(Bloomberg View) — The past few weeks have revealed a systematic unwinding of what had been called “the Trump trades.” After the U.S. presidential election in November, equity markets didn’t fall as many had expected. Instead, we saw higher interest rates, a stronger dollar and an upward ratchet in stock prices, in the market expectation that President Donald Trump might prove better for the economy than Hillary Clinton. Those effects on market prices are mostly gone now, but so far I, contrary to many of Trump’s critics, still expect relative calm to continue.
An initial question was how much of the Trump equity boost came from the expectations of a corporate tax cut, or perhaps hopes of deregulation, including for the financial sector. To that extent, higher stock prices might have been reflecting the expectations of a redistribution of income to corporations rather than hopes for economic growth. Now, with the efficacy of the Trump administration dwindling, and the potential corporate upside receding into the distance, we are learning that the market still sees the status quo as acceptable for equity valuations. Even though the VIX, one measure of market volatility, did spike last week, it is still well below its 2011-2012 levels, or for that matter early 2016.
The point here is not that the market is always right. Rather, confronting market prices as powerful aggregators of information forces us to articulate whether we agree or disagree, and to address where the conventional wisdom might be wrong.
When observing the evolution of market prices in reaction to Trump, I am currently left with a mix of very optimistic and very pessimistic sentiments.
First, the European Union, and not the United States, really does remain the center of Western civilization. The underappreciated good news is that European growth rates are edging up, the euro as a currency appears to have a more secure future, and Brexit, though I view it as a major mistake for the United Kingdom, is not pulling apart the broader European project. The refugee crisis has stabilized, and right-wing populist parties are not taking over Europe. I see that (legitimate) concerns about the impact of Trump are distracting many people from these quite positive developments.
Second, I now view many asset classes as at least partially dependent on Chinese capital, but I’m not so afraid of that capital going away, as those positions have built-in hedges. If China does well, the flow of Chinese capital will continue. If China does poorly, capital will leave China rather rapidly and seek out foreign investments, and that too gives non-Chinese markets a fair degree of protection. China’s highly leveraged position may be precarious internally, but the West has a built-in hedge, namely that bad times for China still send more capital our way, at least for a while. That’s another piece of security that we have been distracted from seeing, though I’m not sure it is good news for China itself.
If you were wondering what to make of low expected volatility in markets, it’s typically worth looking at which asset prices have been volatile. I have two nominations: Chinese corporate bonds and Chinese commodity prices, both of which have fluctuated considerably with changing expectations about Chinese deleveraging. But those have not created a broader crisis of volatility, which is consistent with the above story about how the world as a whole has been growing economically safer. Furthermore, the ongoing growth of emerging economies implies more global diversification over the long run for both trade and investment.
Arguably, the market is suggesting that volatility in both China and the United States can be contained within those countries, at least more than Trump critics and China pessimists might believe. That’s not the market being pro-Trump, rather the market may be relatively bearish on the soft power of the United States — we Americans don’t matter as much as we are accustomed to thinking. As long as the Trump administration doesn’t bring a military cataclysm or an actual collapse of constitutional order, aggregate volatility may stay relatively low.
On the surface, that’s an optimistic prognosis, but in the longer run it ought to be sobering. So many features of our federal government don’t seem to matter so very much for market prices or for volatility, but is that such a positive? Decades from now, we may well need the American federal government to be performing some very different tasks than what it focuses on today (Coping with high rates of dementia? Climate change concerns? Fighting bioterrorism?). Government irrelevance may be OK in the short run, but over longer periods it is likely a signal of a broader societal deterioration.
So yes, there is some good news about low expected volatility, but let’s not celebrate our potential irrelevance just too hard yet.
— Read Gundlach: Get Ready for Higher Yields, Summer Selloff on ThinkAdvisor.