The Behavior of the Market Actually Has Very Little to do with Trump
Because of the US stock market's strong move after the November 8th election, many have referred to it as the "Trump rally," believing political factors are one of the main forces driving investor behavior.
Matthew Kerkhoff, Chief Investment Strategist at Model Investing, however, says that global markets and leading economic indicators are telling a different story.
Reflation Driving Global Markets
“This isn’t really so much a Trump rally,” Kerkhoff said. “It’s a reflation trade. This really goes back to what happened with oil over the past couple of years.”
Reflation is a combination of improving economic growth and a pickup in inflation.
Markets in the US were doing quite well until the middle of 2014, when suddenly they started to falter, largely because oil prices began to plummet and fears over deflation began to strengthen.
This current rally really began around the world when oil bottomed near the beginning of 2016, Kerkhoff said. After that, we really saw the global rally develop in earnest, and it’s still in full force.
Global LEIs Turned Positive Prior to Trump Win
In addition to oil prices (and commodities in general), Kerkhoff points to leading economic indicators (LEIs) as an important signal where markets are headed.
Several months before Trump's win, most LEIs across the globe were already in a rebound, showing that the backdrop for global markets had already improved considerably.
Two widely watched indicators regarding the strength of the global economy are JP Morgan's Global Manufacturing and Services indices. As you can see, global manufacturing slipped dangerously close to contraction (below 50) in February of 2016, when fears over a global recession reached their peak but has since seen a rebound along with services.
When it comes to politics, it was perhaps the uncertainty alone that played a role, more so than the actual outcome, that allowed global markets to eventually realign with the fundamentals and move higher.
Interest Rates and the Yield Curve
In terms of monetary policy and how this plays into the market and economic outlook, Kerkhoff pays special attention to the yield curve — the difference between 10-year and 2-year Treasury bond yields — which, he says, is a strong predictor of recession, Kerkhoff noted.
The Fed has a lot of control over the short end of the curve, Kerkhoff noted, but it isn’t necessarily true that short-term rates and long-term rates move in tandem.
“As we get farther down that yield curve … to 2-year, 5-year and especially 10-year Treasuries and 30-year Treasuries, those interest rates aren’t so much affected by what the Fed does as by what global markets and global bond investors do,” he said.
By measuring the difference between the 10-year and 2-year rates with the yield curve, we have a good way to take a snapshot of what’s going on in the economy, Kerkhoff stated.
We want to see a solid upward slope to the yield curve, generally, to indicate the economy is healthy.
“For a variety of reasons, that’s actually an indication that the economy is doing quite well,” he said. “As the slope of that yield curve begins to flatten, it’s a sign the economy’s becoming a little bit weaker. … and every once in a while, we will get an inverted yield curve, which has a really high probability of predicting a recession, typically within about 6 to 12 months.”
Though the yield curve is not inverted at the moment, it has flattened a bit, but it isn’t signaling imminent problems for the economy, Kerkhoff noted.
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