Trump trade reversal - sign of things to come?

19 May 2017

It's always the same. The moment you comment on an anomaly in the markets, it either ends or is significantly challenged. Last week, we wrote about the eerie calm in the stock markets. This week, Trump's got himself into so much trouble with the opposition and the press that markets woke up and staged a 1.5% one-day sell-off. It seems that market participants are beginning to accept that president Trump may turn out a liability to stock markets rather than delivering a boost. The press busied itself with speculations about impeachment probabilities and parallels to Richard Nixon, the only US president to ever resign. Supposedly, that's where markets took fright and volatility returned swiftly.

We do not believe we are anywhere near such an impeachment scenario - yet - but corporate USA, which was banking on rapid tax and regulatory burden easing, is seeing Trump's political capital dwindling. This means the probabilities of getting anything done, rather than Washington once again getting stuck in gridlock, have fallen substantially - and that was the reason for the market wobble that had almost been recovered by Friday's market close.

In the UK, the main market's FTSE100 stock index hit another all-time high by breaking through the 7,500 level for the first time. This appeared a bit nonsensical against the backdrop of both the Tories and Labour publishing distinctly business unfriendly policy manifestos. Admittedly, Labour's re-nationalisation plans would be far more disruptive to the free market economy paradigm of the past 35 years than Theresa May's plans to neuter the economy of its '˜animal spirits'. However, as she is far more likely to get the mandate to execute her manifesto's pledges, UK's business leaders spent far more time warning against the negative economic repercussions of her policy promises than Labour's. To my mind, the Tories' apparent abandonment of Thatcherism - deeming the forces of the free market economy threats to societal cohesion rather than being desirable contributors to national wealth and prosperity - is just election campaign clamour. Once the Brexit adjustment pains weigh down UK plc prospects, May's 2017 promises will have long been forgotten.

Amongst this noise, the fact that Lloyds bank has reached full re-privatisation status was mostly lost in the back pages. That's a real shame, because it should have been celebrated that, contrary to the wide held public belief that the tax payer lost horrendous amounts of money (which could have funded the NHS), the public purse actually made a handsome profit of nearly £1bn through the bailout. Given RBS is nowhere near a similarly positive outcome, I shall refrain from any 'I told you so in 2009' for the time being.

The most interesting piece of news, in this era of de-globalisation, came from the ruling of the European Court of Justice, which clarified that the EU's political bodies have the power to sign free trade agreements without the need of ratification of all national parliaments. That is great news for the remaining members of the EU, who will now see accelerated progress of pending free trade treaties with economic areas around the world. It is too early to say whether this will also help with a post Brexit trade deal, but I struggle to see it as a negative.

Is this more confirmation of our central scenario of steady but slow progress on the path of economic normalisation for the next few years to come? Yes, in principle. But, for the next 3-6 months, stock markets look more fragile. The prospect of political instability in the US, with its potentially devastating impact on business sentiment, is undoubtedly creating short term headwinds for the global economy. So too is the continued monetary tightening the Chinese authorities are inflicting on their economy in order to reign in their fragile financial sector, and these issues are increasingly identified as being at the brink of triggering another mini slowdown cycle.

Such a scenario leaves stock markets heavily exposed, because only a continuation of the recently very strong corporate profit growth will be sufficient to maintain moderate valuation level assessments after the stock market rally of the past 15 months. This becomes particularly evident if we change our perspective from using forward looking earnings expectations to evaluate valuation levels to actual earnings of the past 12 months (forwards P/E vs. trailing P/E). Just applying trailing earnings numbers makes markets appear dangerously overvalued. The danger is that, in such a scenario, markets react particularly violently to any change of economic progress expectation, which can result in short term sell-offs as we last experienced at the beginning of 2016.

As we have written here before, we would most probably see such a sell-off as an opportunity to increase our equity allocations, as long as our above mentioned central scenario has not fundamentally changed. However, right now, and after 15 months of extended stock market returns, we have begun to seriously consider temporarily reducing our allocations to the equity markets across portfolios, until we gain more clarity whether the economic momentum of the past 6 months can indeed be maintained - or the correction actually happens - which we hope it will not.

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