While the most popular so called ‘Trump-trades’ – in essence long developed market equities and short government bonds – have lost some steam ahead of Donald Trump’s inauguration today, there is still breath-taking optimism on both Main Street and Wall Street. This is mainly fuelled by hopes of unprecedented fiscal stimulus outside recessionary episodes from the incoming US administration.
Equities are discounting a significant growth pick up without meaningful monetary tightening spoiling the show. Confidence among small and medium-sized companies in the US is at the highest level since 2004 and US company earnings estimates for this year were not revised down at the end of last year like they normally are.
However, scepticism is warranted, especially as some markets seem to be priced to perfection when it comes to the overall economic outcome for 2017. More specifically, three inconsistencies underline the vulnerability of current markets.
First and foremost, the current optimism seems at odds with still high or even increasing uncertainty. Whether we look at investors, analysts, companies or consumers, optimism is all around. Take the bond market: the spread between European and US interest rates has risen to the highest levels since the 80s. To justify this, we probably need US growth to head back above pre-Lehman trend levels in the near future – which would require the absolute success of ‘Trumponomics’. At the same time, policy uncertainty is extremely elevated, not least caused by conflicting signals from the incoming US government. And although companies are becoming more optimistic, they also remain very tenuous about the future.
Secondly, although inflation expectations have risen and investors increasingly buy into reflation trades – short bonds, long cyclical equities and growth sensitive commodities – markets are still only pricing two Fed hikes for 2017. If a regime shift in the direction of sustained higher inflation and higher real growth were to happen, the Fed would almost certainly be forced to hike more than two times over the next 12 months. Either the Fed is mispriced or too much of growth upside is priced into risk assets.
Finally, equity market volatility has stayed surprisingly low although the range of outcomes both in economic and market terms has risen over the last few months. In other words, the tails of the outcome distributions are getting fatter. Even Fed members acknowledged ‘considerable uncertainty’ at the latest policy meeting, with six FOMC members being more uncertain about growth, up from only one in September – not a sign of much confidence and not good for central bank credibility.
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