
January 21, 2025
The prevailing bias among market participants ahead of and in the immediate aftermath of the November election was that the Trump policy agenda would lead to a more challenging growth-inflation trade off. Our non-consensus observation was that outcomes could vary widely depending on how and when they might be implemented. There are some obvious and we would argue, well appreciated, downside risks. Moreover, it will be easier to implement the market un-friendly elements of the agenda – increased protectionism, destabilising alliances, and reduced labour supply sooner than the market friendly elements. In contrast, the upside (market friendly) risks – deregulatory push, tax cuts, energy policy and fiscal consolidation – that could improve the growth-inflation trade off will likely occur over time.
Our sense is that the near term (downside) risks have “Trumped” the market friendly elements of the policy agenda. That is probably a key reason why US equities have made limited gains since November and emerging market equities are down about 6% over the same period. The correlated episode has been the rise in Treasury yields since September and the reflexive 10% appreciation of the US dollar index. The context is US equities (the global risk proxy) approaching 2000 valuation levels on a range of measures. A corollary is the extremely narrow credit risk premium and low (albeit increase in equity implied volatility (chart 1). To be fair, a key element in American exceptionalism in a relative valuation and profits sense, is the mega-cap tech sector. Valuations outside that sector are less extreme relative to the rest of the world.
Chart 1

Most market participants tend to focus more on nominal rates which can trend for long periods of time. However, real, or inflation-adjusted rates probably matter more for economic activity and asset valuation. Real rates tend to mean-revert within a range or trends. When real rates decline, they tend to relax broad financial conditions and support economic activity. That tends to contribute to a reflexive or self-reinforcing rise in rates which then leads to a renewed rise in the dollar. Similarly, long phases of low and stable rates lead to an increase in liquidity and leverage which eventually leads to an increase in volatility once rates rise again (chart 2). Phases of high US real rates have tended to be associated with dollar strength and tighter broad financial conditions.
Chart 2

The last spike in real rates back to current levels occurred in 2007 and 2008, with a lag that became evident in the macro news flow, compounded by lots of distortions in expectations. The time series below is over a relatively short horizon. However, a rise in rates and phase of US dollar strength (inverted in the right-hand scale -chart 3) leads US economic surprise indices by a few months. The magnitude and speed of the rise in real rates has probably reached the point where it will have consequences for equity valuation and potential explosive moves in volatility.
Chart 3

On the positive side, valuations, and expectations outside of the United States are much less euphoric. Moreover, the Administration will be likely to implement the market un-friendly elements of the agenda – increased protectionism, destabilising alliances, and reduced labour supply sooner than the market friendly elements. In contrast, the upside (market friendly) risks – deregulatory push, tax cuts, energy policy and fiscal consolidation – that could improve the growth-inflation trade off will likely occur over time and could create a more friendly environment for equities.
Bình luận