⚑ Joe Mac's Market Viewpoints

Joe Mac’s Market Viewpoint: Game-Changer Part I: Trump Win Means Growflation

The surprise outcome of the 2016 U.S. presidential election has led to widespread speculation about its effect on the global capital markets outlook and numerous specific investment themes. Assuming that the Jill Stein-led recount efforts or the final electoral college votes do not reverse the results, there is no doubt that the road ahead has unequivocally changed, and looking for change-driven themes is MRP’s mantra. Clearly, this presidential election was a game changer on many levels.

Nonetheless, we say speculation because it is totally unclear at this point, even with a Republican majority in Congress, how much the Trump agenda – in particular his pro-growth economic plans – will in fact become reality. Steven Mnuchin, Treasury Secretary nominee, has said the priorities for the economy are taxes, regulatory, trade, and infrastructure. Moreover, defense, energy independence, immigration, and the replacement of Obamacare are likely to be front-runners as well. So, we assume these will be the focus in the first 100 days. But only time will tell what makes its way through Congress.

At the very big picture level, the markets have been quick to embrace the impact of higher growth on interest rates and on inflation expectations. The probability of a December Fed rate hike has risen to nearly 100%, and Janet Yellen all but confirmed it in a recent testimony – describing the hike as coming “relatively soon”. Since November 8th, stocks have risen to new highs, though the S&P 500 is only up 2.4% at this point. Meanwhile, bond yields have surged by almost a third, gaining 57 basis points, and the yield curve has steepened dramatically. Inflation expectations in the bond market have risen as well, suggesting that it’s the expected future inflationary consequences of Trump policies that the markets have been pricing in. It is noteworthy, however, that yields and inflation expectations had already risen dramatically from the summer low to election eve, indicating that something more than the Trump win has been at work in the markets for the past six months — perhaps, investor recognition that inflation is on the rise.

While the Trump win reinforces our call on accelerating inflation, it also does raise questions in regards to MRP’s “stagflation” view that the next several years will be characterized by sluggish growth combined with higher inflation. Ironically, in formulating that view, we were not assuming a Trump win. But, one always has to make assumptions about binary outcomes and the stagflation call assumed a continuation of current economic and monetary policy which, for the most part, probably would’ve been the case in the event of a Clinton victory.

Now, suddenly, things have changed, and it is time to rethink the “stag” part of our stagflation view. The St. Louis Fed President said recently that Trump’s infrastructure plans and tax reforms have the potential to “improve U.S. productivity.” Furthermore, incoming Treasury Secretary Steven Mnuchin has pledged to introduce tax reforms that could drive annual GDP growth of 3-4%. Similarly, the OECD believes Trump’s policies “should revive expectations for faster and more inclusive growth, thus allowing monetary policy to move toward a more neutral stance in the United States at least, and possibly other countries as well.”

“When the facts change, I change my mind” said the great Lord John Maynard Keynes. Since MRP was already predicting higher inflation due to the monetary policies followed over the last few years, we are not changing that part of our call. But now, the GDP stagnation part could turn into a growth boom if and when the economic plan from the new administration becomes a reality. This would lead to the “running hot” path that Janet Yellen described and MRP wrote about in October. So, perhaps it is time to start calling our longer macro view “growflation”.

On the other hand, there is much skepticism that the Trump policies will be able to produce the 4% growth that the President-elect spoke about during the campaign. Rather, some industry insiders suggest that, after a short growth spurt, it will just lead to higher inflation. Goldman Sachs reportedly said the possible enactment of Trump’s policy plans toward infrastructure and defense spending, foreign trade, and immigration could eventually produce low annualized GDP growth and high inflation. HSBC has put forth similar arguments. Furthermore, a recent BoA survey of fund managers showed that a “stagflation crash in the bond market” was considered the biggest “tail risk” worry. We disagree with these leading experts.

Since the election results became clear, many of our themes have moved sharply higher (Long Defense, Long Value over Growth, Long Energy, Short the Yuan, Short Long-Dated Bonds, Long TIPS), others have been left behind (Long Homebuilders, Long Coffee), and a few have actually performed poorly (Long Gold, Long Emerging Markets). We will address where we stand on each of these themes.

 

MRP THEMES THAT HAVE GOTTEN A BOOST

Five of our nine investment themes have been reinforced by the election outcome:

Long Value over Growth has been energized. From May of 2007 until this past winter, the growth side of the US stock market had been almost consistently outperforming the value side. But, MRP argued over a year ago that phenomena would be coming to an end: That, as interest-rates began rising and inflation perked up, value would soon begin a multi-year period of outperformance. Now, our value over growth call has been given new energy by the outcome of the election, as higher unit growth and better pricing power will benefit many Value industries. Also, many of our themes overlap with the Value universe, as will several soon to be added new themes.

