The Cadinha Global Asset Allocation Process: Fourth Quarter Performance and First Quarter 2017 Outlook
The election of Donald Trump is drawing some comparison to Ronald Reagan’s victory. In both cases, the press was not too impressed with their election and did not think much of their economic programs. Yet supply-siders argued then—and continue to do so now—that an ideal policy mix includes increased incentives (lower tax rates and regulations), a strong dollar, a low inflation environment, a strong defense, and freer trade. That is what Reaganomics and the Volcker Fed delivered to the U.S. economy. The supply-siders argue that if the Fed cooperates, there are some components of the Trump economic agenda capable of delivering the goods just like Reaganomics did.
It is not that difficult to find an indicator supporting a particular view of the world. The difficult task is to make a coherent collective interpretation of all the indicators. The supplyside perspective offers a bullish interpretation of several key economic indicators. Let’s review the evidence.
Labor Day is traditionally the beginning of the federal election season. From that point on until the end of October, T-bonds showed a slight upward drift, while T-bill yields were moving sideways during that time period. It was not until the first few days of November that the T-Bill yields began a steady climb. Some may attribute the yield increase to the Fed. However, the fact is that yields were moving sideways before the election. If that is the case, it is very difficult to believe that the Fed’s actions were felt at the long end of the curve. The sideways movement at the short end prior to the election makes it very difficult to argue that the yield increase was Feddriven.
The rise in interest rates is consistent with an increase in the expected inflation rate and/or expected real interest rate. The question is which one is it: higher inflation or higher real GDP growth rates? The yield curve information poses a signal extraction problem for investors and policy makers in general.
Additional information is needed to solve the signal extraction problem. The rising slope for the yield curve and a declining spread for corporate bond yields provide some additional information that clarify the market signal. The expected increase in the slope of the yield curve reduces the likelihood that the long end of the yield curve will outperform the short end. The declining spread points to a relative outperformance of the corporate bonds over fixed income, suggesting that equities are likely to outperform fixed income instruments. Yet that does not answer the issue as to what happens to the inflation rate relative to the real GDP growth rate. Again, more information is needed.
The dollar reflects the price of two currencies and, under some general conditions, one can show that a dollar appreciation can be generated by one of three different variables:
1. A declining inflation rate relative to the rest of the world.
2. A rising real rate of return relative to the rest of the world.
3. A decrease in the risk premium relative to the rest of the world.
The dollar appreciation is a blow to the inflationistas, especially if one considers the fact that the rest of the world is not exhibiting rising inflation or rising inflation expectations. In that case, one can infer that a strong dollar points to a declining inflation.
Given all the analysis in the press and recent international developments, it is hard to argue that the Trump victory brought calmness to the world economy and thus lowered the U.S. risk premium relative to the rest of the world. Thus, the process of elimination leaves the real rate of return as the logical explanation for the rising interest rates and a strong dollar.
One simple way to test this hypothesis is to compare at the absolute and relative performance of the U.S. stock market relative to the world index. The U.S. stock markets are not only up, but they also outperformed the MSCI world index. The S&P 500 took off relative to the world index right around election time. The relative outperformance fits the real rate of return story and contradicts the inflation story. Although the markets may have gotten a bit ahead of themselves, we expect that after some catch up by the rest of the world markets, the trend will continue. We look for the international markets to catch up to the U.S. markets. Within the rest of the world, we look for some disparity in performance. We expect the Asia/Pacific region to underperform the emerging markets and these, in turn, to underperform Europe.
Since the election, we have seen the Russell 2000 appreciate relative to the S&P 500. If President Trump follows through on his pledge to reduce the regulatory burden on the economy, we expect the smaller-cap companies to outperform the larger-cap companies. Once again, the evidence supports our interpretation.
Putting it all together, the economic data since the election points to a rising real rate of return in the U.S., both in absolute terms as reflected by the rising stock market, and in relative terms as reflected by the rising S&P 500 relative to the MSCI World Index. The higher rate of return, in turn, attracts a capital inflow. That is reflected in the dollar’s appreciation. The rising stocks also induce a substitution effect away from other return-yielding assets, such as fixed income. Those with the smallest ties or links to the equity markets will suffer the most, i.e. longer duration fixed income instruments such as government bonds. This is reflected by an underperformance of the long end of the yield curve, which eventually translates into a rising yield curve slope, as well as a tighter corporate spread. The investment implications could not be clearer: increase exposure to equites, in particular smallcap domestic stocks. A reduction in exposure to fixed income instruments, in particular the longer duration government bonds, is also warranted.