January 20, 2017
Going from Presser to Presser
Political developments have been the primary catalyst for market moves recently, with hopes that widely anticipated press conferences from Trump and May would shed additional light on their respective policy initiatives. In the case of the President-elect, his trade comments during and before last week's presser have solidified the view that some form of trade tariff will be pursued early in his Presidency. The most widely discussed approach is the use of a border adjustment tax which would collect taxes based on the location of a sale. From a practical perspective, it would collect a tax on imports, while exporting goods produced in the US would not be taxed. Domestically produced goods sold in the US would also be taxed at lower rates, thereby encouraging domestic production. Certain corners of economic theory believe that the border tax will hold prices harmless as it will cause a rise in the US dollar, which will lower the price of imports and therefore offset the import component of the border tax. Increases in domestic production would also help drive growth, creating a win/win scenario. In contrast, others are concerned that the complex global supply chain along with the unique role of the USD will challenge this nicely packaged theory, creating inflation while also lowering growth rates. From our vantage point, these contrasting views highlight the difficulties facing investors as we continue to operate with an imperfect information set and limited historical precedence.
For U.K. Prime Minister May's part, her press conference contained an overview for investors to anticipate, although her view appears in conflict as she attempted to thread the fine line between leaving the EU, while also maintaining access to the unified market. She has targeted March 2019 as an end date to complete the complex negotiations, with both houses of Parliament needing to vote on the outcome. While details were limited, the broad strokes were enough to drive GBP 2% higher after the press conference. We would infer that the possibility of avoiding a hard Brexit was behind the rally in cable, although we personally did not hear anything that drastically lowers the odds of hard landing. The USD has also been mostly weaker since the Trump press conference, as the President-elect stated concerns over the strength of the USD relative to CNY. In contrast, Treasury Secretary Nominee Mnunchen seemed to back a strong dollar policy during his confirmation hearings, which was partially responsible for some of today's dollar strength.
In addition to the reflation trade driving the US stronger, we have seen monetary policy divergence return as the Fed tightens and other large central banks maintain their dovish stance. Today's ECB meeting did not contain any policy changes, although President Draghi stuck a dovish tone with his view that inflation gains may still be transitory and will be ignored in the short term. Fed officials have recently touted the strength in the U.S. economy, with many doves sounding surprisingly hawkish. As Chairman, Yellen's voice always commands attention, so when she proclaimed that the economy was close to being able to stand on its own while affirming that a few rates hikes per year through 2019 was appropriate, investors took note. Earlier in the week, the generally dovish Lael Brainard sounded a hawkish tone in suggesting rate hikes may be needed if fiscal policy focused on inflation inducing short term demand versus addressing longer term structural issues. She also raised the specter of allowing the balance sheet to run-off, in contrast to the ECB which continues to stress that the decline in monthly purchases does not constitute a tapering of purchases. Ultimately, we would not be surprised if the Fed was sending a coordinated message to the incoming President, although we are hesitant to believe that the message would have much impact on his policy initiatives.
While currencies remain quite volatile, other US asset classes have been mostly range bound over the past several weeks, with 10 year yields near the mid-point of the 2.2%-2.6% range that has been established since the elections. Stocks, which have been one of the most resilient asset classes embracing the reflation trade, have been mostly unchanged since the start of the year, signaling to us the need for additional catalyst since pushing 6%-8% higher since the elections. Credit also remains one of the better performing asset classes within the fixed income universe. Investment grade spreads have been mostly unchanged since the start of the year and remain 10 bps tighter since the elections. With a 3.3% average yield, IG is posting a +0.5% YTD total return versus +0.3% return for the aggregate, all while issuance remains strong at over $100 billion to start the month, split evenly between corporate and EM/SAS. High yield continues to post strong returns, with a 1.2% YTD total return as spreads have compressed 70 bps since the start of the year and 90 bps since the elections. With an average yield of 5.8% and a +420 spread level, high yield is now trading at levels last seen in 2014. Given that current year returns are building on the 17% gains from last year, and the 30 month tights from both a yield and spread level, we don't envision much additional tightening. While the 2014 rally saw yields plumb below 5% and spreads as low as +360, we were not dealing with a tightening Fed during that environment. A successful reflation trade with border adjustment taxes will support high yield borrowers, although other discussions also focus on interest deductibility at the corporate level.
While all eyes will be on tomorrow's inauguration and the first 100 days, we will also take cues from earnings season, which is well under way. We have seen less than 10% of company's report, so it is far too early to make any predictions on how earnings will ultimately finish. Having said that, there have been some large beats from the global banks as strong trading revenues have exceeded expectations. So far, 70% of companies have beat expectations, with adjusted EPS growth running at approximately +4.5%, versus a +3.5% expectation. We will see the large technology companies report in the coming week, with industrials set to come out the following week. While there are a number of economic releases in the coming week, most are tier-2 in nature, with durable goods and housing reports having the most market impact.
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