Looking Beyond The 2016 Playbook
Markets moved quickly to price in the results of the U.S. presidential election, where the best-case outcome (from a market perspective) of a Red sweep and not a long and drawn-out contested outcome has come to fruition. Yes, the control of the House is still in question, but the latest count as of Friday evening had the Dems controlling 203 seats and the GOP at 214 – 218 are needed for a majority, and it’s expected the GOP will get to at least this number when all is said and done (Senate seats are 53 Rep. vs. 46 Dem). Equity markets wasted no time putting on the 2016 playbook, with the small-cap Russell 2000 index ripping +8.6% on the week and closing in on its all-time high reached in November 2021. The Nasdaq Composite rallied +5.7% (it has now risen in 8 of the past 9 weeks), the S&P 500 gained +4.7% (ended the week just 5 points shy of 6,000), and the Dow popped +4.6% on the week.
All 11 sectors ended last week higher, with Banks, Energy, Industrials, and the Tech sectors leading the charge. This was the best week for equities in 2024, and the S&P 500 hit its 50th record high of the year. It wasn’t just equity markets that rallied on the news. High yield spreads compressed to levels we last saw in 2007. The VIX experienced its largest weekly decline in three years, and the crypto market surged with Bitcoin making new all-times (approaching $85,000 as I type). The pace of the move following this Trump / Red sweep victory is much quicker than what occurred following similar election results back in 2016.
The bond market had a rough week, but yields settled down following the FOMC meeting, with the yield on the 10-year T-note closing at 4.30% - about where it was trading just before the election. Since the Fed first cut rates by 50bps back on September 18th (they cut an additional 25bps on Thursday), the fixed income market has priced out 100 basis points worth of policy easing for 2025, and now even dialing back odds that another rate reduction will follow in December. Futures markets now imply a roughly 25% chance that the Fed will leave rates unchanged in December (up from 14% a month ago) and a non-trivial 17% chance that the Fed will cut just one more time between now and June 2025.
This has been a tectonic shift in market pricing largely due to a rerating higher of economic growth estimates and indications that inflation readings are nearing a short-term trough. Last week’s post-meeting press conference by Jay Powell was as expected, and the Chair made it clear that the committee wanted to keep all options open for the December meeting. Powell was emphatic that there will be no policy response to any fiscal changes until they happen and can be fully modeled out. Said differently, neither he nor other Fed members have any interest in speculating on campaign promises and will await actual legislation before taking it into account.
Furthermore, Powell was adamant that policy is still restrictive while being convinced that inflation has moved towards target, and the committee’s goal now is to keep economic growth intact while holding the labor market in equilibrium. He was his usual measured self in stating that the Fed intends to be patient in its easing approach, but the ultimate aim is to get to a more neutral rate. What that neutral rate is remains an unknown, but by all accounts, it's somewhere in the 3.0 – 4.0% level on the Fed funds rate – so another 3 – 6 cuts from where we are at the moment.
The Fed has now cut rates -75 basis points from the peak, but the effect has yet to make its way into the economy as most borrowing rates are above where they were when the Fed cut for the first time in September. Namely in the housing market, where the average 30-year mortgage rate since mid-September has increased +70bps to 6.8%. In my opinion this will act as a governor to how high Treasury yields can go without creating even more recessionary pressure in the real estate market (mortgage applications have been down in each of the past six weeks).
Back to the election results and the Trump trade being put on by investors. While it needs to be acknowledged that a Red sweep does bring with it a message from voters that change is wanted (it seems as though the leftward lurch within the Democratic Party in this administration was a reach too far), I have reservations as to how easily such changes can be accomplished. For starters, the GOP is going to have a razor-thin majority in the House, and within its own party, it has 38 Freedom Caucus members who will exercise their values in regard to fiscal responsibility. After all, it is the House that initiates all bills in the legislative process, and my read of the tee leaves is that fiscal recklessness is not part of the mandate.
Humor me as we walk down memory lane, revisit the setup for the 2016 Trump playbook, and compare it with today. For starters, equities were flat to moderately lower leading into the election back in 2016 compared to being up roughly 20% going into the evening of November 5th. Not to mention, investors were depressed and confused following Brexit, with most of the polls showing Hillary was going to win. Market Vane sentiment was 57 then versus pressing against all-time highs of 74% today (see chart below from Rosenberg Research), and the equity-fund manager's cash-to-asset ratio was north of 3.5% back in the fall of 2016 versus historic lows of 1.7% at present.
As for valuations, the forward P/E multiple was 17x in November 2016 versus 23x today – almost every valuation metric from price/sales, price/earnings, price/book, the Buffett Indicator (market cap-to-GDP), and the CAPE multiple are near historic highs. To be fair, this rise in valuations has more to do with structural elements in markets than with politics, but it is a distinct difference in the setup of then versus now. Not to mention, the dividend yield on the S&P 500 is barely more than 1% today versus over 2% then. Investment grade credit spreads were +150 basis points then compared to +85 basis points today, while high yield spreads were +500bps versus +280bps now. Like equities, a lot of good news is already in the price today – not so much back in November 2016.
As for bonds, the Fed Funds rate had only one direction to move – up – with it at the lowly level of 0.5%. Today, it sits at 4.625% and is coming off the cyclical peak of 5.375%, with the Fed underway in a cutting cycle. The yield on the 10-year Treasury not in November 2016 was 1.8% compared to 4.32% today (near the highest level in the past decade), where it offers coupon protection that did not exist eight years ago. Bonds did not offer much competition for equities then, which is not the case today.
