The rally in US stocks are commonly attributed to Donald Trump and his fiscal policy, but these are only one element of a wider movement. In fact, Wall Street gallops on historic highs largely for one much less ‘phenomenal’ reason: in a global context in which inflation is on the rise again, capital must exit from the bonds market.
Having to go somewhere, it moves to Wall Street, to emerging markets, and to gold. It’s not just Trump in the driver’s seat. It is also the lack of alternatives, driving a rotation of investor portfolios. Looking at the financial markets, in fact, something does not seem to square.
It’s possible to see Wall Street as rallying in the hope that Trump’s new tax policy will lead to growing corporate profits. But the same does not explain why purchases are also targeting South America’s emerging markets (with whom the new occupant of the White House is not tender).
And, looking at Wall Street’s records, it even gold’s recent rally appears to be paradoxical: in history, is very rare that the yellow metal, a safe haven, is so requested whilst US stocks runs high, which typically indicates appetite for risk. In reality, these paradoxes are only apparent: everything can be explained by analysing three dominant macroeconomic themes. The first is inflation. The second is Trump’s expansionary fiscal policy. The third is the political risk present in Europe.
Inflation, Bonds and the Great Rotation
Inflation is one of the main themes in today’s markets. In the US, inflation is closer to the Federal Reserve’s target of 2%, and many are starting to ask whether it can exceed this level. Even in Europe, the inflation is rising and now approaches the ECB’s target. In this context, buying bonds – especially government bonds – makes no sense with prices predicted to fall in adjustment towards this higher inflation.
After about 35 years of strengthening bond markets, things are changing. Since November, according to the Bloomberg Barclays Multiverse index, the value of global bonds has fallen by about $1.5trn. It is clear that this mountain of money flying away from bonds is being re-allocated somewhere else.
It is here that the other two variables come into play: Trump and the European situation. The first, with his fiscal promises, has attracted much capital towards Wall Street: after all, if Trump keeps his commitment, US companies’ profits will consistently grow in comparison to the levels expected before his election.
The fear that the Eurozone might implode – due to the upcoming French elections and the unravelling chaos in Greece, is the second dominant theme. These pressures have caused an outflow of capital from the bonds of the Old Continent, directed in part to the US and in part to emerging markets – as well as to gold, motivated by a desire to gain protection from political risks and inflation. This is why Wall Street, gold, and emerging markets are running together: because the capital is seeking new shores.
The Risk of Excess
This produces a risk, though. Wall Street and the emerging economies might attract too much capital that otherwise wouldn’t know where to go, creating something of an imbalance.
And indeed this appears to be what is happening. Take, for example, Wall Street: while it is understandable that the NYSE (New York Stock Exchange) is running high, driven by a president who promises robust tax cuts to businesses, it is less obvious that so much capital should flow in before these promises are translated into law. Of Trump’s ‘phenomenal’ business policy proposals, there is still very little in place.
A similar dynamic is materialising in the emerging countries. It is true that some of them are dynamic. But it is also true that most are heavily indebted to companies with loans denominated in dollars. If the Fed’s interest rates rise, a consequent increase in the dollar’s strength could produce serious dangers for those economies.
But with the absence of alternatives, investors continue to buy, buy, and buy. This is the real paradox of a market too big, too full of liquidity, and too dominated by generally inflexible investors and benchmarks: it produces bubbles by necessity, by fashion, or for the absence of alternatives.