“The most radical revolutionary will become a conservative the day after the revolution.” H. Arendt, The New Yorker, September12, 1970
In his inaugural speech, D. Trump promised an era of radical change, and the first few weeks of his administration were inspired by a revolutionary (and chaotic) vision of the United States’ role, interests, and priorities. Four months later, the new administration has postponed or backtracked on most of its key initiatives: the “Muslim ban” has been stricken down by courts, the repeal and replacement of Obamacare died in the swamps of Congress, ideologues have been replaced by pragmatists, protectionists have been replaced by free traders, realpolitik has fostered a much more amiable treatment of China, and foreign policy has returned to its usual interventionist and anti-Russia course.
Markets have followed a similar pattern. A giant “Trump trade” swept markets following the election: yields soared, the dollar strengthened, the Peso plummeted, gold sold off, and investors rushed to buy banks, cyclicals, value stocks, small caps, high-volatility stocks and high taxpayers. Based on the 10 Trump trades I track, this trend peaked in early January, and has reversed by a median 89%.
The second part of this report will look at flows, which are starting to adjust to the new “post-Trump” reality, and revert back to pre-election themes.
This study of flows and the great Trump reversal raises two questions going forward. First, the S&P 500 index is still about 11.6% higher than it was on November 7: if all the other Trump trades have reversed, when will equities adjust to the new “New Normal”? Second, if the Trump administration is going to follow the recent Republican pattern of high deficits, free trade, a weak U.S. dollar, and interventionist foreign policy, should we not expect the same causes to produce the same effects, i.e., a massive outperformance of European and Emerging Markets equities, as was the case under the Bush administrations?
Trump Trade Fatigue
After a few hours of confusion, a consensus rapidly emerged that the Trump administration would be pro-growth, pro-business, anti-tax, and anti-regulation. “Animal spirits” were unleashed and investors bid up bank stocks at the expense of defensive utilities (red line in the chart below), small caps over blue chips (orange line), value over growth (blue line) and energy stocks (black line). Four months later, two of these trades have fully reversed. Energy stocks have even dropped below their pre-election level on an absolute basis.
A less obvious trade that was favored by many brokers was to overweight companies with a high effective tax rate as they would benefit the most from corporate income tax reform. Alas, the trade peaked on a relative basis in mid-December, and suffered from the failure of the repeal of Obamacare. Similarly, high volatility stocks have given up all of their post-election gains.
From a global macro perspective, the Trump trade meant buying the dollar against the Mexican peso, selling gold, and selling long-term treasuries. But gold is back to its pre-election level, the Mexican Peso is modestly higher, and 10-year yields have given up about half of their gains.
Flows’ Slow Reversal
Investors had massively embraced the “Trump trade”. Commitment of large speculative traders, which track the position of large hedge funds on future contracts, showed a massive net long position on small caps in November and December. This position has now reversed and speculative traders have come back to where they were before the election: long large caps and short small caps
ETF flows have also normalized, albeit at a slower pace. Cyclical sector ETFs attracted $10.7 billion more than their defensive counterparts in the week that followed the election. The gap has narrowed to $4.9 billion because of large outflows from financial ETFs and steady buying of real estate and utilities ETFs
Similarly, selling pressure on foreign ETFs has abated. Europe and Japan funds have issued 8.6% and 10.5% of their assets respectively this year, exceeding inflows into U.S. equity funds. Even Emerging Markets funds have more than recouped the assets they lost in the aftermath of the election. Based solely on performance, I would have expected a larger rotation outside of U.S. equity funds since the category has largely lagged behind Europe and Emerging Markets funds this year, which brings me to my last question.
One Last Question
The table below summarizes the performance of ten Trump trades. Three observations stand out:
- On average, the “Trump bump” peaked in early January
- The Trump bump has reversed by a median 88%
- The S&P 500 index stands out as a trade that has barely reversed: its “Trump bump” lasted the longest, and the index is still just a good day away from its all-time high
Why would the “Trump effect” resist among equities, while it has faded among other asset classes? Part of the reason is that U.S. equities are grossly overvalued, and that they have failed to re-price for higher yields. Seven Reasons Why Higher Rates Have Not Killed the Bull explained why it happened, and why this respite should not last. The second reason may have to do with the sense of relief that D. Trump will eventually follow a fairly conventional Republican agenda: increase deficits, support free trades, and use military force to defend the perceived U.S. interests abroad. G. W. Bush followed this approach for most of his mandate, and U.S. equities rallied by about 6% a year between 2002 and 2007 (albeit from a much lower valuation).
But the real “Republican trade” was to overweight Europe and Emerging Markets, which benefited the most from the U.S.’s deficits. Europe and Emerging Markets outperformed U.S. equities by 100 percentage points and 290 basis points, respectively, over the period. As D. Trump walks away from his nativist program, the best opportunities are likely to be found overseas – and a much cheaper valuations, too.
Article by INTL FCStone Financial
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