Post Trump US Outlook, US Equities, USD Strength
From its February low the broad Russell 2000 equity index has gained 42.3%, outperforming the S&P (+21%) by a wide margin. The outperformance of the inward-looking Russell index suggests investors are assuming that US domestic demand is doing better compared to the demand of America’s trading partners. Relative domestic demand steers rate differentials and exchange rates. Hence, the outperformance of the Russell 2000 is consistent with our call of seeing yield differentials staying wide or widening further from here. The US-German yield differential has reached levels last seen in March 1989 when Europe took longer to recover when dealing with the consequence of the October 1987 equity crash. The DXY rallied 24% from 1897 into June 1989 before falling back again triggered by German unification and the end of the cold war leading ‘peace dividend’ related inflows into the Europe.
Nowadays the situation is diametrically opposite to 1989. Globally, expenditure for military equipment is on the rise, eliminating the ‘peace dividend’. Now, USD denominated investment is not only supported from an economic argument but also from a geo-political angle. Yesterday we saw once again the release of strong economic data supporting our view that the US is closing its output gap quickly. The FOMC minutes showed a similar view on data, supporting a rate hike for December. Remember, strong US October data provide a pre-election snapshot of the economy with economic agents not taking President elect Trump’s neo-Keynesian program into account. Importantly, the November University of Michigan consumer climate not only beat market expectations, but also saw current conditions and expectations rising, adding to evidence that US optimism has survived post-election emotion swings.
The apparently rapidly closing US output gap suggests US demand and supply for capital shifting to the left, creating an environment of higher bond yields unless compensated by USD supportive capital inflows. Our conclusion is that the US has the choice between a higher USD and higher bond yields. US deregulation of its oil and financial sector will increase this trend further. Interestingly, the FHFA (Federal Housing Finance Agency)has raised the maximum loan limits. The housing market as the USD417,000 cap on single-family homes had been in place since 2006 and will be raised by 1.7% to USD 424,100. While this change may look small in nature, it will support the housing market now, on the NAHB index, breaking price levels seen before the financial crisis and pushing more investors out of ‘negative equity’. All this happens when US households operate with multi-decade strong balance sheets and with only a fraction of disposable income required for debt maintenance reaching levels not seen since the mid-70s.
The US economy closing its output gap combined with the planned demand boosting ‘Trump measures’ converts the US from a supplier to a destination of capital. The early days of the incoming US administration will be all about finding funding for planned expenditures, suggesting more capital inflows. Then these funds will be brought to work. At this point it needs to be seen if the US can develop sufficient productivity gains to catapult its economy into a growth potential income. Should it fail in doing so then this neo-Keynesian approach will lead to higher inflation and with the Fed likely to catch up, accelerating its rate hikes, then risk appetite will decline as the US moves closer to recession. However, it may take several quarters for this scenario to play out. Up to then the USD will remain strong.