The Trump Effect--Return of the Bond Vigilantes?

I  haven't written a post since "BREXIT--A Sign Of Our Times" (June 25, 2016).  Given the Trump victory and a Republican majority in both houses of  Congress,  I thought it appropriate to express my current thoughts.

Trump ran on a platform of lower taxes, fiscal stimulus, trade protectionism, and immigration control.  If everything he promised were enacted, the results would be: 1) some movement higher in domestic  real growth from the 2% a year that has prevailed in this economic up cycle, but not nearly to the 4% he promised; 2) much larger budget deficits; 3) significant domestic inflationary pressure associated with protectionism; 4) higher U.S. interest rates due to numbers 2) and 3); and 5) slower global growth.

The markets' initial reactions to Trump's election have been: 1) a "look out below" waterfall decline in the overnight Standard and Poor's 500 Index futures followed by a recovery and sharp rise, bringing today's level  to  a record high  for  the DJIA and within a percent or so of a record high for the Standard and Poor's 500 Index ("500 Index"); and 2) a rare 30 basis points move upward in the yields of long-dated U.S. Treasury securities within one day, followed by another increase today of a few more basis points.

Too soon to say how much of  Trump's platform will be enacted, despite the Republican control of Congress. While President Elect Trump acted "presidential" in his victory speech, my understanding is that "personality transplants" have not been perfected yet.  A lot of his future success is a function of the Cabinet he chooses--whether this egoist can tolerate pushback from presumably more able and stable minds. And even with a friendly Congress, will he have the patience to deal with the give and take that goes on there?

Where We Were Before the Election

In my last post around mid year, the average hourly wages, which are reported monthly, had started to increase at a faster pace.  Subsequent reports have been confirming--the annual increase is now up to 2.8%.  Usually, that means downward pressure on aggregate corporate profit margins and higher product prices. As a result of this inflationary pressure, the Fed most likely will increase interest rates at its December meeting.

After eleven consecutive down quarterly earnings comparisons, due primarily to the strong dollar and the serious slide in oil and gas industry profits, earnings for the 500 Index rose in the third quarter.

Since midyear, both the 500 Index and the U.S. Treasury 10 year note have been trading in narrow ranges--probably due to election uncertainty.

The Future Outlook

Trump's platform is more inflationary than Clinton's; so it is no surprise that interest rates shot up after the election--the extent of that rise, however, was eye popping!  Since higher inflation and more rapid real growth normally lead to higher earnings, the stock market should have a near-term upward bias, particularly the DJIA, which has a greater tilt toward economically-sensitive stocks than the 500 Index. The markets' immediate reactions following the election are reflective of portfolio managers selling long duration fixed income and buying stocks.

Taking a longer term perspective, I rely on Shiller's CAPE Index to determine over or under  valuations.  In his approach, a couple of years of accelerated earnings have less impact than Wall Street might give them because he averages earnings over a ten year period.  My approach takes his Cape Index and adjusts for the level and trend in interest rates. The faster the interest rate on the 10 year U.S. Treasury note reverts to its mean, the faster the 500 Index reverts to its mean.

To me, the key to the future of both stock and bond markets is how fast and to what level inflation accelerates during this up cycle.   The Fed's preferred measure of inflation is the core personal consumption expenditures price index -- now at 1.7%.  Until recently, the Fed had established 2% as the inflation threshold that would lead to further interest rate increases.  Before the election,  Fed Chairman Yellen had commented that she is considering letting the economy "run hot" above an inflation rate of 2% before additional increases in the Fed funds rate (presumably beyond December's expected rise). Given the inflationary bent of Trump's platform,  Chairman Yellen may abandon this "run hot" tactic; if not, she runs the risk of falling behind the inflationary curve.

Years ago, when the Fed was lagging inflation, the fixed income market, ignoring the Fed, adjusted interest rates upward on long duration notes and bonds. This behavior led to the phrase "bond vigilantes"; in essence bond traders wrested control over interest rates.  If the Fed were to fall behind the inflationary curve again, history suggests that the vigilantes will return during the next several years to force the yield on the 10 year note to its mean level of 4% to 5%.  (Its present yield is 2.1%.)

The 500 Index, currently at 2173, is 65% overvalued based on Shiller's mean CAPE ratio.  My adjusted mean CAPE ratio* indicates the 500 Index is 40% overvalued.  If, as I expect,  reversion to my adjusted mean CAPE ratio occurs during the next five years, the total return, including dividends, of the 500 Index will be just 2% to 3% annually--a meager return at best.

 I would rebalance my equity position if Shiller's CAPE ratio reaches 70% overvalued or if the Investors Intelligence  sentiment indicator reaches a level of more than  60% bulls and fewer than 20% bears.  (It is now at 42% bulls and 24% bears.)  As mentioned in previous posts, on the downside, I would begin buying a SPDR Standard and Poor's 500  ETF ("SPY") at a 500 Index level of  1600--which is only likely to occur during or in anticipation of  a recession.


*See my post dated July 10, 2014 entitled "Shiller's CAPE Versus the 10 year U.S. Treasury Note   Yield--an Important Negative Correlation". There I mention that  Shiller's  CAPE ratio was averaged over 143 years; and that, instead, I prefer averaging over the last 50 years.  As a result of these different time frames, Shiller's mean CAPE ratio is 16.7; mine is 19.6--a huge difference.