November Investment Strategy: And then there were none…

Key points:

• The US election should prove a game changer, well beyond economics
• Fiscal support should boost the growth outlook in 2017 and especially in 2018
• Trade remains one of the most uncertain areas

Much like characters in an Agatha Christie novel, traditional political parties seem to be falling in quick succession, as unconventional parties rise to prominence. Yet markets do not react to political surprises in a consistent way. In this month’s investment strategy, we look at the reasons behind the reflation of markets and ask whether this is sustainable. We call for more caution in markets, especially in Europe where the political agenda we highlighted last month remains heavy, and uncertainty remains ahead of the forthcoming Italian referendum. Therefore, we keep a fairly conservative asset allocation… just in case.

While the famous “FiveThirtyEight” website had warned that Donald Trump’s chances of victory had risen to one in three on the eve of the elections, the conservative candidate’s unambiguous victory on 9 November still proved a surprise for most market participants. Trump’s appeasing initial speech spurred a rally on financial markets, which now indicate higher growth and inflation in the US driven by Trump’s stimulus programme, in spite of possible emerging market (mainly Mexico) jitters. What can we glean at this stage?

What we currently know is Trump’s positions, the Republican Party’s positions, and what may be costly in the short and long-term:

• ̶Potentially easy to achieve in the short term: large tax cuts in favour of corporates and households, partial deregulation of the financial sector, and giving up environmental policies.
• ̶Potentially more controversial between Republicans and the White House, and costly in the short term: international trade restrictions, infrastructure spending programme, and Obamacare reform. 
• An important unknown: Fed policy and replacement of Fed members (up to four nominations by mid-2018).

Based on this, we can imply the most plausible scenario is a sizeable demand stimulus1 , but more modest than advocated during the campaign. In our view, this would involve tax changes, partial deregulation of the financial sector, and traditional energy policy. The rest will likely be more difficult or take longer to achieve. Such a program should rapidly fuel growth, which we currently project at 2% on average over 2017-2018, and spur inflation as capacity production remains hampered by the lack of investment. Inflation could rise to 2.5% on average in 2018 from 2.1% in 2017, which, in turn, leads us to revise our Fed call: after one rate hike in 2016, we expect two hikes in 2017, and three in 2018.

Trump’s victory will not be painless: Emerging markets, particularly Mexico, have already been hit twofold by the election. First, Trump’s belligerent trade rhetoric casts a shadow over Mexico and all other NAFTA countries. Second, a rising dollar and US treasury yields will hurt countries with high levels of dollardenominated debt. As a result, the Mexican peso tumbled and emerging market debt and equity suffered (both have fallen around 4.5% since the election). Looking ahead, we do not expect all of Trump’s trade or immigration proposals to be enacted, but there could be renegotiation of existing trade agreements. This would likely disrupt these economies more severely than the US itself, which could be exacerbated if the US charges China with currency manipulation or imposes large tariffs on Chinese exports.

Turning to Europe, the spillover from the US has led to a sharp rise in bond yields, spreads and curves across the board. While the curve effect will be welcomed by the financial community, and rising yields are a boon for the ECB’s QE programme (recent moves have rendered an additional €60-70bn of bunds eligible for QE again, effectively extending the programme by three months), these movements are accompanied by a re-pricing of risks. Spreads in France, Netherlands, Spain and Italy have all widened (by about 25-30bps). Looking ahead, we retain our view that the ECB will revisit thoroughly their economic and financial outlook, pending additional news on US policy. As a result, we predict a sophisticated ECB press conference in December, with parametric adjustment allowing a six month QE extension (factoring the three month extension driven by rising bund yields) but explicitly committing only to QE until June.

Now comes the tricky part: A heavy European political agenda could easily spoil the party. Significant political events remain ahead in the large Eurozone countries, with elections pending in Holland, France and Germany. Primary among these events is the Italian referendum on 4 December, where the ‘No’ vote has garnered a widening lead according 32 polls published by 11 different pollsters since Oct. 21. Granted, the share of undecided voters remains high, as we saw in the US elections. In our view, a ‘No’ vote would not materially mark a change of economic policies, as PM Renzi is likely to form a new government should he resign. But that would also undermine his capacity to pursue a reform agenda, in our view. Moreover, as re-pricing of risk continues, such an outcome would likely trigger another widening of spreads and weigh on financials (which are not included in the ECB’s asset purchasing programme). Market stress would increase the correlation between politics and asset price movements, as the other three countries with elections all have unconventional parties challenging the norm in Europe.

As politics increasingly takes centre stage, we believe caution should prevail in asset allocations. First, there is a lot of uncertainty over President Trump’s programme execution, which markets have underestimated since the vote result in our view. Second, stars look aligned for a re-pricing of risks in the Eurozone. The ECB appears well equipped, but only if it can maintain political support. We have closed our overweight positions on emerging markets, despite the attractive valuations and improving fundamentals. The correction in interest rates looks sustained to us, and we therefore expect capital outflows from emerging markets back to the US. Prepare for a rough ride