30 November 2016
Themes For November
Buoyed by the positive sentiment created by the surprise Presidential victory of Donald Trump, equity markets in North America and Asia recorded strong gains in November with the US up by 3.7%, Australia up 3%, Japan 5.5% higher on the back of a weaker Yen, and China advancing a healthy 5.8%. European markets fared worse, led by the UK which was down 2% due to uncertainty over its withdrawal from the EU, while continental markets were subdued due to concerns about the rise of populist movements across Europe. Predictions for a stronger US growth outlook ignited commodities markets especially industrial base metals with copper, lead and zinc all up in excess of 20% while iron ore rose a healthy 19%. Global sovereign bonds were the big loser for the month as investors rotated out of bonds into stocks fearing a rise in inflation and an accelerated tightening program by the US Fed. US 10 year bond yields rose 45bp for the month and Australian 10 year bonds followed in lock step rising 35bp to close the month at 2.7% producing a negative return of 1.44% for the month. Australian 10 year bond yields are now almost a full 1% higher than 3 months ago. The $US surged over the month especially against the Yen and Euro while the $A couldn’t keep pace with the rampaging greenback, declining by 2.9%.  

The “Trump Bump”

Despite dire pre-election forecasts of financial market calamity in the event of a Trump victory, the US equity market roared ahead in November in the wake of his stunning US Presidential win. While markets tend to dislike uncertainty, the Trump agenda to kick start the US economy gained acceptance on closer inspection as a possible means of the US breaking out of the low growth, low inflation malaise which has persisted for several years now. With a growing belief that monetary stimulus alone will not be enough to ratchet up growth, the expansionary fiscal measures proposed, including large tax cuts and major government infrastructure spending & private sector energy investment, could be just the fillip that the US economy needs. President-elect Trump’s bold economic agenda is not without risk, and represents a major departure from the policy settings under the Obama administration which relied almost entirely on monetary policy to stimulate growth being hamstrung by the Republican controlled Congress.

The risks of the Trump agenda center on the likely short-term blowout in the US deficit, which will be hit by the double whammy of lower tax revenue and higher government spending. Of course, should the stimulus measures be successful, then the tax revenues that flow from higher growth and employment will begin to close the deficit over time. This follows the Reagan economic blueprint during his first term in the 1980’s, which successfully ratcheted up the trajectory of US growth. Another risk is that higher inflation will accelerate the monetary policy tightening timetable of the Fed which will be keen to not fall behind the inflation curve.

The practical reality of US politics is that Trump will have to use his much vaunted negotiation skills to see his legislation passed through Congress. While Republicans control both the House and the Senate, there are hard line elements of the Republican Party who are not Trump supporters and may obstruct parts of his agenda especially plans to increase the deficit and to renegotiate free trade deals, such as NAFTA involving Mexico and Canada, and the TPP involving countries in the Pacific region including Australia. Other reforms, such as the dismantling of the “Obamacare” health care program will no doubt be fought tooth and nail by the Democrats in Congress as will his Supreme Court nomination to replace the conservative Justice Antonin Scalia who passed away earlier this year.

US Fed to raise rates in December

It is close to a certainty that the US Federal Reserve will raise the Fed funds cash rate by 0.25% to 0.5% when they meet on 13-14 December. This will be the first tightening of policy this calendar year following on from a similar move this time last year. During the month the US central bank released its Beige Book which summarises information received from regional Fed banks. This showed improving activity in retail sales, real estate markets and a tightening of the labour market, all of which support the case for a marginal tightening of policy. With the uncertainty of the US election out of the way and in light of President-elect Trump’s pro-growth policy platform, a tightening in December is all but a done deal.

The Fed is keen to continue the process of normalising monetary policy, which commenced last year with the withdrawal of quantitative easing stimulus measures and continued with the subsequent 0.25% increase in cash rates in late 2015. In anticipation of this move, we have seen a sharp sell-off in US bonds, with a flow on effect to other sovereign bond markets such as Australia. While the US is taking the lead in this process, other central banks in the UK, Europe and Japan are still conducting stimulatory policies. It is inevitable however that over coming years they will also follow the same path as the Fed. The consequence of this is that sovereign government bonds are likely to provide very poor, and probably negative, returns over coming years as rising yields produce capital losses for bond holders.

Australian economy losing steam

Australian third quarter GDP showed a surprise 0.5% contraction in the domestic economy reducing the annual growth rate to just 1.8%. To date we have not seen the recovery in the non-mining sector of the economy that the Government and RBA had hoped for with business and consumer confidence falling, construction data weak and only modest growth in retail sales. Adding to this has been the persistently strong $A which is driving import strength and harming the traded services sector of the economy. While the recent strength in commodity prices will help improve the terms of trade in the December quarter, the RBA must now seriously consider the prospect of easing policy in the first half of 2017 by possibly up to 0.5%. Recent moves by banks to increase rates on various loan products may force the RBA’s hand to offset the contractionary impact of these moves. With US cash rates moving in the opposite direction, expect to see the $A weaken over the first half of 2017 which will provide further stimulus to the economy.

Investment Outlook

There’s no doubt the impact of the Trump election victory and the subsequent rally in equity & commodities markets took almost everyone by surprise. This has largely been a sentiment driven rally as it will be several months into the new administration before any new policies are passed by Congress let alone implemented. As a consequence, we are likely to see some consolidation in equity markets from here. Tighter US policy, political uncertainty in the UK and Europe and pressure on emerging economies from the strong $US and protectionist trade policies will pose challenges for markets in coming months. As we have discussed on several occasions recently, the biggest threat in financial markets is the likely increase in sovereign bond yields over coming months which will not only subdue the returns from this defensive asset class but negatively impact on the valuation of growth asset classes such as shares and property. We have maintained a marginally positive pro-growth strategy in diversified portfolios and will look for opportunities to exploit any market weakness by using cash to build positions in equity markets.