In the last two months of the year, financial markets responded to the unanticipated election of Donald Trump in a textbook fashion — not only at the asset class level, with the major moves up in stocks and government yields, but also within asset classes as financials and the dollar surged.
In doing so, they were responding to prospects for higher growth, inflation and market inflows following the President-Elect’s policy announcements on deregulation, tax reform and infrastructure. Even more impressive, this occurred in a remarkably-orderly fashion, with little evidence of distress among investors, many of whom were not set up for the sharp re-pricing of financial assets.
Trumponomics will remain an important market influence in 2017, with investors particularly interested in two things: the transition from announcements to detailed design and sustained implementation; and outcomes, particularly when it comes to the mix between higher growth and inflation. But when it comes to the evolution of the trifecta that influences most the wellbeing of investors — that is, returns, correlations and volatility — four other macro influences will also be in play:
Monetary policy beyond data dependency: The anticipation of a more active fiscal policy under a Trump administration, together with relatively firm economic numbers, will encourage the Federal Reserve to evolve its policy stance beyond just responding to high frequency data releases. It will become more strategic and be inclined to tighten somewhat beyond what the markets are currently expecting.
Imperfect global policy rebalancing: Such Fed tightening is part of a gradual policy rebalancing after too many years of excessive reliance on central banks. This is a good thing as the benefits of unbalanced policies have been declining while costs and risks have been rising. But only the United States, with its stronger economy and the endogenous political disruption occasioned by Trump's surprise election, is able and willing to undertake this policy transition. In the systemically-important economies of Asia and Europe, the People's Bank of China, the Bank of Japan and the European Central Bank will remain the "only game in town" policy-wise.
Divergence and the risk of too strong a dollar appreciation: Greater disparity in policies and economic performance will widen interest rate differentials and place further appreciation pressure on the dollar. As more Asian and European financial capital migrates to the US in search of higher returns, the dollar will appreciate beyond what economic relationships can readily support, thereby fuelling anti-globalisation rhetoric and increasing the risk of protectionism.
Dealing with the anti-establishment surge: Non-traditional movements, while even more influential on both side of the Atlantic, will probably have different implications. In the US, with its stricter checks and balances among the three arms of government — executive, legislative and judicial — political disruptions will occur within broadly stable parameters as to how the economy operates. Not so in Europe where unpredictability extends to the most basic economic parameters, from the redesign of the UK's trading relations to growing nationalist pressures in France, the Netherlands and (even) Germany that hinder the needed strengthening of the regional architecture and increase its vulnerability.
All this speaks to 2017’s heightened “unusual uncertainty” as both political and economic systems continue to respond to too many years of growth that has been too low and insufficiently inclusive. It is a situation that raises tricky questions for investors, not only about what to think but also how to do so. With that, conventional tools of analysis and prediction are be further challenged, especially when it comes to evolving portfolio positioning with longer-term trends.
In the weeks ahead, the expansion of the Trump Rally depends on how the new Administration governs relative to its electoral promises. Beyond that, it requires that other countries overcome the headwinds of political fluidity to join the US in rebalancing their fiscal-monetary policy mix while, importantly, also pursuing pro-growth structural reforms. In the meantime, investors would be well advised to book some profits while also rebalancing some of their remaining risk exposures in favour of sectors that have lagged behind (such as traditional tech), and also to emerging markets with strong balance sheets, limited currency mismatches and sound management.
Mohamed El-Erian is chief economic adviser to Allianz and author of 'The Only Game in Town'.
(Copyright The Financial Times Limited 2017)
