Proceed with caution: Resilience of financial markets to Brexit, Trump shocks may not last
Can anything upset financial markets?
This is a question which would have sounded ludicrous to most investors if they had been asked at the beginning of last year whether Britain’s decision to vote to leave the European Union (EU) and the victory of Donald Trump in the US presidential election would prompt a sharp and disorderly sell-off in markets.
Not only were these two political developments considered highly unlikely by the vast majority of traders and investors – particularly Trump’s triumph – they were perceived as “tail risks” which, were both of them to materialise in the space of four-and-a-half months, would have caused the mother of all sell-offs.
Yet six months after the twin political shocks of Brexit and Trump’s victory, markets remain relatively calm.
How is it possible that sentiment has held up so well – and even improved following Trump’s triumph – and are these benign market conditions likely to last?
These questions are on the mind of every investment strategist right now.
To be sure, the Brexit vote has taken a heavy toll on the British pound which has fallen by a dramatic 19 per cent against the dollar since the UK referendum was held on June 23. In early Asian trading on Monday morning, sterling fell below the US$1.20 level for the first time since October.
As I wrote in my column last week, currency investors have been the most sensitive to the escalation in political risk in 2016.
The pound is the third worst performing currency against the greenback this year (after the Turkish lira and the Mexican peso) and could even fall by a further 10 per cent if Britain opts for a clean break from the EU, according to HSBC currency strategists.
Yet UK stocks have surged since the Brexit vote, with the benchmark FTSE 100 index up 15.5 per cent since the plebiscite (partly because of the weakness of the pound) and standing at a fresh record high at the end of last week.
The market reaction to the upset victory of Trump – a brazenly populist and nationalist figure who has doubled down on his incendiary anti-establishment rhetoric since he won the election – has been even more striking.
The benchmark S&P 500 index has risen more than 6 per cent since the election and currently stands just a whisker below its latest record high set on January 6. The dollar index, meanwhile, a gauge of the greenback’s performance against a basket of its peers, although down 2 per cent since January 3, is up more than 3 per cent since Trump’s victory, buoyed by stronger US economic data and a more hawkish Federal Reserve.
Even fears of a disorderly sell-off in the benchmark US debt market have abated, with the yield on the 10-year Treasury bond falling 20 basis points since mid-December to 2.39 per cent.
According to JPMorgan, emerging market (EM) mutual bond and equity funds, which have suffered heavy outflows since Trump’s victory, are now enjoying inflows again. In the week ending January 11, EM bond funds recorded their first week of sizeable net inflows since Trump’s victory, while net flows to EM equity funds turned positive for the first time since the election.
The inescapable feeling, however, is that international investors are being far too complacent.
Although 10-year Treasury yields are still 60 basis points below their peak following the so-called “taper tantrum” in the summer of 2013 and have even fallen over the past month as the “Trumpflation” trade has lost momentum, global inflation rates are rising at a time when central banks’ ability to stabilise markets is increasingly in doubt.
Just as importantly, equity investors have gotten ahead of themselves in assessing the prospects for faster economic growth once Trump assumes office.
Following last Wednesday’s eagerly anticipated press conference in which Trump provided no details of his administration’s fiscal policies and instead continued to disparage his opponents and the media, markets are belatedly beginning to question Trump’s policy agenda.
The risk is that international investors lose confidence in “Trump the reflationist” and start to fret about the political, geo-political and policy-related consequences of “Trump the demagogue”.
The fact is that Brexit has not even happened yet – UK premier Theresa May has pledged to formally invoke the exit clause by the end of March – while Trump’s policy agenda remains unclear.
Markets have shown remarkable resilience up until now, but the real test lies ahead.
Nicholas Spiro is a partner at Lauressa Advisory