Throughout the 2016 Presidential election the news was full of analogies of Donald Trump and Ronald Reagan from the standpoint of how Trump's bold planned economic tax cut initiatives mirrored the "Gipper." Not many in the journalism business gave Trump a chance going into Election Day, so when the unthinkable happened on November 8th the financial markets were caught off-guard. The markets began to quickly re-price as news of a possible Trump victory turned from a low probability into reality on election night. The trading in the E-Mini Dow Futures December contract (CBE: YMZ6) (NYSEARCA:DIA) showed a very wide swing in value when reviewed on the timeline from election night through the trade once the US market opened on November 9th.
The "knee jerk" futures market reaction was to plummet, triggered by large drops in the Nikkei (JP:NIK) (NYSEARCA:EWJ). The investor response seemed to be an overseas driven reaction to expected Trump trade policies. When the price level bottomed around midnight around 17,400 on the DJIA, the expected plunge in the DOW would have put the DOW Index in negative trading territory for the year, which usually happens when there is a high probability of an impending recession.
However, market buyers entered the market by the time the election was being called for Trump, and it ascended right through the close on November 9th. And the buying euphoria did not stop as the DOW reached a new all-time high on 11/10/16, and bettered the mark the next day. News reports were numerous saying that the DOW's performance for the week had not been this good in a long time, (see Trump Optimism Propels DOW to Best Week in Five Years).
What can explain the "head fake" plunge in the futures market election night, and the post-election day euphoria in the cash market? Stock values are driven by expectations. From the recent trading pattern it is likely that a group within the futures trading community, probably more internationally biased, initially sold the news hard because they were not positioned correctly for a Trump win. Once the market opened, the breadth of the trade meant that the market move was more than a short covering rally. A larger group of investors recognized that "highly probable" across the board corporate tax cuts meant US corporate earnings forecast would need to be re-assessed higher - for some companies more so than others. So trading pattern reflected not only a broad market move higher, but also a portfolio rotation into stocks investors expected to fare better under a Trump administration like defense (NYSEARCA:ITA), healthcare (NYSEARCA:XLV), financials (NYSEARCA:XLF) and oil (NYSEARCA:XLE) (ALMP). And out of the previous market leaders, primarily tech-related (NYSEARCA:IYW).
I get the market move up and the portfolio re-allocations. However, I personally advise against investing new money in euphoric markets based on politics as there is usually a "gotcha" in the works - for traders, however, the volatility brings opportunity. The initial impression of the futures market, although I doubt the low water mark of 17,400 will be breached by the market by December, may turn out to be a level which the market will easily break through as we progress through 2017.
To give some hard evidence that this perspective is not too farfetched, I went back in time to review the market reaction when Ronald Reagan became president and his bold tax cut plan was approved and implemented. Then, I bring forth the eerily similar market metrics and expected trends, which although the time periods seem completely different, actually show that on a relative basis the stock market may well suffer the same demise.
Stock Market Reaction to Reagan Election
How many investors, without actually looking back in time to review the data, actually recall that the Reagan stock market actually broke down and fell substantially below its post-election euphoric all-time high set immediately after he was elected? Post Reagan's election the S&P 500 (NYSEARCA:SPY) (SPX) roared higher over 10% in the month November, and essentially held that new all-time high mark through the first quarter of 1981.
However, once the honeymoon was over and the markets began to adjust to reality, stock prices began to tumble. By the end of the 3rd quarter of 1981 the market closed down almost 20% below the all-time high, clearly signaling the 1982 US recession. Throughout the recession, however, the stock market was able to maintain values above the March 1980 pre-election level of 103 (36% below the all-time high mark) where the pre-election run-up in stock prices began.
What are some of the factors that precipitated the major pre-election run-up in 1980? Was it just investors anticipating the Reagan policy change? Or, were there Carter monetary and fiscal policy moves made leading up to the election that "juiced" the market? The historical data show that the run-up was definitely a function of both. The biggest Carter pre-election influence came in the form of a major monetary policy boost in the form of a 900 bp (yes 9%) drop in the Fed Funds rate which remained in effect from May through August before escalating again. Additionally the Fed was an active buyer of Treasuries during this time window, even with the high inflation rate which was being driven by a combination of high rates of fiscal spending growth and all-time high oil prices.
The changes the Reagan agenda eventually implemented would reverse many of the extreme financial market conditions that were occurring at the time. The stock market initially reacted favorably in a risk-on fashion post the 1980 election, but then had a reality check, most likely due to wearing off of the pre-election economic stimuli, the lag in the fiscal policy affect and the blunt force of higher real interest rates during the transition.
