Typically, U.S. Presidents are wary of claiming stock market performance as a referendum on their success. Most have seemed to understand that taking credit also means accepting blame, and no one would want to make the tortured argument that the positive moves reflect well on their presidency but that the negative moves do not. But Donald Trump has shown no reluctance to make any argument that suits his political purpose of the day, no matter its absurdity, and no matter if he has to contradict the arguments he made last year, or last week. Perhaps he assumes, as most investors seem to, that the risks are minimal because the Federal Reserve will jump in to save the markets if things turn bad. But in binding his performance so closely to the markets he overlooks the possibility that the Fed will be far less charitable to him than it was to Obama.
The Federal Reserve’s Quantitative Easing program, which lasted from the end of 2008 to October 2014, was specifically intended to push up asset prices by lowering long-term interest rates and reducing financial risk. This provides a good explanation why the stock market gained nearly 200% from the bottom in March 2009 to October 2014 despite the fact that the U.S. economy persistently performed below expectations during that time.
Many people, myself included, argued that once the stimulus was removed stock prices would have to fall. Two and a half years later that has yet to occur. Although U.S. stocks are no longer rocketing upwards like they were during the QE era (the S&P 500 is up just 19% since the program wound down completely in November 2014), they have yet to experience any type of meaningful correction. Certainly market observers sense danger, but with the Federal Reserve cavalry always ready to ride to the rescue (as they did in January of 2016), markets have been free to drift upward.
Right up until his election, Trump argued, correctly in my view, that statistics suggesting economic strength, such as the employment or GDP reports, were fake news designed to hide the truth of a faltering Obama economy. He similarly argued, also correctly in my view, that stock market gains were evidence of a “big, fat, ugly bubble” created by the Fed in order to bail out Obama’s bad economic policies. But the day after the election, all that changed. Now he claims that the very same statistics (which haven’t moved much over the past year) are proof of his success. Gone are the claims that employment and GDP reports are fakes. Similarly, he has fully embraced the 18% rally on Wall Street since right before his election as proof of his deft economic stewardship. The fact that he is placing his own neck clearly on the chopping block does not seem to deter him at all.
The President’s gambit does present the Federal Reserve with a huge opportunity to exert political power. There can be little doubt that Trump does not enjoy tremendous support from the members of the Fed’s Open Market Committee, who are generally drawn from the center to the center-left of the economic spectrum. Most members, including Chairwoman Yellen herself, are products of the academic world, where wonkish devotion to theory and mild-mannered communications style are the ideals. Trump is the opposite of this profile, and may be the kind of leader who they are pre-programmed to dislike. The fact that Trump has openly vowed to replace Yellen next year likely adds to the bad blood.
This was not the case with Obama for whom the Fed was much more inclined to give breathing room. In fact, even Ben Bernanke later admitted that his optimistic assessments of the U.S. economy, and his dismissal of the housing and mortgage risks leading up to the Crisis of 2008, resulted from his perception that he was speaking as a member of the Bush Administration (he was a Bush appointee), and should therefore not undercut the optimistic narrative put out by the White House. I seriously doubt Janet Yellen fancies herself a member of Team Trump.
The Fed delivered its first rate hike of the current cycle (in fact its first rate hike in nine years) in December of 2015 when it raised rates from zero percent to 25 basis points. Although such a move had been expected for many years, most market observers had been assured that the economy would be on solid ground when it finally came. In fact, when the year began, many expected the first hike to occur in March, with several more hikes happening before year-end. Yet a data-dependent Fed held fire until December. After that first raise, the consensus on Wall Street was that Fed funds would be between one and two percent by the end of 2016. Those expectations were largely echoed in the Fed’s own communications. But when 2016 got underway, economic data began to soften and Wall Street suffered a panic attack, falling eight percent in the first two weeks of the year.
I believe that the Fed, sensing that continued market declines could devastate Obama’s final year in office and make it harder for Hillary Clinton to ride his coattails into office, acted in mid-January and threw out its prior commitments to raise rates and made it clear that it would keep rates low for as long as it took to restore “financial stability.” In other words, it was not prepared to stand by and let markets fall. The shot of confidence reversed the losses, and stocks have been trending upward ever since.
However, Clinton still lost the election. I believe this was primarily because Trump was right in his claims that the economic recovery touted by the Fed, the Obama Administration, and Wall Street, was primarily an illusion, and that the stock market rally was nothing more than a bubble that would inevitably pop.
It is also significant to note that a “data-dependent” Fed used weak economic data as an excuse to delay its long-expected initial rate hike to December of 2015, and then another full year (and a presidential election) to raise them again. In fact, the Fed had consistently used weak current data as an excuse to delay hikes for nearly the entire eight years of Obama’s presidency. But the data is as weak now, or even weaker, than it was then. Despite this, the Fed has already raised rates three times since Trump was elected. Perhaps it has removed the kid gloves?
There could be no easier way to undermine the entire Trump presidency than an official bear market to erupt on Wall Street. In that sense, as I have said in a prior commentary, Janet Yellen presents a much greater threat to Trump than does Robert Mueller or Chuck Schumer. Yet despite these warning signs, investors have not yet shown much concern. They still seem to believe that if anything goes wrong, the Fed will provide the bail out. But that is not a risk Wall Street should be eager to test. My guess is that the “Yellen Put” is still in effect, but the strike price may be much lower than most investors believe, meaning more substantial losses could be required before the Fed acts.
One indication that the markets may be coming to grips with the heightened risk is the way in which new technology IPOs have been treated. These can often be used as a barometer of investor sentiment. Lately the news hasn't been good. Two weeks ago, the highly anticipated IPO of Blue Apron, an online service that delivers pre-packaged baskets of uncooked food so that consumers can prepare gourmet recipes at home, fell flat on its face. In order to debut successfully, Blue Apron’s bankers slashed their initial valuation by 1/3. Despite that, the stock opened flat on its opening day. From then, it’s almost been straight down, with the stock falling almost 35% below its IPO price.
It should have been clear that the company was a bust from the start. Its losses have been staggering, and just about any rival can replicate its services with minimal expenditure. But in good times new technology IPOs have gone up no matter the fundamentals. Yet one week following its $10 per share IPO, a Wall Street analyst slapped a $2 price target on it, which values the entire company at approximately $380 million, just $80 million more than was raised by selling just 15% of the Company to stock investors. Ouch.
Also, shares of SNAP, another high profile tech IPO, have recently come under pressure. The stock went public back in March at $17, quickly surging to a high of $29.44. Yet in recent days the shares have traded below $15 per share, 12% below its IPO price, and half the high price enthusiastic investors paid just a few months ago.
Aside from these IPO flameouts, there is gathering evidence that corporate earnings assumptions will be downgraded. A key factor in the post-election stock market rally was that corporate earnings would benefit from Trump’s anticipated pro-business tax and regulatory reforms. His failure to deliver on these fronts (as well as the failure to repeal Obamacare) have helped lead to a complete reversal of the U.S. dollar rally that began right after the election (the Dollar Index has since fallen 9% since its January high). How soon before stock market investors connect the same dots? With the Fed not only threatening more rate hikes, but also making noises that it will draw down its balance sheet, which would result in "quantitative tightening,” U.S. stock market investors should not be getting too comfortable.
Instead, the falling dollar and the more positive economic results coming from non-U.S. economies might suggest that a move into long-beaten down foreign markets may be opportune. It should not be overlooked that thus far this year the Vanguard FTSE all World ex-US ETF (which measures the cumulative results of all markets outside the U.S.) is beating the S&P 500 by almost 60%.
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Euro Pacific Capital
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