Wednesday, November 16, 2016

Economic Commentary: Trump

This commentary is a purely economic analysis of the election results. 

This election marks a major secular shift that will replace the long-term trends of 1. increasing global interconnectedness, 2. mild fiscal policies, 3. sluggish domestic growth, disinflation, and falling bond yields, with 1. economic and social isolationism and protectionism, 2. expansive fiscal policies, and 3. faster domestic growth, higher inflation, and rising real yields.

On election night, global markets tanked.  By noon the next morning, US equities had regained all the lost ground and then some (although emerging markets remain depressed).  Why?

The first reaction was a top-down analysis.  Trump has threatened economically devastating protectionist trade wars.  He's threatened to pull out of NAFTA, to impose massive tariffs on China, and much of his economic policy seems vague and poorly thought out.  These factors are all heavily bearish all equity markets.

The market rally was a bottom up analysis focusing more on the GOP control of the legislative branch than of the Trump presidency.  The promise of rescinding Dodd-Frank sent financial stocks higher.  A likely reduction in environmental regulation sent investors scrambling to buy the energy sector.  Less regulation of pharmaceuticals (both in general, and due to the failure of California's proposition #61 to pass), is bullish the biotech sector.  

Additionally, investors found evidence for optimism among Trump's policy goals.  Greater infrastructure spending and repatriation of offshore corporate cash could spur domestic growth.  Lastly, investor Ray Dalio of Bridgewater notes that there was also a sudden shift in market participants - "those who drove the markets after his election were largely those who kept their powder dry until they saw the outcome and chose to process (and bet on) the policies themselves."

Markets are very cautiously reflecting an expectation for higher US GDP growth, moderately higher inflation, and higher real interest rates.  Markets are also implying that Trump will enact at least some of his protectionist policies, which will be very damaging for emerging markets, especially those that are export-focused like Brazil.  It's critical to note that on many of these policies, Trump and the GOP leadership are at odds.

There is a possible Goldilocks scenario in which we get the best of Trump's policies and the best of the GOP's policies: increased infrastructure spending, offshore cash repatriation, lower corporate tax rates, smart reductions in onerous regulations, and minimal reduction in foreign trade.  This scenario is extremely good for the US economy and strongly bullish US markets and moderately bullish global equities.

There's also a nightmare scenario where we get the worst of both worlds: Global trade wars and not only no new infrastructure spending, but fiscal austerity.  That scenario likely produces a global depression in which emerging markets are hit the hardest but no risk asset is unscathed.

Each extreme is very unlikely.  

My own view is a slightly less rosy version of current market expectations.  Now more than ever, I think it's important to think probabilistically.  The range of possible outcomes is very wide.  Trump will be hashing out his policy agenda with GOP leadership over the next few months, and no one (including Trump and the leadership) know the outcome of those negotiations at this point.  I think the most likely endpoint of equities in 5 years is higher today than it would have been under a Clinton presidency, but uncertainty is much greater as well, and the market correctly applies a discount rate to uncertainty.  For me personally, those two factors roughly balance out and I continue to view most equity markets worldwide as unattractive from a risk/reward perspective.  I paired my moderate emerging market exposure by 1/2, but will consider dramatically increasing the size of the position if protectionist policies become less likely, or if the market overreacts and send EM stocks far below their current already very cheap valuations.  Trump's election validates the market's long running favoritism of US equities over emerging market stocks and is likely to cause that outperformance to continue, but the valuation differential is already so large that I'd rather stand on the sidelines of that trade, wait until it reaches a greater extreme, and then bet against it selectively.

In all likely paths forward, the USD will rally versus most other currencies.  I established a substantial short EURUSD and expect to hold it for at least a year.  It is a bet on stronger US GDP growth, rising US interesting rates, but even more a bet against the Eurozone.  Trump's election increases the odds of similar nationalist elections throughout Europe.  Italy has a major nationalist referendum next month, France may elect Le Pen, Austria's far-right continues gaining power, and if Angela Merkel chooses to retire, that will likely be the nail in the Eurozone's coffin.  Short EURUSD is a bit of a crowded trade, so I'm sizing it to be prepared for a major snapback.  If the EUR rallies to 1.17 I will happily triple the bet size.  This is a screamingly good trade and I'd suggest having it on, just size it to allow for substantial volatility.

Gold looks less attractive now as it is usually highly negatively correlated to real interest rates (a far better model than comparing gold returns to inflation), but it potentially benefits from increased uncertainty and may become sought after by global elites in response to Trump protectionism and possible resulting collapses of EM currencies; I think there's a decent chance it falls 25% from current levels and I will view that as a great buying opportunity.  Cryptocurrency (mostly bitcoin) remains a very substantial portion of my portfolio and the asset I'm most excited about.  Stay away from energy commodities because reduced environmental regulation and increased middle-eastern geopolitical uncertainty will likely increase both US and OPEC oil production, but other commodities are likely to benefit from infrastructure spending.

For those of us in "asset owner" roles who were starting to wonder if active management can produce alpha: we're likely entering a golden age for hedge funds of almost all types.  There will be great opportunities for global macro and stock selection alpha generation over the next few years, and I'd wager that unlike over the previous presidential term, hedge funds will outperform passive investment.    

Lastly, I think volatility (and things that are volatility related like credit default swaps) are currently extremely underpriced by the market as a remnant of "financial repression" (i.e. artificially low global interest rates that force investors to find yield by doing things like selling options).  This probably won't last long.  I would much rather own moderately out of the money equity calls than outright equity today.  Emerging market CDS looks very cheap.

For the more active traders out there, we also have opportunities to trade around volatility; we're seeing sharply increased volatility of volatility (reflecting a more uncertain world), but spot vol itself remains depressed due to financial repression.  In the last two weeks, the VIX (a measure of short-term S&P 500 implied volatility) rallied from 14 to 19 fell to 15 rallied to 24 and then fell to 14.  I'll be playing it from the long side whenever it gets below 16.  There are a number of structural costs that make a simple strategy of buying VIX when it's low ineffective - you have to account for the term structure.  When I say that I'll buy "VIX", I'm oversimplifying, it's sometimes more attractive to buy volatility 3 or 6 months forward, or to buy volatility on currencies, bonds, or commodities rather than on equities.  If you're experienced with vol trading there are some great opportunities; if you're moderately knowledgeable but uncertain on execution, I'm happy to chat about it.

*I owe about a quarter of the analysis in this commentary to Ray Dalio of Bridgewater.  


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