Contrast of Extremes 1980 vs. 2016
How does the 1980-81 experience compare to the situation that investors face now that Trump has been elected in 2016? This question is very pertinent given the close analog in how Trump's planned policies will shift the fiscal policy, monetary policy dynamic in Washington. In so many ways the two points in time seem so obviously opposite in terms of financial extremes.
The elephant in the room in terms of differences, then versus today, is the relative magnitude of the US debt. Relative to GDP the US debt is now over 3 times higher, with almost 2.5 times more of the publicly traded debt on a proportional basis held by foreign entities, either sovereigns or multi-national corporations. The interesting consequence of the policies under Carter are that inflation in 1980 was at an extreme high, and as a result interest rates were very high, buoyed by extremely high inflation expectations and excessively high money supply growth.
The extreme reversal in these economic statistics began when Reagan took office, but really accelerated in the 1990s with international arrangements with China and the signing of NAFTA caused a steady deflationary wage induced spiral to grip the market through time.
1980 Marked Watershed Turning Point - And 2016 May Also
As much as these two points in time seem to be a contrast of opposites, looking at the situation in relative terms rather than on an absolute basis, the two situations become much more similar. At the point leading up to the 1980 election the US economy was experiencing very low real growth, not keeping up with inflation. In fact, real GDP grew -1.6% in the 12 months leading up to the November 1980 election. And the American electorate felt the problem.
Likewise, the Fed leading up to the 1980 election, as it had been throughout the 1970s, was guided by the philosophy that targeting interest rates was the best way to encourage economic growth and keep unemployment low. The result is that the Fed prescription when the economy looked bad was to allow real short-term interest rates to run below the inflation rate, i.e. negative interest rates. You can see that was exactly what was happening pre-election in 1980 as the economy was weak.
And, not surprising to me, the Obama administration's major policies of high fiscal spending and targeted interest rate monetary policies produced a similar economic scenario leading up to the 2016 election. The fiscal spending levels as a percentage of GDP in both time periods are virtually identical. Reagan campaigned on the promise to reign in federal spending at the time; however, a democratic majority House of Representatives stood in his way of dramatically changing fiscal spending in Washington. However, he did manage to slow down the fiscal spending growth rate, which eventually led to lower inflation.
Given the economic situation similarities in both time periods, you can see the appeal of the similar Trump and Reagan prescriptions, aggressive across the board tax cuts. The change in both cases puts fiscal policy, not monetary policy, much more at the forefront in potentially affecting economic growth. The question investors should have, however, is how did the financial markets respond in 1981 to the increased government financing need as the tax cuts were implemented, and will the markets react in a similar fashion this time around?
In 1980 Fed Changed Monetary Policy in Response to Fiscal Policy Shift
Once Reagan was in office, the Paul Volcker-led Federal Reserve took over and control of the money supply, not targeting interest rates for economic stimulus, became the guiding principle in an attempt to rein in inflation. At least that is how the history books read. Most definitely the real rate of interest was pushed up aggressively as Reagan took office and negative interest rates were not a Fed policy tool for another 12 years, and then only for a brief period until the War of Iraq under Bush II.
The rise in the Fed Funds rate in 1981 was initially greeted by the corporate bond market as welcome as the Treasury to Corporate spread narrowed indicating a risk-on trade. However, by the summer of 1981, the risk-on trade reversed and corporate bond interest rates churned higher as the Fed Funds rate moved lower as investors fled to Treasuries and out of stocks in anticipation of the upcoming recession. Through this time period inflation actually began the long process of reversing off its historic highs. But interest rates remained historically high in real terms.
Why did interest rates remain so high relative to inflation even when the economy was in recession? There is a very simple explanation - the change in fiscal policy meant the US had a growing deficit to finance. By comparison, in January of 1980 the US government needed only $3.6B per month on average in financing on $550B in annual fiscal spending. By the end of 1981 the financing need had more than doubled to $8.9B per month on $650B in annual spending. And by the end of 1982 the financing need almost doubled again to $15B per month. The deficit spending has only intermittently changed course from moving progressively higher since 1980.
Based on this analysis, the most likely culprit that led to the 1981 stock market demise under Reagan was most certainly not his tax cut plan. The stock market correction was the market response to interest rates going up, and staying up as the Treasury entered the market to finance its large new funding gap. Eventually the higher rate structure slowed economic growth and the stock market suffered. However, the overall impact of the tax cuts laid the foundation for higher long-term growth, and the economy came roaring back in 1983 and 1984.
