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Does Trump pose a threat to complacent markets?

Investors respond rapidly to incoming US president’s unpredictable rhetoric and policy

Donald Trump’s US presidential election victory in November triggered one of the biggest post-election stock market rallies in history, but will Trump’s reign live up to the expectations of investors? Or are markets complacent about the risks posed by this most unpredictable of presidents?

The S&P 500 has enjoyed a double-digit percentage bounce since election night, with investors betting that Trumponomics – reduced taxes and regulations as well as increased infrastructural spending – would deliver higher economic growth and inflation.

Not many anticipated such a rally; prior to the election, Trump was widely viewed as a protectionist and a demagogue whose policies would result in trade wars and increased geopolitical risk.

Clearly, the conciliatory stance adopted by Trump on election night reassured investors.

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Since then, investors have bet that Trump will deliver on his pro-business policies while refraining from his less palatable populist promises.

But the assumption that Trump would adopt a more presidential persona has been cast into doubt in recent weeks.

Markets took fright a fortnight ago, following a bizarre press conference where he slammed US intelligence agencies, reiterated his willingness to impose trade tariffs and make Mexico pay for a border wall, and said pharmaceutical companies were “getting away with murder”.

His rhetoric has been similarly inflammatory in more recent interviews, alarming policymakers in Europe and China with a series of provocative criticisms.

“Investors have been inclined to downplay the risk of candidate Trump’s trade protectionism being implemented by the new administration,” said UBS, which cautioned that this view “may need to be revised”.

That was echoed by Merrill Lynch, which said the press conference was a “scare” as markets “had priced in a very positive scenario of Trump: fiscal policy without trade protectionism”.

Loose cannon

Others were blunter. "Investors should be more worried of his presidency than they appear to be," said David Holohan, chief investment officer at Merrion Capital. "He is a total loose cannon."

Global commodities broker Marex Spectron warned that “anyone who thinks this presidency is going to be all sweetness and light really needs to take a harder look at the man himself”.

Société Générale cautioned the “combination of an erratic [president-elect] and a market which leaps to conclusions and heads off down culs-de-sac with manic enthusiasm is a recipe for mayhem and anarchy”.

Other suggest the move into equities and risk assets may only be getting started.

Last month, Ray Dalio of Bridgewater, the world's largest hedge fund, said Trump's administration could unleash "animal spirits" and this change in psychology could have a much bigger impact on the US economy than any stimulus package.

“If this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge,” said Dalio.

The shift from the Obama administration to the Trump administration will likely be even more significant than that seen in 1979-1980, he added, when Margaret Thatcher and Ronald Reagan came to power.

Some evidence suggests these animal spirits may well be stirring. US consumer confidence recently hit a 15-year high.

Sentiment among small business owners has surged higher, according to the latest National Federation of Independent Businesses survey, with optimism levels registering their largest monthly increase since 1980.

Economic scepticism

The question is will this optimism dissipate should Trump fail to implement his promises?

With a debt-to-gross domestic product ratio of 77 per cent, US debt is already quite elevated. Neil Woodford, the enormously successful fund manager often termed Britain's answer to Warren Buffett, warns there is "simply no room for the fiscal expansion Trump is proposing".

There will be limited tax cuts and spending increases, says Woodford and this will deliver “slightly higher US growth” but “not to the extent the market’s reaction would suggest”.

Former Federal Reserve chairman Ben Bernanke appears similarly sceptical. Although financial markets are pricing in faster economic growth, Bernanke notes that Federal Reserve forecasts show little change in their economic or interest rate outlooks.

Republican policymakers may be reluctant to sanction Trump’s planned spending increases, warns Bernanke, who says the Fed is rightly cautious given the “uncertainty about the timing, size and composition of the fiscal package, and the resulting uncertainty about its likely economic effects”.

Indeed, this caution is largely shared by the economics establishment.

