Jorge Nuño, Gestor Fidentiis Global strategy
Since the summer, we have tried to identify causes for the sudden rate hikes and the steepness of the yield curve. The consensus explanation has been an improvement in inflation expectations and growth data, that is, at last, a genuine “reflation” impulse.
Our interpretation of the movement of rates has been based on several factors: on the one hand, the central banks’ implicit recognition of the depletion of monetary policy and, in particular, the perverse effect of the negative rates on the transmission mechanism and on the financial sector. The movement of real rates and slope in both Japan and Germany supported this view. On the other, and in addition, we had not seen convincing data to confirm the acceleration of domestic demand in either the US or Europe. Finally, the stagnation in underlying inflation rates also called into question the reflationary argument.
On November 9, there is a turn. The biggest surprise is not so much Donald Trumps ‘victory, but the interpretation of results within hours that the markets do of its consequences. While the stock markets were expected to fall 10%, the bonds rise strongly, freezing the rate hikes, depreciation of the dollar and in general the beginning of a stage of high uncertainty with high volatility, ends with a post-Brexit mimetic reaction and contrary to all the forecasts that once again ridicules all the analyzes.
In the victory speech, barely a few conciliatory words and three phrases about infrastructure spending are enough to raise the stock and the dollar, hit the emerging ones, increase the probability of raising rates by the Federal Reserve in December and start the biggest Correction in bonds since 2011.
Trump’s economic program boils down to aggressive tax cuts, infrastructure and defense spending, trade and immigration restrictions, federal budget cuts, and deregulation.
Regardless of the inaccuracies and the ability to materialize these proposals. We believe that the program has two implications, on the one hand, a pro-growth angle that leads to a fundamental change in the mix of economic policy in force in recent years, and on the other, an inflationary risk.
Trump’s victory comes just as the effectiveness of monetary policy is being challenged and when voices proposing aggressive fiscal policies sound louder. In addition, the American fiscal margin and the new republican majority in both chambers make possible the materialization of the fiscal stimulus. Conversely, the American cyclical position, practically in full employment and with signs of wage pressure, means that an additional impulse to demand may translate into greater risk for inflation.
Markets have begun to anticipate policy change consequences in the US and the movement of asset classes positioning’s has only just begun.
Institutional investors have been exposed to financial repression from central banks for years in a low-growth scenario without inflation. Everything has revolved around the mantra over interest rates: lower for longer.
The generalized investment strategy went through the pursuit for yield in long-term defensive assets and adding risk in corporate credit and emerging markets. With this scenario, within the allocation of global assets, the stock market has not been an alternative beyond defensive sectors and with visibility in the dividends. The rate increase in recent weeks shows the enormous risk of this positioning and opens the door to important movements between different types of assets:
- The most palpable is the exit of government bonds, the point of extreme valuation with expected returns even negative, the risk of inflation, increase of supply and the gradual disappearance of the support of the central banks make them the main source of funds.
- Corporate bonds are suffering and credit spreads are widening in all categories. However, carry remains attractive and expected returns are already above the historical average. We believe that additional falls will be an opportunity.
- The stock market is the most controversial asset and where we will need more time to see the implications of what is going on. The key is to try to gauge the real impact on growth. That is to say we could ask several questions: will the fiscal stimulus give a significant boost to growth capable of prolonging a very advanced cycle? Will profits return to the path of growth?
At the moment, the increase in the positive correlation of real rates and inflation expectations in the US suggests that investors discount higher growth with stable risk premiums. However, the starting point of valuation is demanding and a rise in rates without improvements in profits, supposes an increase of the discount rates, and therefore an additional deterioration of the valuations.