Market Commentary

I am not one of those who knew how the evening would end. I saw Hillary Clinton winning for all the usual reasons. Now the usual reasons are pretty much out of the window. ~Peggy Noonan, The Wall Street Journal
Ken Leech
Chief Investment Officer

Executive Summary

  • In this note we discuss the election of Donald Trump, Western Asset’s investment thesis, the rationale behind recent observed price movements and a review of how we are positioning client portfolios.
  • The predominant feature under a Trump victory scenario was the expectation of a risk-off event motivated by fears of trade restrictions and anti-globalization broadly. Like Brexit, the pollsters missed badly. Unlike Brexit, the risk-off trade did not last long.
  • Today’s market narrative is developing around the idea of increased US growth behind the thrust of fiscal stimulus. If anti-globalization and foreign policy missteps are avoided, the addition of meaningful fiscal stimulus could become a game changer.
  • Our base case for US growth remains in the 1.5% trend, and while we are clearly heeding potential policy changes, we need to see more evidence.
  • The initiatives Trump has outlined for his first 100 days constitute a clear break with the pro-globalization policies of the past 30 years. It is far from clear to us how this will play out. The optimistic scenario being priced into today’s markets may be overdone.

We’ll start this note with the newly elected elephant in the room (Donald Trump). Next, we will review the market reaction, the potential rationale behind observed price movements and our own view. Last, we will review our portfolio construction, discuss winners and losers and comment on potential portfolio modifications. First, we’ll review our thesis leading up to the election.

We thought slow but stable growth would continue, both in the US and globally. Our working premise has been a trend growth rate of roughly 1.5% for the US and just under 3% for the global economy. In order to take advantage of the ongoing global and US recoveries, the preponderant amount of our risk budget was devoted to spread product, in the belief that even slow growth, if sustained, would be sufficient to bring down credit spreads. We have also utilized macro strategies, particularly overweights to duration, that have helped protect the portfolio during risk-off periods, while also benefiting from the slow pace of interest-rate normalization.

Just like Brexit, this election was a potential watershed event. Though some have suggested that Brexit should have made the outcome easier to see, we resist such statements to some extent. The enormity of work that political and statistical modelers put into their effort not to make the Brexit mis-forecast led them to broaden their distribution of outcomes and test a greater array of turnout scenarios. In our view, that makes the forecasting and the actual election results all the more remarkable.

We did a substantial amount of pre-election work evaluating the probabilities of various possible election results and their implications for markets. Ken Winston, our Chief Risk Officer, prepared Trump scenarios just as he had prepared Brexit scenarios. In his message to the Firm, he explained how difficult this process was, since the range of potential outcomes was so broad, reinforced by wide differences of opinion in the research papers across Wall Street and other firms. While there were great divergences in actual scenarios, the predominant feature under a Trump victory was the expectation of a risk-off event motivated by fears of trade restrictions and anti-globalization broadly. Like Brexit, the pollsters missed badly. Unlike Brexit, the risk-off trade lasted but an hour.

My personal and our Firm expectation was that Hillary Clinton would win, albeit in a reasonably close race. In our 12-person US Broad Strategy Committee, only Portfolio Manager Mark Lindbloom had the winning call. My question to people lately is: when did the jaw-dropping moment occur? When did you realize Donald Trump was actually going to win?

For me, I took a brief break around 5:00 PM (8:00 PM on the east coast) when the exit polls suggested Hillary was exceeding expectations and the betting odds went to 92-8 in her favor. My son, who is the statistical and political expert in our family, texted me, “Dad—you need to get back, Donald Trump just jumped up to 70-30.”

I cleverly replied, “What, why?”

“The early county returns are nowhere near the exit polls—he’s in it.”

And as victory increased in probability, the market went down one of the two paths open to it—risk-off versus risk-on. The initial risk-off reaction had the S&P 500 down 100 points and ultra-long Treasury bond futures up 4 points. The next day, however, the markets took the other path. Risk was on. The stock market was up and bond futures went down 7 points, an 11-point swing in less than 24 hours.

