Henderson: Hey, big spender

Good Trump/Bad Trump

After years in the shadows, politics has made its big comeback as an investment theme. Few predicted a UK Referendum result in favour of Brexit, fewer still that the ‘King of Debt’ would become the 45th President of the United States. In this new world – where tweets announce policy, and personality moves markets – investors are having to learn on their feet. Assets haven’t behaved the way people thought they would: a Trump presidency was expected to trigger a lengthy sell-off in US equities, but the S&P 500 has continued to climb, buoyed by ‘reflation trades’. Investors have been pricing in ‘Trumpflation’, believing that the new administration will make good on its pledges for US$1trn infrastructure spending, significant corporate tax cuts, and measures to re-shore domestic manufacturing. While these could be good for growth and inflation, we are worried that the market is understating the potential for ‘bad Trump’ outcomes: the increased chance of a trade war (China, Mexico, Germany) and a ratcheting up in geopolitical tensions (China, Iran, Russia).

Old money, new money

While political developments have been grabbing column inches, monetary policy has been receiving comparatively less attention. Behind all the noise of Brexit and Trump, the major developed market central banks have been dialling down their stimulus. Their foray into negative rates and broader baskets of asset purchases looks to be at an end. The US Federal Reserve has already embarked upon raising interest rates, signalling three hikes in 2017. Investors should not underestimate the significance of this shift: there could be serious ramifications for areas of the market that have benefited disproportionately from quantitative easing. As monetary stimulus recedes, fiscal stimulus is touted to take over, not just in the US, but also in other major economies. Pressure to act is growing in Japan, and fiscal expansion is becoming a theme across Europe too, now that austerity has slipped from the policy agenda. This further supports the view that we can expect more growth, more inflation and further rate rises. This could cause indigestion within the bond markets, after a 30-year run-up in prices.

Europe: populism and popularity

In Europe, the election cycle presents political risks, which we continue to monitor carefully. Brexit has dealt a blow to the European Project, and populist parties have seized their chance to try to widen anti-EU fissures. Although it looks unlikely at this stage any of them (Party for Freedom, Netherlands; National Front, France; Alternative for Germany) will gain enough support to form a majority or governing coalition at elections this year, the seats they win could disrupt policy-making mechanisms. If we look at investors’ attitudes towards European investment, however, there is an argument that they are being overly pessimistic. Equity valuations do not appear as stretched relative to the US, and with spare capacity in the euro-area labour market and lower inflationary pressures, corporate earnings could play catch-up with their US peers. We are being selective in our allocations across Europe, looking for pockets of growth and value.

The new regime

We believe reflation is coming as the recovery continues. We also expect fiscal policy to define the new regime as central banks step back from stimulus. In this scenario the performance of assets are likely to diverge as investors reassess the value of their investments. Broadly, we think this environment is supportive of equities – although we think returns could be lower than recent years. Our tactical strategy, given political unknowns, is to exercise caution but be prepared for opportunities. This has seen us tilting into reflation trades, such as commodities and instruments exhibiting a value style bias, while at the same time taking profits on trades that have performed well for us, such as high yield bonds. Market volatility looks set to pick up around election dates, on noise surrounding Trump’s policies, and further Brexit developments. We will look to add to areas dynamically where assets have sold down and we see value appearing.

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Glossary

Fiscal policy: government policies involved in setting tax rates and government spending levels. Fiscal expansion typically relates to an increase in government spending and/or a reduction in taxes.

Reflation: policies intended to stimulate an economy and promote inflation (rising prices). Reflation trades are investment positions that could benefit from rising inflation and higher economic growth. ‘Trumpflation’ is the inflation that may appear as a result of Trump’s policies.

Spare capacity: unused economic resources (labour and capital). If an economy has spare capacity it can respond to an increase in aggregate demand without suffering pressure on supply.