Long Defense: In November 2013, MRP recommended going Long Aerospace and Defense stocks. A boom in civilian aircraft demand was the core driver of the theme at the time, although rising defense spending outside the U.S. and Europe also played a role. Over the past year, the defense side of MRP’s theme has taken precedence, as increased geopolitical instability has galvanized countries in Asia, the Middle East, and parts of Europe to boost their defense spending. Now, with President-elect Trump also promising to rebuild the U.S. military, a major shift within the sector toward defense spending-sensitive issues is in order.

Long U.S. Energy: MRP’s energy theme continues to be one of our favorites in the post-election environment. Our expectation that crude prices would rise to $60-$80 by the spring of 2017 remains intact. In the short-to-intermediate term, although U.S. production seems to have stopped falling, the just-announced OPEC cutbacks will help constrain supply. But if the Trump growth goals of 3-4% come anywhere close, the demand acceleration will be huge. The U.S. is still the world’s top oil consumer and revved up economic growth will  mean big gains in energy consumption. Longer-term, however, the $60-$80 range may become a ceiling on prices as attention in the US turns more and more toward new drilling and exploration, like the names that are in the OIH.

Long TIPS and/or Short Long-Dated US Treasuries: As inflation and inflation expectations continue to creep up, MRP’s recommendation to be Long TIPS should perform well. So will our recommendation to be short longer-term bonds. We have been tracking these two recommendations, since their October 26 launch date, with the iShares TIPS Bond ETF (NYSEARCA: TIP) and with the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA: TBT).

Short the Chinese Yuan: The RMB has weakened further post-election and, overall, has declined more than 10% over the past two years. But, we believe this recommendation has played out. First, by looking at a simple purchasingpower parity model, we find that the yuan has moved from one standard deviation rich to close to one standard deviation cheap. Secondly, by looking at the real rate differential between two countries, one can clearly see that it is the adjusted-inflation rate that drives most currency trends. The CNY/USD exchange rate and the difference between the inflation-adjusted interest rates of each country are now statistically out of sync. The combination of these two factors is significant enough to compel us to close our Short the Chinese Yuan theme.

MRP THEMES THAT HAVE LAGGED

Long U.S. Homebuilders: MRP’s U.S. housing theme will receive a boost if Trump’s policies regarding trade, taxes,  and infrastructure succeed in creating more jobs for Americans. This will unleash pent-up demand for housing from lower-income earners and first-time home buyers, such as the millennials, who have been on the sidelines waiting for their financial situations to improve. Given the already tight inventory, homebuilders will have to build more homes to make up for the shortfall. Some will argue that rising mortgage costs will be a headwind for the U.S. housing sector, but we would argue that powerful demographic forces will overshadow that negative. Moreover, if Trumponomics boosts jobs and wage growth, it could accelerate the process.

Long Coffee: MRP’s recommendation to be Long Coffee is driven by our belief that an existing demand/supply imbalance in the coffee industry will persist. This year, production is expected to rise just 1.5% against demand growth of more than 2%. Moreover, global climate conditions are changing in a way that will continue to hurt the supply of beans from the finicky plant. Meanwhile, demand is only set to increase — coffee is a relatively inelastic commodity that is fairly resistant to economic downturns compared to other potential substitutes. All of this adds up to a growing tension in the industry, which, we believe, will result in higher future prices.

MRP THEMES THAT HAVE PERFORMED POORLY

The strength in the US dollar since the election is one of those items that we think will be reversed in the coming months. Although stronger GDP growth and rising inflation is logically considered by many to be drivers of a strong dollar performance, we still believe that the accelerating inflation will in fact lead to a weaker dollar before very long. As a consequence we are sticking with our call on gold and on emerging markets.

Long Gold and Gold Miners: The price of gold and gold miner shares continue to be poised to benefit from the quintupling of the Federal Reserve’s balance sheet and similar behavior by central banks in other developed markets. In addition, India’s unprecedented move to ban existing large-denominated banknotes may in time accentuate upward pressure on gold prices.

Long Emerging Market Equities: The EM’s will be beneficiaries not just of the weaker dollar but of the stronger US growth as well. The US continues to be the engine of world growth, accounting for almost 1/4 of worldwide economic activity.

This U.S. presidential election represents a major disruptive change and the effects will reverberate across many other industries. In a future report, we will touch upon those other industries and present some new themes we see unfolding.