Investors on Wednesday quickly went to the 2016-2018 playbook, which was the last time the Trump-led GOP pulled off a clean sweep (the Republicans look set to do so again this time around, though the House race has not been formally called as of writing). The risk-on trade is in full swing — equities are ripping, led by Tech and Financials, and safe-havens like gold and especially Treasuries are getting smoked. Oil is under downward pressure as is the U.S. dollar. Emerging Markets, the Mexican peso and the Canadian dollar are big losers.
It may be just a bit too simplistic to assume that we are going to be in for a repeat of 2016-2018, but that surely is the early expectation by the investment community. So far, just a day after the election, the old playbook is playing out to a tee. But will it last? The runway seemed a lot more enticing back then.
First, equity market positioning, sentiment and valuations were light years away from where they are currently. Investors were depressed, coming off Brexit and believing Hillary Clinton was going to win. Market Vane’s bullish sentiment was 60 then, and is at a nosebleed 70 currently. Today, investors had largely priced in a Trump victory early on and markets are frothy to say the least.
The forward P/E multiple was 17x in November 2016 versus 22x currently. Every valuation metric from price-to-earnings, price-to-sales, price-to-book, the Buffett Indicator (market cap-to-GDP) and the CAPE multiple are completely off the charts today — which was not the case the first time Trump won. Not to mention the S&P 500 dividend yield being over 2% then and barely over 1% today.
High yield bond spreads were 500 basis points then and are 280 basis points now. For investment grade, try 140 basis points then and 85 basis points today. Like equities, a whole lot of good news and then some are embedded in the credit markets at current levels. Not the case back in 2016.
For bonds, the starting point for the 10-year T-note yield in November 2016 was 1.8%. One could have easily argued for a cyclical bear market (lasted exactly two years) in Treasuries at that yield level — but today’s 4.5% yield offers coupon protection that did not exist eight years ago.
The stock market already had a tailwind behind it in November 2016, with or without the GOP sweep, as there was no competition back then from a 0% real risk-free rate (using the yield of the 10-year Treasury minus the impact of inflation). Today, that inflation-adjusted rate is north of 2%. Big difference.
The Fed Funds rate was near the zero bound at 0.375% back then — and it had only one way to go (to 2.5% at the December 2018 peak). At 5% today, and coming off the cycle peak, there’s only one way to go on this score — lower. The only question is the path and magnitude.
With respect to the economy, 2016 was more mid-cycle in nature with a near 5% unemployment rate versus the current late-cycle 4% jobless rate. That is a huge difference. What it means for Donald Trump’s policy plank is that there are more acute capacity constraints today compared to the 2016 election win.
The deficit-to-GDP ratio of 3% and federal debt-to-GDP ratio, of 95%, were far less of a fiscal constraint on Trump’s fiscal ambitions then compared to today where the deficit tops 6% of GDP and the debt ratio is fast approaching 130%. This is a fiscal straight jacket that the market bulls, yet again salivating over prospective tax relief, may not be factoring in.
And there is an added constraint on fiscal finances — back in 2016, debt-servicing costs were absorbing just over 10% of the revenue pie. That interest expense ratio is double that today and even before Trump’s tax measures, that ratio is set to spiral to over 30% within two or three years. This structural debt and deficit dilemma is not on anyone’s mind right now. But once the debt service ratio tops 30%, what follows are failed Treasury auctions, a destabilizing decline in the dollar, and credit rating downgrades that will pose a threat to America’s reserve currency status.
Ask anyone who was in Canada back in the early 1990s as to what life is like once the government fails to prevent the debt service ratio from piercing the 30% threshold. Not a pretty picture. And something that the credit default swap market, unbeknownst to the equity market bulls, is beginning to sniff out.
David Rosenberg is founder of Rosenberg Research.
Also from Rosenberg Research:
A Donald Trump win means big trouble for the Canadian dollar
Don’t believe the academics. Trump’s policies won’t be all that inflationary at all
Love him or hate him, an economy under Trump should fare better than under Harris
These will be the stock market sector winners and losers after the U.S. election
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.