Blog

“Far more than we like to admit, the world is to a remarkable extent a self-organizing, self-changing place.” - Matt Ridley

As Matt Ridley observes in his book, The Evolution of Everything, leaders tend to emerge in response to a massively complex, self-organizing evolutionary process. Often ignored or in the background for years, when the time is right, particular individuals rise to power with a suddenness that confounds much of the populace. Ridley also points out that the same idea, invention or movement tends to appear in many places at the same time, confirming that the developments are a product of an underlying evolutionary force rather than the creation of those individuals to which we are assigning credit. 

Viewed in this context, Donald Trump ascended to the U.S. presidency by tapping into the anger and frustration of the “forgotten man,” who views the elected elites as out of touch and inept. The widely held theory that we are in a period of “secular stagnation” also led voters to act against the status quo. He is joined in Europe by leading Brexit proponent Boris Johnson, Frauke Petry in Germany, Marine Le Pen in France, Virginia Raggi of Italy, and many other “populist” leaders around the world. Consequently, we think it is helpful to view the Trump election as part of a broader shift from unsustainable to sustainable drivers of economic growth and away from distortive and ineffective policy responses (Exhibit 1). The primary effect of the likely monetary and fiscal policies that emanate from this environment is a reconnection of the financial markets with the real economy, or in simple terms, greater alignment of Wall Street with Main Street.

These shifts will have a meaningful impact on the policy tools used by global leaders given that much of the population has not benefitted from the inflation of financial assets and is actually harmed by the distortive effect of negative real interest rates.  Central bankers will continue to buy $200 billion in bonds every month but will adopt a mechanism called “permanent monetization” to fund a massive increase in fiscal spending. They also will attempt to target longer-term interest rates as the yield curve steepens and inflation rises, thereby maintaining a highly expansionary environment. The stated goal is to create an “overshoot” in inflation and stimulate strong gains in wages. President-elect Trump has pledged to fully embrace these actions and will implement an unprecedented mix of supply-side and demand-side stimulus via tax cuts and infrastructure spending.

Expansionary fiscal policies are also being embraced by Europe, Japan, China, India and many emerging markets. Much of this spending will expand government deficits and require new bond issuance. This is occurring just as we believe the two main drivers of deflationary pressure are abating. Both debt fueled malconsumption in the West and related mal-investment in capacity in the East appear to be substantially cleared out of the system. China is no longer exporting deflation, as manufactured goods prices rose for the first time in over five years. Consumers have de-levered and restrained consumption for several years, which sets up the potential for pent-up demand for everything from luxury goods to housing. Finally, companies have for several years been underinvesting in capital goods and capacity, which should begin to increase operating rates in many industries. Already we are seeing new 12-month highs in industrial commodities such as copper, zinc and iron ore.

None of this is very bond friendly as policymakers explicitly move to a goal of decreasing the burden of their liabilities by debasing the value of these highly inflated debt instruments. Considering that roughly $12 trillion in sovereign bonds pay negative yields and flows into fixed-income funds have been robust for much of the past decade, we suspect that most investors are not positioned for a reversal of the 35-plus year bond bull market. Additionally, equity fund flows have been dominated by “low vol” and dividend-seeking passive and active strategies. In short, the world has crowded into one big bond-correlated pool of assets just as the environment is becoming hostile to that positioning.

While bonds and bond-like stocks are highly valued after several years of outperformance, everything else is priced to reflect the current pessimistic outlook for the global economy. Banks and many economically sensitive shares are priced at recession level relative valuations. From a factor standpoint, low volatility, quality, growth and momentum are expensive while value and high beta/risk are cheap.

The framework that bond beta is expensive and stock beta is cheap is useful in understanding how asset prices reacted to the surprise election of Donald Trump. After an initial 867-point plunge in the overnight futures markets as Trump took the lead in key battleground states and a victory looked imminent, the Dow Jones Industrial Average rebounded by over 1,100 points to close up 257 points on November 9th. Financial and cyclical shares led with gains of 2% to 4% along with a rebound in the hard-hit pharmaceutical sector. Defensive consumer staples companies retreated by over 1% with interest rate-sensitive real estate and utility stocks falling 2% to 4%. Bonds behaved in exactly the opposite manner as early gains just after the election results were erased by steady losses during the next trading day, leaving the 10-year U.S. Treasury bond yield back above 2%.

The election of Donald Trump and his proposed aggressive pro-growth agenda will strongly reinforce the actions of like-minded policy makers all over the world. This stimulus comes at a time when reflationary forces were already building and the recession in dollar-denominated GDP growth was coming to an end. Consequently, we expect the unwinding of the bond-correlated, low volatility bubble to continue in favor of sectors and regions that benefit from the normalization of interest rates and improving global activity. We believe that value-based investment strategies are particularly well-positioned to benefit from these shifting fundamentals. Regardless of style, the key for investors over the coming years will be to have exposure to assets that are inversely correlated with bonds.