Is the “Trump Trade” a good deal?

• Small caps: Small cap stocks rose by 4.6% as Trump’s odds were improving, mirroring the “1.0” trade. However, over the same period, large caps returned 6.7%. Interestingly, small caps have started to outperform large caps despite the decline in Trump’s odds. This suggests that there is more to small cap outperformance than just the election. Interest rates and valuations are the more likely drivers of small cap returns. As our Asset & Wealth Management Chairman of Investment Strategy Michael Cembalest noted in his latest piece, more than 40% of the small cap index is unprofitable. That makes them reliant on debt capital markets for financing. Therefore, the prospect of lower interest rates has a large impact on small caps. Small caps have benefitted from the view that inflation has finally turned the corner and that the Fed will start cutting rates in September.
• Energy: The energy sector rallied in 2016 based on optimism around less onerous regulations and more independent U.S. energy production. Eight years later, the U.S. is now the world’s dominant oil producer. While less regulation could bring even more production, an oil glut could put downward pressure on prices and negatively impact energy company earnings. This time around, the energy sector declined while Trump’s odds were increasing.

• Bond yields: This time, bond yields across the curve have declined since President Trump’s odds have increased, but the yield curve has steepened. Said differently, shorter term interest rates are moving lower faster than longer term interest rates. To us, that suggests that central bank policy expectations are the primary driver of bond yields, and not the election. This is perhaps the biggest difference between 2016 and today. Then, the central bank was desperate for any signs of inflation that would allow them to raise rates above nearly 0%. Today, the central bank is desperate for confirmation that inflation is low enough to allow them to lower rates from 20-year highs. The key risk for bond markets is that protectionist economic policy, such as increased tariffs and less immigration, will reduce growth and increase inflation at the same time that the extension of tax cuts will increase the deficit. The good news right now is that it seems like bond yields are taking their cues from the growth, inflation, and central bank policy outlook. 

Overall the Trump Trade 2.0 seems relatively inconclusive. Instead, it appears that markets are reacting more to the increasing likelihood that the Fed will be lowering interest rates with a backdrop of relatively decent underlying economic growth. However, certain sectors and industries may be more sensitive to changing election perceptions. Regional banks, for example, have reacted positively to an increase in Trump’s odds. Meanwhile, clean energy and Chinese stocks have been negatively impacted. The bottom line for investors is that we believe the growth, inflation, and policy backdrop will be the primary driver of market moves, but the election will matter underneath the surface.

What does history have to say about Election years?

Election years tend to bring similar levels of equity market volatility until October, when there is a noticeable uptick in the VIX. However, since 1984 there has only been one election year where the market was lower 12 months after the election—in 2000, amid the tech bubble. Notably, implied equity market volatility falls relatively quickly after the new composition of government is confirmed, and on average equities are higher 12 months after the election.