The Trump Euphoria: Fantasy vs. Reality

After the surprise results of the U.S. presidential election in November, markets moved decisively to the upside on anticipated household tax reform, along with Trump’s official promise to focus on corporate tax cuts and deregulation. Trump’s pro-growth plans for fiscal policy have fueled speculation about whether Keynesian “animal spirits” (emotional responses that inform consumer confidence and behavior) could lift U.S. economic growth, from economists’ prior estimates of roughly +1.7% to nearly 3% or more over the coming year. Business and consumer confidence measures have surged, and if maintained, argue for an acceleration in growth as businesses and households start to consume and invest more today.

Still, we remain cautious on the economic front, as markets have priced in expectations for rapid earnings growth (over 40%) for the coming year (depicted in Figure 1 below). The markets are discounting a minefield of risks that exist both domestically due to policy uncertainty and geopolitical risks driven by excessive leverage and rising populism across the globe. With Trump’s election, the Brexit vote, Italy’s “No” and China’s debt and currency woes, the world economy has embarked on a journey into the unknown. Acknowledging Mr. Market's bias to the upside, we attempt to assess how punch drunk the party really is. Using history as our guide, we note that, often times, the punch keeps on coming, and investors get toasted. Accordingly, we manage assets with financial prudence, taking advantage of today’s herd dogma with exposure to domestic equities, but remain vigilant to the prospect of a ‘breakout’ event that could drive an abrupt shift in the economic consensus.

Figure 1: Earnings Revisions to Analysts’ Estimates for 2017 

Note that Figure 1 reflects analysts’ collective revision to earnings for the S&P 500 (all companies) – in January alone, street analysts have projected a 43%+ boost to corporate earnings. This is incremental to the upward revisions made by analysts prior to the 2016 year-end, following the pro-growth announcements made by Trump in November.

The world has now fully arrived in a radically uncertain, seemingly stable but not secure predicament. The only certainty, in our view, is that the tails of the distribution of potential macro outcomes have grown fatter. “Fat tail risk,” or higher risk to the downside, has emerged and is defined by elevated and rising debt levels, monetary policy exhaustion and the populism-powered transition toward ‘anti-globalization.’ The ‘hope trade’ on the back of Trump’s pro-growth policy announcements is likely overdone, but only time will tell when the markets will reset expectations.

Risks that keep us on the sidelines with respect to international (ex U.S.) equities include:

(i) the impending collapse of the European banking system, resulting the eventual disintegration of the European Union;

(ii) a 'balance-of-payments' crisis (capital flight) in China, the world's second largest economy, coupled with the nation’s $34 trillion in new debt accompanied by monthly deficit spending of roughly $80 billion which, if sustained throughout the coming year, would bankrupt the nation by the end of 2017;

(iii) currency crises in much of Latin America (e.g. Brazil, Argentina, Venezuela), where countries borrowed heavily in cheap U.S. dollars as the Fed opened the liquidity spigots during the QE craze, suppressing growth in these markets as debts rise in value as currencies weaken relative to the dollar, threatening these countries prospects for economic prosperity;

(iv) the devastation caused by India’s ‘cash ban,’ a move that in our view represents among the most ludicrous episodes of government-led financial mismanagement, which largely remains misunderstood by the population outside of India (though the media is, ever slowly, beginning to catch on); 

(v) sluggish productivity growth coupled with growth-suppressive demographics in much of the developed world, including the EU member countries, Britain, and Japan; and

(vi) most importantly, over $250 trillion, or multiples of the world’s total (aggregate) GDP, of opaque derivatives exposures concentrated among the world’s twelve largest banks. This alone could collapse the international monetary system as we know it.

The following chart illustrates the magnitude of the global banks’ exposure to derivatives, using Deutsche Bank as an example.

Figure 2: German GDP vs. Total Eurozone GDP vs. Deutsche Bank Derivatives

Figure 3 that follows lays out the 25 banks with the greatest derivatives risk (measured by derivatives exposure relative to assets) at the end of the 3rd quarter (2016).

Figure 3: Top 25 Banks by Derivatives Risk (excl. Credit Derivatives)

Source: www.occ.gov

In a follow-up article I will discuss how these derivatives exposures pose a massive threat to the global financial system.

Turning to the domestic market – as Trumponomics looms, consumers have taken a very positive stance on our economic prospects.

It is hardly unprecedented in politics for the promises of the campaign trail to dramatically change by the time policies are actually implemented. Tax law changes may not take effect until 2018, and deficit-financed spending – if fiscal conservatives allow it to pass – is unlikely to occur until the fiscal year beginning October 1, 2017. Infrastructure projects in particular are notoriously slow to commence, and could be further delayed if the incoming administration seeks to establish an infrastructure bank to finance the planned spending (through a combination of public- and private-funds). For a myriad of reasons, the direct economic impact of fiscal-policy proposals could remain elusive throughout the 2017 calendar year.

Moreover, the range of potential economic outcomes based on planned policy announced to date is complex, with growing tail-risk on both ends of the curve. Pro-growth policies could support riskier assets (equities). But, tougher trade policies could create significant foreign policy risks, triggering sharp ‘risk-off’ moves.

Globally, central banks have created a warped sense of reality through a form of consensus groupthink, particularly among the elite market participants, or those who seldom question the unquestionable authority of the central banks. Remember, central banks are not omnipotent. The next "Too Big to Fail" could become "Too Big to Bail-Out."

Blind assumptions have led to mistaken beliefs, including (among others):

(i) that bonds are a safe haven and when 'risk-off' movements occur, bond prices will go up and yields will fall. To the contrary, history shows that when consumers lose confidence, panic erupts as consumers rush to sell assets and withdraw funds. Selling begets selling. When this happens, the correlation between equity and bond market performance breaks down -- both move in the same direction (down, and fast). As an example, for a period of time during the 2008 panic, you could not find a buyer, at any price, to offload AAA-rated corporate debt (think Proctor & Gamble intermediate-term bonds). Even U.S. Treasuries, presumed to be 'risk-free,' were selling in thin markets at firesale prices.

(ii) stock price declines will be truncated by policymaker intervention, thus we needn’t worry about any meaningful pullback; and

(iii) no major financial institution will fail in a way that could cause a new Global Financial Crisis (GFC II), thanks to central bankers and their blinding quest to stabilize prices.

It seems to be common belief that the central banks, or self-proclaimed "magic people," will always step-in and save the day. But what people fail to recognize is the magnitude of growth throughout the global banking system, both in scale and complexity. Opaque, over-the-counter (non-public) derivative exposures make any attempt to evaluate solvency among the world's largest banks a virtually impossible task. The banks themselves would be lost trying to disentangle the mess.

The various thought dislocations discussed previously make today’s sensitive market outlook particularly well-suited to active management.

To contact the author with specific inquiries, you may email her at [email protected]

-- Submitted by Emma Muhleman, CFA, CPA (January 20, 2017)