About a year ago, the U.S. stock market was breaking a record. And, it wasn’t a good one. It had the worst start ever to a year, with the S&P 500 Index dropping about 6% in the first five trading days of the year.¹ The Federal Reserve had just raised rates for the first time since 2006, and the stock market didn’t like it.

As we begin a new year, there’s no doubt that the Fed will also play a key role in what happens in 2017. But, the Fed and its monetary policy will have to share the spotlight with President-elect Trump and his fiscal policy. We explain below why this interaction between the Fed and the new administration could determine the most important investment trends of 2017. Just keep in mind that this is not a pro-Trump political argument. We’re simply analyzing what’s driving the markets right now and what could surprise investors in 2017.

What’s Driving The Trump Trade?
As soon as Donald Trump got elected, we saw an immediate and radical change in market sentiment. Investors went from worrying about deflation to preparing for inflation. This has triggered a big rotation in investment portfolios, with investors buying the U.S. dollar and stocks, and selling bonds and precious metals.

Some have called this “the Trump trade.”² See, the consensus right now is that Trump’s policies could lead to a huge boom in the stock market. Investors expect that his proposal for lower corporate taxes, repatriation of overseas cash, less regulation, and fiscal stimulus could give a boost to earnings in 2017. And, that’s the narrative that has pushed stocks to new highs after his election.

Investors also expect the new administration’s fiscal policy to be more inflationary. For that reason, the 10-year Treasury yield has jumped from 1.8% to 2.4% (as of Jan. 3) since his election.³ That may not seem like a lot, but it’s a jump of 33%. And, it reflects the new reality that investors are no longer worried about deflation and negative interest rates. They’re now starting to worry more about inflation.

Ray Dalio is considered one of the richest investors alive. He is chairman and co-Chief Investment Officer of Bridgewater Associates, one of the largest and most successful hedge funds in the world.⁴ In a letter he wrote recently, he summed up the current market consensus:

“…We are about to experience a profound, president-led ideological shift that will have a big impact on both the U.S. and the world. …[It] could have a much bigger impact on the U.S. economy than one would calculate on the basis of changes in tax and spending policies alone because it could ignite animal spirits and attract productive capital. Regarding igniting animal spirits, if this administration can spark a virtuous cycle in which people can make money, the move out of cash (that pays them virtually nothing) to risk-on investments could be huge. Regarding attracting capital, Trump’s policies can also have a big impact because businessmen and investors move very quickly away from inhospitable environments to hospitable environments.” ⁵

This change in sentiment is already leading to some important market rotations. I already mentioned the outperformance of U.S. stocks and the U.S. dollar. We should also consider the underperformance of bonds and precious metals.⁶ But, the “animal spirits” have also given a big boost to more cyclical sectors, such as financials, industrials and energy. While more defensive sectors, such as health care and utilities, have underperformed since the election.⁷

With all these big trends emerging, the question everyone is asking right now is “will the Trump trade continue as we head into 2017?” And, that’s where the Fed comes in.

Passing The Baton From Monetary To Fiscal Policies
Ever since the 2008 market collapse, the Fed’s zero interest-rate policy (ZIRP) has been a key driver of the markets. In other words, monetary policy, not fiscal policy, has dominated the headlines over recent years. But, now that the Fed has started to hike rates, we’re transitioning to a new phase where fiscal policies are expected to play a bigger role. The Fed is passing its baton to the new administration. While investors are hoping this transition will go smoothly, there are plenty of challenges ahead.

For example, the expectation of three more Fed rate hikes in 2017 is giving a big boost to the U.S. dollar. But, the strong dollar could not only hurt profits for companies that do business overseas; it could also trigger a crisis in emerging markets. According to the Bank for International Settlement (BIS), over the past eight years, emerging markets have increased their U.S. dollar denominated debt by more than $3.5 trillion.⁸ A stronger dollar would make it harder for them to repay their debt. Not to mention the fact that higher interest rates in the U.S. could induce a capital repatriation from emerging markets back into the U.S.

Another risk is the quick jump in Treasury yields. If the 10-year yield keeps rising, at some point it may cause problems for stocks. See, when yields are rising, bonds become more appealing to investors. In that environment, investors may be less willing to take on the risk of owning stocks. Then there’s also the negative impact that higher yields could have on the housing market through higher mortgage rates.

The key question here is how high can yields go before they begin hurting stocks? Jeffrey Gundglach thinks that number is 3%. In a recent interview, the chief executive of DoubleLine Capital, known in Wall Street as “the bond king,” said that a yield above 3% could harm stocks and the housing market.⁹

And, let’s not forget that nobody knows if Trump will be able to implement all the policies he has proposed. If not, we could see a major reversal of recent trends. On the other hand, if he succeeds, we should all pay close attention to the Fed. Because higher expectations of inflation may force the Fed to hike rates more quickly than anyone is predicting.

As you can see, there are plenty of unknowns ahead. By now, I’m sure your inbox is overflowing with predictions for 2017. The truth is nobody knows what will happen. Last year was full of big surprises, like Brexit and Trump’s election. And, nearly nobody predicted that the markets would be making new highs as we headed into 2017.

We’ll be following these developments and others very closely in the days ahead. So, stay tuned.

Until the next Daily Pfennig^® edition…

Sincerely,
Mike Meyer
Vice President
EverBank World Markets, a division of EverBank
1.855.813.8484
everbank.com