After the surprise results of the U.S. presidential election in November, markets moved decisively to the up-side on anticipated household tax reform, along with Trump’s official promise to focus on corporate tax cuts and deregulation. Trump’s pro-growth plans for fiscal policy have fueled speculation about whether Keynesian “animal spirits” (emotional responses that inform consumer confidence and behavior) could lift U.S. economic growth from economists’ prior estimates of roughly 1.7% to nearly 3% or more over the coming years. Business and consumer confidence measures have surged, and if they stay elevated, they serve as an argument for an acceleration in growth as businesses and households start to consume and invest more.
Financial Advisors Still Managing Client Funds Cautiously
But there are still reasons to be cautious on the economic front, as markets have priced in expectations for rapid earnings growth (over 40%) for the coming year (reflected in Figure 1), discounting a minefield of risks that exist both domestically due to policy uncertainty and geopolitical risks and rising populism across the globe. With Trump’s election, the Brexit vote, Italy’s “No” and China’s debt and currency woes, the world economy has embarked on a journey into the unknown.
Financial advisors, acknowledging the market’s optimism, attempt to assess how punch-drunk the party really is. Using history as a guide, oftentimes we see that the punch keeps on coming, and investors get toasted. Accordingly, advisors should manage client funds with financial prudence, taking advantage of today’s herd dogma with exposure to domestic equities, but remain vigilant to the prospect of a breakout event that could drive an abrupt shift in the economic consensus. (For related reading, see: Stocks, ETFs to Watch During Donald Trump's Presidency.)
Figure 1: Earnings Revisions to Analysts’ Estimates for CY 2017
Note that Figure 1 reflects analysts’ collective revision to earnings for the S&P 500 (all companies). In January alone, street analysts had projected a 43%+ boost to corporate earnings. This is incremental to upward revisions incorporated by analysts following the election results.
Global Financial Uncertainty
The world has now fully arrived in a radically uncertain, stable but not secure predicament. To me, the only certainty is that the tails of the distribution of potential macro outcomes have grown fatter. Fat tail risk, or higher risk to the downside, has emerged and is defined by elevated and rising debt levels, monetary policy exhaustion and the populism-powered transition toward anti-globalization. The "hope trade" on the back of Trump’s pro-growth policy announcements is likely overdone, but only time will tell when the markets will reset expectations.
Risks that may keep investors on the sidelines with respect to international (ex-U.S.) equities include:
- The potential collapse of the European banking system, resulting in the EU’s possible disintegration;
- A balance-of-payments crisis (capital flight) in China coupled with the nation’s experiment with $34 trillion in new debt, which will at the very least requires restructuring of the country’s entire banking system, leading to losses across the globe to the country’s lenders.
- Currency crises in much of Latin America (e.g. Brazil, Argentina, Venezuela), where countries borrowed heavily in cheap U.S. dollars as the Fed opened the liquidity spigots during the QE craze and are now challenged by weak currencies and a growing load of dollar-denominated debt.
- The devastation caused by India’s "cash ban," a move that is in our view among the most ludicrous episodes of government-led financial mismanagement, which largely remains misunderstood by the population outside India (though the media is, ever slowly, beginning to catch on).
- Sluggish productivity growth coupled with growth-suppressive demographics in much of the developed world, including the EU member countries, Britain, and Japan.
- Most importantly, over $250 trillion, or multiples of the world’s total (aggregate) GDP, of opaque derivatives exposures concentrated among the world’s 12 largest banks.
The following chart illustrates the magnitude of the global banks’ exposure to derivatives. (For more, see: What Are Derivatives?)
Figure 2: Top 25 Banks Total Assets/Derivatives Exposures, excluding Credit Derivatives
The Effects of Trumponomics on the Domestic Market
Turning to the domestic market—as Trumponomics looms, consumers have taken a very positive stance on our economic prospects. It is hardly unprecedented in politics for the promises of the campaign trail to dramatically change by the time policies are actually implemented. Tax law changes may not take effect until 2018, and deficit-financed spending—if fiscal conservatives allow it to pass—is unlikely to occur until the fiscal year beginning October 1, 2017. Infrastructure projects in particular are notoriously slow to commence, and could be further delayed if the incoming administration seeks to establish an infrastructure bank to finance the planned spending through a combination of public and private funds.
For a myriad of reasons, the direct economic impact of fiscal policy proposals could remain elusive throughout the 2017 calendar year, requiring markets to adjust expectations to align with economic reality. Moreover, the range of potential economic outcomes based on policy announcements made to date is complex, with growing tail risks on both ends of the curve. Pro-growth policies could support riskier assets. But tougher trade policies could create significant foreign policy risks, triggering sharp risk-off moves.
Globally, central banks have created a warped sense of reality through a form of consensus group-think, particularly among the elite-market-participant establishment, or those who seldom question the unquestionable authority of central bank omnipotence. The mistaken beliefs include:
- Bonds are a safe haven and when risk-off movements occur, bond prices will go up and yields will fall.
- Stock price declines will be truncated by policy-maker intervention, thus we needn’t worry about any meaningful pullback;
- No major financial institution will fail in a way that could cause a new global financial crisis (GFC II), thanks to central bankers and their blinding quest to stabilize prices.
The thought dislocations discussed previously may make today’s sensitive market outlook particularly well-suited to active management. In the coming weeks, I will post more articles outlining one of the investment themes described above.