Prior to November's election, a group of 370 economists, including eight Nobel laureates as well as World Bank chief economist Paul Romer, signed a letter warning that Trump represented a "dangerous, destructive choice", someone who failed to "listen to credible experts" and who promoted "magical thinking and conspiracy theories over sober assessments of feasible economic policy options".

Scant optimism

Those opinions don't seem to have softened. Writing about the recent American Economics Association annual meeting, University of Michigan economist Justin Wolfers said he "didn't encounter a single economist who expressed optimism that Mr Trump's administration would be good for the economy".

The only optimists, he said, were those who thought Trump would not actually implement his agenda.

Bulls might counter that while Trump’s plans may not be optimal for the economy, they are indisputably good for corporate America, with tax cuts alone providing a meaningful earnings boost.

Second, equity market gains in recent months are not solely due to Trump. Markets had been getting into gear since the summer; bond yields bottomed in July, the so-called earnings recession had ended, and cyclical stocks were outperforming.

Investors had begun to price in a reflationary environment, irrespective of who would win the election.

Third, the impact of presidents upon stock market cycles tends to be overstated; stock markets rise most of the time, no matter who is in power.

Nevertheless, few would deny that optimism about “Trumpflation” has galvanised stock markets and that sentiment has got a little frothy.

In a recent note, Eric Peters of One River Asset Management related how an investing acquaintance was disgusted by Trump's aforementioned press conference.

“Total fiasco, utter circus!” he protested breathlessly. “Single worst press conference for a world leader in history . . . We didn’t learn a single thing about policy. For the sake of our nation, pray The Donald sticks to Twitter.”

Worst of all, he added, “it didn’t spark a big enough correction to let me back into all my favourite Trump trades”.

That's echoed by Reformed Broker blogger and Ritholtz Wealth Management chief executive Josh Brown. Risk appetite is rising, says Brown.

“Even the people who are horrified by all the stupid things he says – they want in on it too.”

Market volatility

As a result, investors appear to be shrugging off issues that would normally cause concern. The Economic Policy Uncertainty (EPU) index, a measure devised by US academics, has been at extremely elevated levels recently.

The EPU is a leading indicator, one that often foreshadows concerning economic news; accordingly, when it rises, so does market volatility.

That hasn’t happened this time. Stocks have remained in a very tight trading range and volatility, as measured by the Vix index, has remained near multiyear lows.

Economic uncertainty aside, it’s notable that Trump’s rule-breaking geopolitical outlook – antagonise China and Germany, criticise Nato and the EU, praise Brexit and Russia – has also failed to drive any sort of Vix movement.

Whether this insouciance will persist is another matter. Markets can change their mind quickly.

Billionaire PayPal co-founder Peter Thiel, a Trump supporter, recently related how he spoke to hedge fund investors in the week after the presidential election.

“They hadn’t supported Trump,” said Thiel. “But all of a sudden, they sort of changed their minds. The stock market went up, and they were like, ‘Yes, actually, I don’t understand why I was against him all year long.’”

Threat of protectionism

Merrill Lynch’s latest monthly fund manager survey shows 29 per cent of investors believe possible trade wars represent the biggest tail risk facing global markets; another 24 per cent say protectionism is the biggest tail risk.

Ironically, the same fund managers appeared blissfully unaware of these possibilities in December.

Then, trade wars and protectionism were not even mentioned in the survey.

The potential for volatility was encapsulated by trading in the Mexican peso during Trump’s aforementioned press conference.

The peso hit record lows against the dollar after Trump warned US companies that planning to build plants in Mexico was “not going to happen”.

Trump then changed his tone, saying Mexico “has been so nice, so nice”; the peso shot back up.

Donald Trump’s behaviour and policies will dictate whether further market U-turns arise.

“The question is whether this administration will be a. aggressive and thoughtful or b. aggressive and reckless,” said Ray Dalio.

“We are pretty sure that it won’t take long to find out.”