Stock markets really are strange beasts. Those of us observing global financial markets expected stock investors to run for cover and scurry off towards safe havens like the Swiss Frank, Japanese Yen, US treasuries and gold following Donald Trump's shocking ascension to US presidency.
But the American market is euphoric. Following election till November 25, stock market indices like the Dow Jones Industrial Average and S&P 500 gained 4.5 percent and 3.5 percent respectively. To put it in full perspective, the entire year-to-date gain till November 8 for Dow Jones and S&P 500 was 5.2 and 4.7 percent, respectively. Another index the Russel 2000, which consists of small companies, broke through the roof gaining around 12.7 percent during the same 17-day post-election period! It is almost fitting that after one of the most atypical election cycles in memory, the stock market is behaving in an even more unprecedented manner.
So how did a man who has no track record in government, insulted racial and religious minorities, promised to build a wall on the southern border and threatened to pull the plug on free trade, get the stock market – a supposed soothsayer of the economy – so upbeat? To understand this rally, a bit of historical context might be in order.
Following the global financial crisis of 2008, the big-shot of global monetary architecture, the US Federal Reserve (Fed) drove down borrowing costs to zero and adopted quantitative easing, hoping to ignite demand and escape deflation. Within a few years, the European Central Bank (ECB) joined this “unconventional” monetary policy club to revive Europe from the ashes of the 2011 debt crisis. With the other heavy-weight central bank, the Bank of Japan (BOJ), already pursuing such super-loose money policies to fend off more than 15 years of on-again off-again deflation, the world drowned in an ocean of depressed yields. Indeed, persistent deflation and sagging growth eventually forced the ECB and later on BOJ to implement the highly controversial negative interest rate policy!
But for all their efforts, these behemoths of the international financial arena could not move the wheels of global growth as fast as the world would like to have seen. Faced with limited investment options and convinced that central banks would be forced to keep rates low for long, institutional investors and traders pumped trillions of dollars into government debt, expecting that prices on these bonds would continue to rise, allowing them to sell before maturity and make some profit. No doubt there was fair amount of disillusionment among investors whose earnings were plummeting from such suboptimal strategies, leading them to believe the monetary policy was running out of steam to spearhead global economic recovery and it was time for fiscal policy to do some of the heavy-lifting.
Trump promised to do just that. Even a student of Economics 101 knows that a spending mania and massive tax cuts in an economy close to full-employment is expected to fire up inflation and spark growth. So stocks in various sectors look more attractive.
Take banks for instance. Higher inflation will push up interest rates, giving their increasingly squashed net interest margins some breathing space. All the better if Trump adds to the bonanza with a heavy sprinkle of financial deregulation giving banks freer rein, as he promised. Not surprisingly, infrastructure investment will turbo charge industrial sector stocks given a pretty direct link. To cap it off, the entire market will be energised by lower corporate tax rates. The upshot is that investors anticipate a jackpot and duly ditched less-profitable bonds to make room for American stocks.
The story doesn't end there. This stampede from bonds to stocks was amplified by the manner of Trump's victory. That the new president will have Republican majorities in both houses of Congress suggests that stalemates on issues ranging from tax cuts, public debt to infrastructure spending will be much less compared to the era of a Democratic president with a Republican Congress.
To be sure, one could ask if a return to expansionary fiscal policy was the answer to improved economic outlook and market sentiment why did the previous government not pursue it more aggressively? The reasons are deadlocks in a divided government and the need to contain government debt, which ballooned to 100+ percent (of GDP) by the end of 2012 from 62.8 percent in 2007. If the stock market believes now Trump can push through his tax cut and spending package, it may also expect that debt-GDP ratio will be under control in so far as output increases from fiscal expansion. In other words, the market is turning a deaf ear to detailed analysis by Washington's Tax Policy Center of a substantial increase in debt from Trump's plans.
That is just the tip of the ice-berg. The debt factor aside, there are a number of ways which could make this plot twist unpredictable and dent market sentiment. First, the Trump-powered surge in capital inflows will only add fuel to the fire of dollar appreciation, which has been gaining strength as it is. A more expensive dollar will no doubt eat up profits of exporting firms. In fact, the Russel 2000 index's tremendous gain rests squarely on the fact that its companies' sales are mostly domestic. On the other hand, around 25 percent of profits in S&P 500 companies are in non-dollar currencies, explaining why it has gained comparatively less.
Second, given the dollar's strength and deteriorating current account deficit, Trump could be sorely tempted to see through his promise of higher trade protection on the pretext of saving local jobs. Imports will become more expensive, stoking inflation faster than necessary. That, coupled with fiscal expansion, could force a vigilant Fed to tighten monetary policy at a quicker pace in order to put a leash on prices. Rapid increase in interest rates will further appreciate the dollar, drag down growth and scare off investors leading to stock sell-offs.
That said, if Trump bullies the Fed into keeping rates low, escalating prices will hurt lower income families relatively more -the very people he campaigned for.
Finally, diluting financial reforms which prevent excessive risk-taking simply means pushing Wall Street back in time to 2006. We all know how that worked out. That the market is discounting all these risks must mean it is putting more weight to short-term gains rather than longer-term risks. Only time will tell how wise a bet that is.
The writer is a macroeconomic research analyst for an organisation in Washington D.C. and Fellow at the Asian Center for Development in Dhaka.