Trump is not the only risk to US markets

Spotlight September 2016

From bonds, to shares, to the general economy, America has little room to move.

Urgent concerns are rising in the US, from the bond market to The Donald, explains Mark Rider.

During my recent visit to the United States it was hard to get away from the US presidential election campaign. With Donald Trump making gaffes almost daily, and Hillary Clinton unable to shake the issue of her use of a private email server while serving as US secretary of state, there’s a clear sense the vote is for the least unpopular candidate.

From an investment perspective, the sharemarket has been pricing in a Clinton victory, with strong performance in sectors such as infrastructure and weakness in pharmaceuticals. That assumption leaves sharemarkets vulnerable to a surprise victory by Trump.

Complacency v new reality

Another cause for concern is the sense of complacency that was evident in the US toward bond markets. In particular, there appears to be a widespread acceptance that bond yields will remain low for a long time, with little upside risk.

While inflation is rising modestly in the US, normally an indicator of higher interest rates to come, there’s an expectation that it’s different this time. The US Federal Reserve (the Fed) is expected to raise rates once before the end of the year, probably in December, and then very gradually thereafter. In addition to this is $US3 billion of bond purchases by major central banks this year and next, which many hope will keep yields anchored for the foreseeable future.

With interest rates so low, there’s a view that there is no alternative to shares as an investment, despite the risks. This view is driving share prices higher into expensive territory, which brings the sustainability of these prices into question.

US demographics and monetary policy

There is also increasing acceptance of the view (one we have been arguing) that potential growth in the US economy has fallen due to a fall in overall population growth and the retirement of more productive, older workers.

With the US unemployment rate now below 5 per cent, there are increasing signs that the labour market is beginning to tighten, with:

  • wages growth picking up
  • the unemployment rate for the least skilled workers falling 2 per cent in the past year
  • real median household incomes finally recovering back to their pre-global financial crisis peak.

The maturing and normalisation of the US recovery, with more broadly rising real incomes, provides support for consumer spending – which is positive for the sustainability of the economic expansion.

As this is taking place, there is growing debate about the effectiveness of monetary policy, and that the negative interest rates in Europe and Japan are having perverse impacts. In particular, rather than stimulating consumer spending, lower expected investment returns from low-interest rates may just be making things worse – with investors increasing their savings in an attempt to make up for lower returns.

A groundswell is building for central banks to stop additional easing measures, building pressure on governments to adopt policies aimed at higher government spending.

Risks are building

While markets are vulnerable to a Trump victory in the US election, our major concern at the moment is the complacency in bond markets. With bond and share markets both looking expensive, the risk is for weakness in both markets in the shorter term.

The increasing criticism of central banks and the effectiveness of their ultra-low interest rate policies may prove a catalyst for this weakness, with markets likely to be disappointed by a lack of further stimulus measures or more aggressive-than-expected rate rises in the US.

See the Investment Spotlight for September.