Wade O’Brien
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Some of the reflation trades that received a boost from the US election (such as the stronger US dollar and higher US bond yields) look to be merely taking a breather as investors square positions; however, the fundamental support for others—particularly the outperformance of US small-cap equities—is challenged.
The US election was not the only driver of gains for global risk assets through year-end; improving earnings prospects and rebounding global economic growth also played a role. Nonetheless, certain US assets saw a discernible impact as uncertainty faded and markets rushed to price in the expected effects of an assumed switch from monetary to fiscal stimulus. Expectations of corporate tax cuts, higher government spending, and reduced regulatory burdens all combined to give equities a boost. Particular winners included US small-cap stocks (which returned around 14% from the election through the end of 2016), financial sector equities, and a variety of natural resource–related assets. Conversely, bonds sold off as interest rate curves priced in higher inflation and growth; rate-sensitive sectors like REITs also underperformed. The DXY dollar index rose around 4% through year-end, bolstered by the assumption that faster US growth and higher rates could attract foreign capital and higher trade tariffs might improve the country’s balance of trade.
The pause in some of these trades since the beginning of the year reflects several dynamics. US small-cap stocks have returned 2.7% year-to-date through February 13, underperforming large-cap equivalents by almost 200 basis points (bps). Small-cap US companies may benefit more from proposed corporate tax cuts given their higher reliance on US revenue (and thus higher effective tax rates), and are less exposed than multinationals to the stronger US dollar. However, headwinds like near-record valuations (both normalized and short term) will threaten future performance. And to a lesser extent, the rising cost of their floating-rate loans, which are prevalent among more leveraged small-cap companies, will also threaten future performance.
US Treasury yields were stable in January and have dipped slightly into February, also diverging from their recent trend. The yield on the ten-year bond rose around 60 bps after the election, accentuating a sell-off underway since late September. This move seems significant, but less so considering the significant plunge in rates during the first half of last year; in July, the yield had fallen below 1.4%. Net-net, the yield on the ten-year Treasury ended 2016 just 20 bps higher than where it started, despite improving data and the potential for new policies to generate further inflation. Given this, pressure on rates may be biased to the upside. That said, the weak fourth quarter US GDP number is a reminder that it will take more than confidence and rising asset prices to boost activity, and elevated political risk in other developed markets may keep a lid on how high US rates can ultimately go.
The US dollar’s ascent has also taken a break recently. Like small-cap stocks, the currency looks overvalued and, by our metrics, is approaching the top decile of its historical valuation. Yet the dollar could prove to be more in demand if US economic growth substantially outpaces that of peers, if interest rate differentials between US bonds and global equivalents remain elevated, and if some of the new administration’s proposed tax policies curb US demand for foreign currencies and narrow the trade deficit. At the same time, the strong currency seems anathema to President Donald Trump’s professed goals of boosting US exports and competitiveness, and depressed currencies such as the euro and sterling could quickly rally if some of the political uncertainty clouding their outlook clears. While seemingly little-noticed in the post-election media frenzy, Eurozone GDP growth actually exceeded that of the United States in 2016, and the January reading for the composite UK PMI (a broad measure of manufacturing and service industry health) at 55.5 is, perhaps surprisingly, among the strongest of all developed economies.
Our assessment of these recent reversals is that the outperformance of US small-cap equities could experience more than just a short-term pause, even in the unlikely event the new administration is able to quickly deliver promised regulatory and tax reforms. The recent calm in the bond market may prove more temporary, as stronger US growth and inflation—or other dynamics such as foreign central banks rolling back asset purchases—could push rates higher. Given the unpredictability of currency moves, we are reluctant to make much of the recent minor sell-off in the US dollar. Valuations seem stretched and policies could disappoint, but history suggests cycles are long, and this one may have more room to run.
Wade O’Brien is a Managing Director on Cambridge Associates’ Global Investment Research team.
Originally published on February 14, 2017
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