I have always said that any analysis based on a method of strategic thinking will require us to periodically shut it all down if a new variable enters the equation. We now have a new variable. The election of Donald Trump has thrown a wrench into the analysis of fixed income markets. There are two new issues to consider:
- Stronger domestic economic growth caused by the transfer of jobs from Mexico (or Canada or China) if trade agreements are cancelled or new tariffs announced. Such new growth may be very good for small cap stocks and domestic producers, and very bad for offshore manufacturers.
- Higher domestic inflation caused by the transfer of sourcing from cheaper suppliers in Mexico to local US producers. The scale of this issue is very hard to ascertain. Will all of NAFTA be cancelled outright or will there just be Mexican tariffs to (say) pay for a wall. The impact would normally be limited because sellers don’t want to risk loss of market-share by having big price hikes.
The first test we need to pass to be sure that the gauges will continue to work, is – the (short term) correlation between stocks and bonds must remain negative. It was easy to imagine a world where tariffs both hurt profits and elevated inflation. If that was the markets’ belief, then both would rise and fall together. Bonds would lose their safety role. So far that has NOT been true.
The second test is to see if bonds stay connected to oil, stocks, utility prices and currency movements. Initially they should under-perform vis a vis their “normal” inputs. After a quick adjustment, they should resume their normal behavior. I don’t believe markets are slow to figure such things out. They may well hit another period of uncertainty next year as we begin to see how extreme Trump’s trade policies are. We need to see a period of “normalcy” after the initial shock or yield adjustment. We can measure this by looking at their negative beta verses the S&P. If that stabilizes and moves in proportion to historical volatility then we’ll be ready to switch everything back on.
In the meantime , we must be wary of very high (bond) gauge readings with such a scary new factor now in the offing. I would recommend an RP weighting more in favor of stocks than volatility implies since they seem to have adjusted to the tariff story rather quickly. One might even want to substitute Russell 2000 contracts for ES.
The changing beta of bonds tells us this is not just a simple story of stock market excitement over a Republican unified government.