A lot has changed in the world since markets reeled in the immediate aftermath of Brexit. Donald Trump’s unexpected ascension to the US presidency has accelerated a shifting market narrative of higher growth and reflation.
After several years of austerity politics and central bank liquidity, there is now an evolving consensus that governments need to spend their way out of the low growth trap. The focus is the US, where perceptions of a pro-growth agenda have ignited the ‘Trump trade’. Cyclical stocks – industrials, financials and energy – continue to surge ahead, propelling major US equity benchmarks to record highs.
As global growth forecasts have been revised higher in 2017, investors now talk about the revival of animal spirits, whereby confidence becomes self-fulfilling.
Expectations may well have run ahead of reality, leaving room for potential disappointment as we move through this yearTime will tell whether this is the case or, rather, if this new found optimism fades away. Assuming Trump can cut corporate taxes and attain budgetary approval to significantly increase infrastructure spending – and the support of a Republican controlled Congress must surely increase his chances – these policies are expected to lead to stronger business investment and improving corporate profitability.
More confidence in the US reverberates globally. Since late last year, we have seen sizeable recoveries in business sentiment surveys globally. The most notable improvements have been seen in Japan and Europe, economies contending with disinflationary forces.
Some of this rebound in survey activity is now translating into actual activity data, such as stronger export growth and rising levels of industrial production. The hope is that a strengthening economic backdrop will help to ameliorate some of the populist forces in key countries facing elections this year – the Netherlands, France, Germany and possibly Italy.
Is all of this sounding too good to be true? Expectations may well have run ahead of reality, leaving room for potential disappointment as we move through this year. While financial markets so far appear resilient, their progress has been punctuated by a few ‘show me’ phases, in which investors have questioned whether expectations of stronger US-led growth will be backed-up by actual policy execution.
The fear is that the pro-growth agenda in the US will be overshadowed by the focus on protectionism and nationalism. While lower taxes, more spending and more jobs are good for growth, these benefits are likely to come with the costs of impinging on global trade, the possibility of too much inflation and worries about the funding of government deficits in the longer term.
The risk of individual human error is also on the rise, whether by accident or design, as leaders in the US, UK and Russia speak to electorates through the prism of ‘new nationalism’. While the status quo is likely to be maintained in the various elections in Europe, we cannot discount the risk of a Marine Le Pen victory in France.
Assuming that the political hurdles are cleared in Europe and we see some moderation in the nationalist rhetoric, we must also consider the unwanted side-effects of a US economy that runs too hot.
Higher inflation reduces real incomes over time and acts as a constraint on household consumption. Rising price pressures could spark a significant upward move in US Treasury yields and a stronger US dollar. Both of these factors have the potential to curtail global growth, create stresses in emerging markets as well as in the financial system more generally, and ultimately, sow the seeds for a slowdown in US growth.
A central view remains that the longer-term inflation outlook remains benign by historical standards, with the effect of higher energy prices likely to be transitory. Moreover, the structural cap of ageing demographics and technological advancements on the job market should help to limit a material increase in wage pressures.
There are many risks and for this reason it is prudent for investors to continue to hold reasonable levels of liquidity, which can be used as opportunities inevitably arise during periods of market volatility. But accepting those risks, it can be argued that the reshaping of US politics has changed the environment to one that is more constructive for risk assets in the near term. Investors find themselves in uncharted territory as we enter the eighth year of the extended bull market. There is a sense, though, that developments in the US could support the market just that bit further.
Noland Carter is chief investment officer at Heartwood Investment Management
