Election rally levels off
Trump trade looking crowded COMMENT
The post- election rally blew off a little steam on Friday, as the U. S. dollar, the Dow Jones i ndustrial average (which hit a new record on Thursday), the S& P 500 and the small- cap Russell 2000 ended the day more or less flat, and Treasury yields levelled off a bit.
Optimism still seems to be the order of the day — driven by a combination of animal spirits and expectations for reflation.
But the Trump trade is beginning to l ook pretty crowded. And that should get any self- respecting contrarian taking a hard look at the assumptions behind it.
The gains have been large and concentrated, in the assumption that industrials, financials and small caps will benefit “bigly” from president- elect Donald Trump’s promised spending and deregulation, as well as an anticipated hike in interest rates from the U. S. Federal Reserve.
But all three groups are looking pricey.
The Dow is trading at more than 20 times 12-month trailing earnings, its P/ E up nearly 25 per cent in a year. The Russell 2000 index is trading at 47 times earnings, well above its five-year average. The broad S&P 500’s P/E is above 24, an increase of five per cent year- over- year, and the S& P 500 financials subindex — which had gained only 3.2 per cent on the year to Nov. 8 — has climbed 13 per cent since then.
Are these valuations justified? Maybe not, if you agree that it’s not at all clear things will turn out the way markets seem to think they will.
First, there is the minor issue that Trump has not enacted any policies yet, nor has he been clear which policies he will enact or what they will look like. Granted, he seems to have chosen a very pro- business cabinet, full of billionaires, but has offered little or nothing in terms of concrete and clear undertakings.
The deregulation i nvestors in financials are expecting is hardly a done deal — during the campaign, he promised less bank regulation, and also more bank regulation. His trillion-dollar infrastructure “plan,” meanwhile, looks like it will contain little spending and lots of tax breaks, which may or may not amount to many real dollars on infrastructure.
Another variable — even though there seems to be a lot of certainty about it right now — is the rate environment. Bond yields have risen sharply in the past month, as investors see inflation and rate hikes on the horizon. That’s in part a confirmation that the U.S. economy, which posted GDP growth of better than three per cent in the third quarter, will maintain or even accelerate its growth trajectory; investors expect moderate inflation to return.
Markets are now pricing in a better than 90- per- cent chance of the Fed raising rates later this month. The question is how many more hikes will follow. There are enough wrinkles in the data to suggest we moderate expectations.
Wage growth, for one, unexpectedly declined in November even as unemploy- ment fell to a multi-year low of 4.6 per cent. That’s concerning. If wages continue to stagnate, it could delay or mute the Fed’s tightening.
The Fed will also have to be alive to the effects of normalization on the U.S. dollar — which will hurt corporate profits — and on consumer spending. U.S. consumer debt service payments as a percentage of income are at historic lows right now, largely because the proportion of take- home chewed up by mortgage payments is at the lowest level since the early 1980s. Credit payments, however, have been edging up. It might not take much of a hike in borrowing costs for consumers who still remember the Great Recession to turn tail.
The labour participation rate also declined in November, to near its lowest level since mid- 2015. The longterm trend on labour participation is starker: in the past five years, it’s declined by 3.6 per cent. That might mean the U.S. employment landscape is not as robust as the top-line jobs data suggest, or that the Fed’s estimate of “full employment” (a five-per-cent unemployment rate) might soon seem too high.
Of course, the November wage and participation data might just be a pause. Or it might be that structural changes in the aging U.S. labour force are taking hold. There’s another country where unemployment, labour participation and wage growth has been low for more than a decade: Japan.
My point isn’t that expectations of rate hikes and debtfuelled inflation are wrong. It’s just that there are several possible outcomes to the fiscal and monetary policy mix in the coming months, and there are many unknowns. Given t he concentrated stock surge post- election, many investors seem to be underpricing risk and betting that it will all turn out as advertised.
Of course, if you’ve been holding U.S. banks and industrial sally ear and reaped double-digit returns in the past three weeks, then there’s no reason not to celebrate. But it might make sense to take something off the table and do a little Christmas shopping.