As for the economy, there isn’t much difference then vs. now. The unemployment rate was nearly 5% in the Fall of 2016 versus 4.1% at present, and GDP growth is a little bit higher, around 2.5% - 3.0%, compared to around 2% back then. Where things are a lot different is on the debt side of the ledger. The deficit-to-GDP ratio was 3% in 2016, with federal debt-to-GDP at just over 100%, and the government interest expense was under $500 billion. Today, Uncle Sam is running deficits of 6-7% of GDP, and federal debt-to-GDP is approaching 130%, not to mention that nearly $15.5 trillion in debt is due for refinancing over the next three years, which will push the government interest expense beyond $1.2 trillion annually. This represents a fiscal straight jacket and suggests that spending without restraint may no longer be feasible (maybe they will try, but we’ll see). Look, back in 2016, debt-servicing costs were absorbing just over 10% of the federal revenue pie, and that ratio is tracking towards 30% within two or three years even before the likely extension of Trump’s 2017 tax cuts.
It will be fascinating to watch policymakers navigate these fiscal constraints because these structural debt and deficit dynamics are real. When they matter is anyone’s guess – many have argued that we could never get to this point, but here we are. Economic theory suggests that a shift toward austerity is needed, but such a pivot does not seem likely in this era of populism. Remember that the debt ceiling, which was temporarily suspended last year, will come into play on January 2nd and will provide valuable insight into how this iteration of GOP control views this dilemma. From here, we can evaluate how to think about the other campaign goodies that were thrown around (15% top marginal corporate tax rate, tax-free tips, overtime, and social security…).
One thing the history books show about the Trump presidency from 2016 until COVID-19 hit is that it was not terrible for the bond market or inflation. It was the same policy prescription that’s being bandied about today – lower taxes, immigration curbs, and tariffs – yet during the three-year Trump tenure prior to Covid, both inflation and Treasury yields held firmly around the 2% level. So no, this policy mix wasn’t inflationary back then, and we’ll have to wait and watch to see if it works its way through the system in the same manner this go round, hence why I’m not afraid to own short-to-intermediate term Treasuries with yields in the mid-4% area.
The last point I’ll make on politics, which is more a general statement, is that politicians get way more credit and blame than they deserve. The U.S. economy is the most complex and dynamic system in the world, where most of the time, it's going to do what it's going to do irrespective of marginal policy moves. Sure, policies matter, particularly over the long term, but look at the chart below that shows the performance of the S&P 500 under both Democratic and Republican Presidents. It goes up and down under the leadership of each party – the grey dots measure the maximum drawdown under each Presidential term. Sure, you can get more myopic on the details, but I’d argue you’re missing the forest for the trees.
As for how I’m thinking about markets from here into year-end. Equities drift higher outside of some unexpected influence that jolts them off the current trend. Earnings continue to grow, with Q3 results showing that S&P 500 eps are up +8% y/y vs. expectations for +3%.
Furthermore, I expect the Trump trade and all the pin action caused by the choppy reshuffling playing out since Tuesday will start to fade over the next week or two. Then, the focus will shift to cabinet appointments, policy, and data. As for data and S&P 500 earnings, don’t be surprised if in 2025 we see some rotation back to the big is beautiful theme where Mega Cap Tech showcases its dominance. That is what we are seeing in the analyst's EPS projections over the next 12 months, with most of the other 493 not seeing a similar bump.
However, two things that will threaten the current drift higher in equities that I have been watching closely are the surge in 10-year treasury yields and the strength in the U.S. Dollar. The yield on the 10-year T-note is up from 3.65% on 9/17 to an intra-day high of 4.48% following the election – that is a meaningful 83 basis point rise in long-end yields while the Fed has cut rates by 0.75%. Keep in mind no one borrows at the Fed Funds rate, the Federal Reserve adjusts these rates with the expectation that eventually it will filter its way into intermediate and long-term yields. But there are a lot of other variables (inflation expectations, liquidity, risk appetite, economic growth…) that have an impact further out the curve. I ultimately think there are larger and more disruptive obstacles to equities and markets come the second half of 2025, but that is a worry for another day.
The dollar is hitting a fresh four-month high, and the gains against other G-10 currencies are broad-based. The dollar has risen for six straight weeks in its longest winning streak since February, but it's coming up against the upper end of the trading channel that has been in place since Q4 2022 (see charts below).
Unsurprisingly, a strong dollar is weighing heavily on commodity and international equity markets – the U.S. exceptionalism trade is on. One thing that caught my attention last week that I think is important is a comment from the Chinese Politburo (China’s top decision-making body):
“The wealth effect brought about by a rise in the stock market can directly increase investors’ income and boost income growth expectations, thereby translating into actual consumption”.
This sounds very similar to comments made by former Fed Chairman Ben Bernanke following the subprime crisis back in 2010 where the desire was to get stock prices higher to create a “wealth effect” and dispel economic gloom.
To me this is a classic illustration of Michael Hartnett’s adage, “when policy makers start panicking, investors stop panicking”. The Beijing put is in full effect and I think Chinese officials are done standing idly by while their stock prices decline. Without question, China has some real structural problems and so far the stimulus efforts they’ve announced and/or implemented have not been enough, but I don’t think they stop until it is enough. If so, this would bode well not only for Chinese equities but emerging markets in general.
Bottomline, with central banks in easing mode, corporate earnings growing, and governments around the world looking to stimulate activity – I think the general trend in equities and risk assets remains higher. Interest rates have moved up to a level where they are enticing and while gold is going through a necessary pullback I think it remains as asset that should be bought on dips.
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