Immediate 2016 Treasury Market Reaction - Risk on
It should come as no surprise to many that the immediate response by the US Treasury market to the Trump election was a spike higher in yield and lower in price, just like 1980. This observation holds true across the entire Treasury yield curve, but is more pronounced on the longer duration bonds.
The bond market is leading the way down (higher rates) at this point, making room for a massive shift from monetary policy trying to promote economic growth, to fiscal policy having a kick at the can. The Achilles Heel for the Trump fiscal plan is going to be financing. Foreign money is exiting the Treasury market at an abnormally fast pace at the present time, when compared to the past 25 years when it normally has shown an insatiable buying appetite. (See my prior article here for more data on this topic)
Interest Rates Likely to Continue Higher in Response to Fiscal Policy Shift, but not as strongly as 1980
If the virtuous flow of foreign capital continues to reverse going into 2017, US interest rates will continue higher and could explode much higher. If this happens, there is nothing the Fed can rationally or politically do, except possibly lag in increasing the short end of the curve in order to keep the cost of the debt as low as possible for the new Trump administration. If the Fed, in working with the Trump Treasury chooses this course of action, it would be similar to the "even keel" policy of the 1960s and 70s, which was inflationary.
There is ample US money supply in the world today, given the extraordinary monetary policies under the Obama-influenced Fed, to spark a serious bout of US inflation if a major fiscal policy initiative is unleashed without a major, corresponding rise in rates. The $2T USD of excess reserves in the financial system worldwide is currently "dead" money which has allowed the Fed to keep rates historically low. Turn that money into a US fiscal spending plan which uses these reserves and the Fed is going to have a real chore in keeping both inflation expectations and reality in check.
I believe the current round of market rate re-setting is primarily about the tax plan financing. If Trump pushes his Trade plan hard, rates will go even higher, but at some point the dollar should actually break down (opposite of right now). The exiting of international flows of funding to finance the US debt provides an interesting dynamic as foreign governments would expectedly push back on the Trump trade plan by withdrawing funding. The current circumstances seem to put the US government in a "darned if you do, darned if you don't" situation, just like they had in grappling with very high inflation in 1980. In 1980 the country chose the path of high real interest rates, which worked well through the 1980s. The right path is probably the same today, but will require a lower, not higher dollar to be successful.
Once the trade deals in the 1990s gave countries incentives to "cheat" to gain trade advantages by keeping their currency weak against the U.S dollar, dependency on foreign money to fund the U.S. debt grew, and U.S. businesses, particularly manufacturing, paid a severe price. Reversing this trend will not be easy, especially when the action of proposing a major fiscal initiative to drive the U.S. economy leads to higher US rates and simultaneously a stronger dollar - at least at the present time. Trump has a negotiating challenge on his hands when foreign countries act to withhold support for his trade plan simply by withholding financing, and by so doing, their goods and services become even more competitive in the US market. Just watch the price of oil continue to decline as this phenomenon grips the market. Shale producers suffer as this happens, and so does US energy independence.
I believe the Trump plan means the Fed will move to the sidelines and back to at least a neutral stance relative to inflation on short-term interest rates, rather than negative rates. The position will be inflationary enough to allow Trump to deliver on his trade promises, whereas in 1980 the Fed chose a much more deflationary high real interest rate policy.
Trump Post-Election Market a Trader's Delight
The information I have shared in this article leads me to believe the Trump stock market has a good chance of continuing higher in the near term as the bulk of the selling pressure is being borne by the bond market.
The trade right now is definitely risk-on, out of the collapsing Treasury bubble and into a temporary hiding place of equities driven by post-election euphoria based on expectations of better corporate earnings going forward with lower taxes and regulations. However, I expect this trade to reverse, probably at some point after the 1st quarter of 2017, as rates and economic reality cause stocks to hit the breaking point.
The analog to this very scenario is what happened pre and post Reagan's election.
My opinion is that any portfolio re-balancing should be defensive as prices rise, not offensive at this time. Offense should not be played again until this scenario plays itself out over the next several years. Stocks are likely to either rise or stay near their current all-time high through year-end and probably the spring of 2017 as the Trump plan is approved. But I believe a big gotcha is in the works and if this assessment is correct, stocks will get clobbered given the Fed bubble that underlies the market valuation. Investors need to pay attention to the credit market for signs when the attitude changes from risk-on to risk-off going forward. Overall, I would trade this market, but not put new money to work long-term at this time.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.