Higher, Higher, and Higher
Bank of America Meryl Lynch put out an interesting piece of research this week raising alarm bells over a potential déjà vu in the financial markets. The recipe of a run up in stock prices led by financials, tightening of credit spreads, declining volatility, and a decline in real interest rates where all factors that preceded the “taper tantrum” in the US in 2013 and the German bund “tantrum” of 2015. In both these instances, whether fundamental reasons were because of the US Federal Reserve paring back their asset purchases or anticipating inflation in the EU, significant moves higher in yields were witnessed.
Since Trump’s inauguration, now 5 weeks into his presidency the S&P 500 is up 4% and both the Dow Jones Industrial Average and NASDAQ are up over 5%. As many begin to question the stability of this rally as US equity markets have already matched the average year-end forecast of analysts surveyed by Bloomberg, others are left wondering whether this market has legs.
While we could begin to see some volatility here in the short term, there are a number of positive factors that lend support to the equity markets through the first half of this year. First, the chatter around the US Fed at the moment is that the likelihood of a March rate hike will be pushed off until June. Second, as recently confirmed US Treasury Secretary Steve Mnuchin told the Wall Street Journal this past week, he sees an overhaul of the US tax system by August. Third, investors continue to anticipate a “pro-business” agenda of the Trump administration and the Republican controlled chambers of the US Congress.
Janet Yellen and the US Fed seem to be making their way out of the headlines, which is likely where they’d prefer to be. Since the financial crisis, Federal Reserve officials have made the case for the need of fiscal policy over (or in combination with) ultra-accommodative monetary policy. This includes or commonly alludes to increased government spending on infrastructure projects, which has been perhaps the one amenable proposal of the Trump Administration with the Democrats. That would further take the Fed out of the spot light in the near future. Furthermore, recent headlines have hinted at the disagreeing remarks between the Trump White House and Fed Chair Janet Yellen. The new administration will have influence over appointments in the years ahead, and how that changes the trajectory of Fed policy is ultimately unknown. It’s always been my view their policy decisions were made between a rock and a hard place.
The changes to the US tax system, along with proposals to make the US more “business friendly,” (which is as ambiguous as it sounds) are the second and third factors driving investor sentiment. Jack Mintz opined in the financial post this week that Canadian’s should be worried about the Republican Tax plan not because of a border adjustment tax, but because it makes their tax code more competitive and will attract investment. The border adjustment tax is no different in nature than the GST, or any other value-added-tax in place in 150 countries around the world.
Certainly equity market valuations seem elevated in terms of how quickly we have moved higher in the recent months. And although accompanied uncertainty may prompt some volatility, the ultimate question is what has motivated this leg higher and whether any of those factors have changed. At this point, the answer seems to be not yet.