spike in Italian 10-year yields. Political risks have increased in the eurozone, in our view. We expect the ECB to announce in December that it will extend its asset purchase programme beyond March 2017, probably by six months. For country-specific issues, the ECB can resort to Outright Monetary Transactions through which it can buy individual country bonds, provided the country agrees to macroeconomic adjustments.
GROWTH IN ASIA’S BELLWETHERS HOLDING UP, FOR NOW
The Japanese economy grew by 2.2% QoQ annualised in the third quarter, at the strongest pace since the first quarter of 2015. The details were not convincing. As mentioned above, we do not think that the global economic and political environment is particularly positive for trade, so we would not count on exports saving the Japanese economy. Consumption and business investment growth were basically flat in the third quarter in real terms. Even more worrying were the declines in consumption and business investment since these imply the economy is not responding to the BoJ’s extreme stimulus measures. The strength of the yen and the return of deflation have raised serious concerns.
Chinese economic growth is holding up, even with the measures taken to cool the housing markets. Car sales slowed as the impact of tax incentives is wearing off. Some acceleration of inflation caused real retail sales to slow by slightly more than nominal sales. Investment was strongly supported by infrastructure projects and manufacturing investment growth remained very modest by Chinese standards. So the main imbalances in the housing market and credit growth remained firmly in place, while fiscal stimulus is clearly fading. China’s GDP growth stabilisation still has somewhat of a temporary flavour to us. However, in the run-up to the 19th National Congress of the Communist Party next autumn, we expect the authorities’ drive to stabilise the economy to become even stronger.
ASSET ALLOCATION: LOOKING TO INCREASE RISK EXPOSURE
We are looking at ways of increasing our exposure to risky assets. For us, the corporate earnings outlook is no longer negative. Analyst expectations have become more realistic, in particular regarding 2016. We think the valuations of developed equities are rich, especially in the US and to some extent in Europe, but monetary policy is still positive. We would look selectively at asset classes or sectors that would benefit from the possible positive impacts of the changes in the US, but that would also be shielded against the risks.
In the bond sell-off, our underweight in emerging market debt in hard currency versus US Treasuries has started to pay off, although risk spreads are still narrower than they were when we implemented the trade in March. We have kept our overweight in US government bonds versus eurozone government bonds. Yields in the US have risen faster than in Germany, but political risks have led to a spike in Italian yields. So overall, the position has not suffered much. We have kept our long position in eurozone inflation-linked bonds versus nominal bonds.
In commodities, copper prices have surged partly on the prospect of US government spending on infrastructure. On balance, our commodity price index, which excludes agricultural products, has trended lower in the past month. Our position is above the level it was at when we implemented it, but the negative carry on oil has partly offset this.