By Rishi A. Mishra
Most analysts covering the US Presidential Election saw a small, non-trivial possibility of a Trump victory. A few saw something more. These few were either prophetic enough to predict this upset, or calculating enough to hedge their bets. Let’s assume you were one of the latter. On the 9th of November, the world would have been at your feet. Everyone would have been in awe of your ability to understand the irrationality of the electorate.
But hold on! What good is awe? You wanted your positions to turn gold. You were hoping that the ESZ6 contract that you had shorted would be trading at close to 2000. That there would be a global rally, and a bull-steepening of the US yield curve. What you wanted was a shattering of every emerging market currency. Unfortunately, none of this happened. Markets pared back losses, and the world seems to have moved on. Care to know what happened? Read on.
Principal reasons for market stability
There are three principle realsons why there was no immediate “risk-off” move in the market:
Some very large investors were positioned for Clinton
Simply put, stock prices move when stocks are traded. They move lower when the people willing to sell outnumber those willing to buy. This results in continuously falling ask prices. As counter-intuitive as it may sound, if these funds decide to hold on to their positions, how do you expect a sell-off?
The uncertainty in policy vs. the certainty of stimulus
Part of this stubbornness comes from the belief that any increase in volatility would be countered by either the Central Bank or the Treasury, or a combination of both. This has played out right after Brexit, another unexpected event. There, after a brief sell-off, markets rallied on hopes of a comprehensive stimulus package from the Bank of England.
The calm before the storm
However, another factor, which may seem more rational than the ones above, is that there are a couple of months before Trump takes office. Thus, at least for a while, everyone’s safe. It’s only once he has taken office that his trade, immigration and fiscal policies start affecting anyone.
Trump and optimism
But is that all? No – there is a missing cog in this wheel and the name of that cog is optimism! The root of this optimism is Donald Trump’s incredible jump from a ‘candidate’ to the President. As a candidate, there was little to lose and far more to gain from an anti-trade, anti-immigration rhetoric. Now, every step he takes will have consequences.
Many are hoping that this realization itself will keep Trump from carrying out some of the bizarre ideas that he put forward in his campaign. This includes constructing a wall on the Mexican border with Mexican money! The focus has shifted possibly to market-friendly policies. These could consist of a fiscal boost and perhaps, a longer business cycle. Accordingly, it’s best to shift focus to a slightly more long-term view. Thus, we should look at the impact of Trump’s ascendance on the Emerging Markets (EM), the Developed Markets (DM), and finally, on the US itself.
A quick look at the key themes of Trump’s Presidential campaign, and it is clear that the EMs have reason to be nervous, mostly because, over the next year, any changes in trade policy would likely be disproportionately felt by EMs. This would lead to a divergence in economic prospects of the EMs and the DMs.
Trump’s ticket to fame has been the idea that the US can cut trade and bring back jobs from these developing nations. Given that he would have to stand by at least some of these promises, countries with large trade surpluses with the US, such as those in NAFTA and Asia, are likely to make for the biggest targets in Trump’s crusade against globalisation.
Amplifying worries for the MXN (Mexican Peso) and ZAR (South African Rand), is the fact that Republicans have control of the senate. They also control the house, which gives Trump the ability to muscle through legislation in areas like trade and foreign policy. Also, if Trump were to look at outsourcing, India and the Philippines would be under scrutiny. Policies like Modi’s ‘Make in India’, which focuses on export-led growth, would be under threat.
Countries like China and Taiwan might be subjected to punitive tariffs on charges of currency manipulation. This is despite the fact that US Treasury has cleared them. This could push the Yuan to close to 7-1 against the USD (United States Dollar), despite the likely intervention in both onshore and offshore markets by the Chinese authorities.
If trade falls, a re-narrowing of the EM-DM gap is likely. This, along with the elevated risk aversion, implies greater capital outflows from, and lower exchange rates in, the EM. At the least, this could drag the EM currencies down by nearly 3% vis-à-vis the USD.
With a significant Net International Investment Position to itself, the JPY (Japanese Yen) is one of the two major safe haven currencies of the world. Further, given the uncertainty around expected policy lines in the coming month, the prospect for the JPY remains the brightest. The case is strengthened by the fact that Japan is one of the few countries largely shielded from the current geo-political risks, with the Abe administration expected to be in power till 2021.
Obviously, the same can’t be said about the EUR (Euro) or the GBP (British Pound). Despite the re-pricing of Fed’s December hike, which should have been a net positive for the EUR, the currency is likely to underperform. This is as Trump’s election portends a strengthening of nationalist movements across Europe. And, with a number of elections coming up next year, including those of Germany and France, the prospects aren’t too bright.
Signs of an emerging wave of nationalism had begun to appear in Europe post the double-dip recession. However, the far right populist parties drew first blood on June 23rd. This was the day when the citizenry in the UK decided to leave the European Union (EU). Since then, there has been no looking back. In fact, post Trump’s upset on November 8th, the trot is now threatening to become a canter, thus threatening the EUR.
Complicating matters further is the uncertainty around the future trade relationship between the UK and the EU. With the Supreme Court set to rule in January 2017 on the UK Government’s authority to use the Royal Prerogative with respect to leaving the EU, there is little about Brexit that can be said with confidence. However, some prominent European leaders have said that it’s either going to be a hard-Brexit or no Brexit at all.
The Federal Reserve and the USD
However, the most important short-term impact of Trump’s victory is likely to be on the expected Fed hike in December. The Fed has proved in the past that it doesn’t like surprising the markets. Accordingly, an adverse market reaction is likely to prevent the Fed from tightening, weighing on the USD vis-à-vis other reserve currencies.
Another factor which may be weighing on the Fed’s decision to hike rates next month is the likelihood of deterioration in the economy if the US’s interactions with China or the Middle East take a turn for the worse. Under such circumstances, the Fed would be discouraged to hike rates, as it could exacerbate matters for the economy.
Trump’s promises on trade and immigration, if implemented along with a new fiscal stimulus program, may add to inflationary pressures in the US via the tightening in the labour market. This should result in a steeper yield curve leading to bond market outflows, which could help the Fed take the foot off the paddle. In short, if the current calm in the markets is to continue, the Fed would be likely to go ahead with the rate hike.
However, with relatively stronger fundamentals, the US is in a position to weather global headwinds from the rising geopolitical risks, which, along with the safe-haven demand for the US Treasury bonds, should keep the USD from depreciating too much.
I believe the most likely outcome of Trump’s election will be a rise in domestic inflation and the steepening of the yield curve. Naturally, 2-10 years curve steepeners and inflation-linked products are likely to outperform in the medium term. In foreign exchange, the EUR is likely to perform the worst, followed by the GBP. The JPY and USD should remain in demand, while EM currencies face substantial capital outflows.
Rishi A. Mishra is an investment banker based out of Delhi.
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