Make Volatility Great Again!
Election season is finally over, and like most of you, we are breathing a sigh of relief. Trump’s win was a big upset for 50% of us, while the other 50% are already cautiously optimistic for the secession of California. The obvious question at hand is what it all means for us as investors?
Easy Money Is Over
The era of quantitative easing and ultra-low interest rates is over. Trump has said many times that he believes interest rates are too low. Yellen, in spite of stating repeatedly that the Fed is not politically motivated, has done a great job of transferring future investment earnings to the present in order to preserve the political, social and economic status quo. As a side effect, she put the economy in a precarious situation, as the Fed now has no room to lower short term interest rates should the likely scenario of a recession materialize. Our best prediction from the beginning of this year was that the Fed would not increase rates this year. We might just be right, or at the most we’ll get a quarter point raise next month.
In spite of latest comments, we believe there is a high likelihood that Yellen will not finish out her term through February 2018. Quantitative easing has been a massive failure for America’s middle class. While we would argue that it was necessary during the worst days of the Great Recession, it went on far too long in the US, and now continues to drag on at the Bank of Japan, ECB, and Bank of England.
Why is the public so angry that it would throw out the political establishment? Because QE and zero short term interest rates have done the people no good. For fixed income savers such as retirees, ultra-low interest rates have meant they made no money on their savings and their pensions are now at risk. For ordinary workers it has had no value, as inflation-adjusted wages have been stagnating for years. In fact since 1992, the average income of an American aged 18-34 has declined by about $3000 per year in real dollars. The only people that have actually been aided by easy money have been the wealthiest people in our economy: Those with the most wealth benefited the most, as their real estate, equities, and collections increased massively in value.
The most recent vote might after all be less a vote for the GOP but against the status quo of work harder and make less, while the rich get richer. In this election, it is clear to us that the angry lower income voters but also educated hard-working middle class voters who have felt so disenfranchised and left out of this economic expansion, voted with their wallets.
Interest Rates are Going Back Up
For those of you who listened to Trump’s acceptance speech, you’ll notice the first thing he stated is that he wants massive infrastructure spending. This is one way to increase wages and put lower income people back to work. Arguably, an infrastructure overhaul is long overdue in America. The problem is all of this costs money unless we wait and finance it out of growth. The latter would require patience, which everyone runs short on. Hence, we will either see an increase in taxes or debt – or both. Given the pre-election rhetoric, tax increases are off the table, thus we are in for more, in fact much more, debt. More Government debt will impact interest rates. With more debt supply, interest rates will have to rise to entice people to fill the demand. Ten year treasury interest rates are already up 30bps since Trump’s election.
Rate Sensitive Assets Will Suffer
Years of ultra low interest rates have left stocks, bonds, and real estate massively overvalued when compared to more normal levels of interest rates. We believe that as real interest rates increase in the United States, eventually some air is going to have to come out of these asset classes. As a question of supply and demand, if we were to return to a more normal situation where 10-year treasury rates hover around 4-5% yield, demand for real estate and equities at current valuations will automatically diminish. In addition, higher real yields in the United States will draw capital into the United States which will make our dollar stronger vs. other currencies. A stronger dollar will reduce profits in our largest businesses, as approximately 50% of S&P 500 sales are made overseas. The dollar has already strengthened since the election.
A Recession is Likely Coming Regardless
The economy moves in cycles regardless of who is in the oval office. This will be hard for Trump’s presidency, as he inherits the economy at the end of an expansionary cycle, propped up by a dovish central bank with monetary accounting tricks. As we have been writing about for most of the year, we feel that we are positioned towards the end of the economic expansion cycle. Defaults in many areas are starting to increase and profits are beginning to fall. Net losses in subprime auto loans are up 9.3%, up 23% from last year, and high yield defaults are also increasing. We think regardless of strong fiscal spending, the economy is in an uphill battle against faltering as soon as the Fed’s life support will be turned off.
The Next Fed President
We think there is an outside chance that Neil Kashkari could become the next Fed president. It would be an outside shot, but mark a break from the tradition of appointing academics to lead the most important financial institution. Neil was appointed to the Fed in 2015 after unsuccessfully running for the governor of California in 2014. He is best known for running the TARP program in the Great Recession, while working for Hank Paulson. Although some would say he lacks experience, we think Neil has a chance because he is a Wharton alum, just like Trump, and he has business experience, having previously worked for Goldman Sachs and PIMCO. We know that Trump will value business experience over academic experience.
Big Banks May be Broken Apart
We note that Kashkari made the point soon after joining the Federal Reserve that large banks should be broken apart. It’s been an issue that he cares deeply about lingering since the financial crisis. Trump has also made similar points on the campaign trail. We think there is now some likelihood that Glass Steagall could be reenacted to separate deposit taking institutions from investment banking. Many have said that Bill Clinton’s repealing of Glass Steagall paved the way for the Financial Crisis. We tend to agree. It is certainly better to save depositors the risk. Perhaps we are a bit far off in this prediction, but we would not be surprised if the issue surfaced in the second or third year of a Trump presidency.
Everything Points to More Volatility
Everything points to an increase in market volatility under this administration. An increase in Government debt and end to the current ultra-easy monetary policy will push interest rates up. That will deflate stocks, bonds and real estate assets. Asset classes never tend to deflate smoothly. Many Trump election promises could impact trade. Glass Steagall could be reenacted. And lastly, after years of economic expansion, a recession is likely. We don’t see smooth sailing for the financial markets in the future. As always, our downside-protected Smart Wealth portfolios are built to deal with turbulences and smooth out the ride. Buckle up folks. There will be a bumpy ride ahead.