Today’s market narrative is developing around the idea of increased US growth behind the thrust of fiscal stimulus. This, combined with the withdrawal of anti-growth regulations, is expected to provide a much more favorable climate for business and growth. If anti-globalization and foreign policy missteps are avoided, the addition of meaningful fiscal stimulus to a substantially closed economy such as that of the US—which is already operating near full employment—could become a game changer. Growth could accelerate, and the Federal Reserve (Fed), already desirous to raise rates, would abandon “low for long” and tighten more meaningfully. Additionally, the disinflation backdrop would reverse to inflation, also helping to boost interest rates. TIPS would do much better than nominal Treasuries. Bank, energy and defense companies would prosper, the dollar would rise and emerging markets would come under pressure.

But should the other prospective paths be discarded? Igniting US growth in the context of a very weak global environment has proven exceedingly difficult. Trump’s trade policies are potentially negative for global growth. The implications of labeling China a currency manipulator and the erection of trade barriers may reinforce the global risk-off episodes we have seen intermittently over the last five years.

Most importantly, the market’s optimistic growth expectation is based on policies that may come over the next 12 months. But the bond market has already raised interest rates today. Can the global and US economy remain vibrant? It was not quite a year ago that optimism about US growth led the Fed to forecast four rate hikes in 2016, only to see China fears and global growth concerns lead to a very different outcome.

We think the bond market has moved too far too fast. The evolution of Trump’s economic policies will be crucial. Our view is that the jury is still very much out.

So how do we position portfolios given meaningfully changed circumstances and policy uncertainty? In a disinflationary environment, the benefits of the negative correlation between risk assets and high-quality bonds is a powerful benefit for portfolio construction. In a “taper-tantrum,” or rapid switch to an inflationary regime, the correlations would likely turn positive. While this scenario is not a given, the higher probability means we have to reconfigure and potentially trim our duration sails. Similarly, the environment that has been so favorable to emerging markets is becoming more vulnerable, and our overweights there need to be reexamined.

On the yield curve, though, there may be an opportunity developing, as consensus thinking has induced a severe steepening. The thinking goes that higher rates, in conjunction with a very low fed funds rate, could lead to a sharply steeper curve. In the immediate future, this reasoning is plausible. But the yield curve is already very steep by historical standards as short and intermediate Treasuries have benefited disproportionately from expectations of little Fed policy change. Think about the implications of a regime change to either much faster or much slower growth. We have seen that the global growth slowdown fears have led to bull-flatteners. Indeed, our last note reported on our reducing our curve-flattener overweight position due to the rally over the summer after Brexit. If growth moves up meaningfully, as the Trump position postulates, we suggest not only that interest rates will normalize more quickly than currently expected, but also that the yield curve will have to normalize more quickly.

Over time, the fundamentals of growth and inflation drive interest rates and spreads. We are optimistic that the global and US recoveries will eventually see better growth outcomes, but this improvement is likely to be gradual. We still expect slow but sustainable growth for the foreseeable future. In this environment, spread product figures to do better than Treasury or sovereign bonds. If global and US growth improve more meaningfully, outperformance of spread product should be even more pronounced.

We have discussed the parameters for the potential change in the US growth outlook. Remember, though, this change is completely conjectural at this point. Our base case for US growth remains in the 1.5% trend, and while we are clearly heeding potential policy changes, we need to see more evidence.

On the non-US portion of global growth, we are much more concerned. We worry about the slowdown in Chinese growth, which was attenuated this year by the withdrawal of once massive stimulus. The early improvement in non-China emerging countries may now come under stress from US trade policies and the potential change in Fed policy. European growth, a bright spot so far the last two years, is now faced with the uncertainty of both Brexit and the potential for a continuation of the anti-globalization politics, as the referendum in Italy is next on the docket.

In short, the current slow growth and low inflation backdrops both here and abroad have not changed. Markets have priced in the expectation of an imminent and radical shift in US growth. We don’t dismiss this possibility, but we also recognize that disappointment would prove painful. While we intend to modestly reconfigure positions to improve our prospects under a stronger US growth scenario, it is more important to us to remain flexible so that we will be able to react to alternative scenarios.

The initiatives Trump has outlined for his first 100 days constitute a clear break with the pro-globalization policies of the past 30 years. It is far from clear to us how this will play out. There are strong potential risks, and the optimistic scenario being priced into today’s markets may be overdone.

Past results are not indicative of future investment results. Investments are not guaranteed and you may lose money. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.
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