Tactical Asset Allocator: markets may have got it wrong about Trump
Donald Trump's first 100 days in office is the stuff of tomorrow's MBA textbooks on poor practice in management and governance. Those of his cabinet colleagues who are not relatives have connections with him in the commercial world, which does nothing to temper his autocratic tendencies.
So it is curious that the markets are seeing what they want to see and ignoring the negatives. All the good news on corporation tax and infrastructure investment has already been priced in, despite remaining somewhat abstract and with substantial barriers to implementation.
Yet Trump's plans on immigration and protectionism are another matter. Much more tangible, the threat to the freedom of movement of talented technology and banking staff has been allayed for now.
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But allegations of currency manipulation against China's sensitive leadership could prompt a trade war, and the market has not fully factored in the president's relationship with Putin.
To complicate matters, the very fiscal stimulus that the market has so warmly welcomed could damage the economy by promoting inflation. That could push the Federal Reserve to raise rates and shrink the money supply, perhaps acting too hastily for the stimulus to take hold.
Critically, it is not only defensive and income stocks that have fallen in the various minor market sell-offs so far this year.
Financials have also tumbled at times, despite Trump's promise to reverse the Dodd-Frank banking reform measures, and director dealing data shows a disproportionately high level of activity among investment banking executives.
In the UK, economic data has also surprised on the upside, but the pessimistic forecasts made before the referendum about a Leave vote were based on Article 50 being triggered straightaway, which would have created greater economic disruption.
In the event, until the UK leaves the EU, it can enjoy trading in the EU with all of the benefits of a weak currency. The delay in triggering Article 50 also allowed the Bank of England to get in first with an interest rate cut and increased support for businesses and banks.
So both here and in the US, the rationale for current confidence looks shaky.
Inflation is increasing, which sooner or later will be painful for consumers; businesses are delaying expansion plans and some UK banks are relocating staff. In the London market, only the mining sector is helping to prevent a serious plunge.
Economically speaking, it leaves Theresa May with little choice but to talk up the UK/US 'special relationship'. She needs to present a vision of UK trade post-Brexit and instil confidence for the future.
She may even hope that her bargaining position will benefit from a wave of populism in the French, Dutch and German elections and the scandal around Francois Fillon - the right-wing candidate to Marine Le Pen - who has dented his credibility by paying his wife for work as his parliamentary assistant.
What we do know is that over the past year, almost all commentators and analysts have called the markets completely wrongly. How investors should respond now is as difficult as at any time in history.
Recent shorting activity by institutional investors, who borrow and sell shares in expectation that the price will fall, suggests caution is in order.
Historically, stocks that have suffered most in the preceding month perform best in rising markets, according to Bespoke Investing Group, but that has not been the case so far this year.
The firm's analysts looked at the year-to-date performance of the 20 most unloved stocks in the S&P 1500 that have been heavily sold short over the past month and, despite the equity rally, they are down overall.
If this trend of underperformance continues, it would be a cause for concern for the broader market, Bespoke says.
The CBOE volatility index (Vix) also surged in the first week of February - its biggest rise since September - which is another good measure of sentiment.
However, the Vix hike is from a low base and it still remains below its long-term average; but at some stage, probably this year, it could break out and rocket.
Sadly, it is not possible to place pure bets on the Vix, because it is based on a mathematical formula, but bearish investors can buy the VXX ETF (iPath S&P 500 Vix Short-Term Futures ETN), which is based on Vix futures and is therefore slightly less volatile.
Other ETFs that could benefit from a US sell-off include the ProShares Short S&P500; or if you think the Fed could move too quickly on rate rises, there is the Direxion Daily Total Bond Market Bear 1X ETF as high rates are bad for bond prices.
For the UK market, Deutsche Bank's x-trackers offer a standard short FTSE 100 ETF or, for the very brave investor, x-trackers offers a leveraged short ETF that returns two times the inverse of the index's returns, while ETFS offers an inverse ETF with three times leverage.
This is a dangerous game however, and owing to the compounding effect on the daily index movements, the returns will be much more exaggerated (in both directions!) than the sum of the inverse of the daily index movements, particularly in volatile markets.
For the less brave, emerging markets (EM) debt seems to be one of few bright spots and looks set to build on its positive returns last year.
China's greater focus on stability ahead of the 19th Party Congress later this year should be supportive, while emerging market sovereign fundamentals have been bolstered by more competitive foreign-exchange rates, a reduction in short-term debt and improved current account deficits.
Valuations might even be called attractive. EM hard currency debt spreads have widened 100 basis points compared with US bonds since the presidential election.
US asset manager GMO forecasts that both EM equities and EM bonds will outperform their US counterparts in the coming years, suggesting that emerging market debt will generate an annual return of 1.5 per cent over the next seven years, versus a loss of 0.6 per cent for US bonds.
Similarly, it forecasts that EM stocks will generate 4.4 per cent annualised over seven years, compared with a 3.1 per cent annual loss for US large caps, and a 2.1 per cent loss for US small caps.
Our portfolio is light on bonds, so we are taking this opportunity to boost our holding in Standard Life Investments Emerging Market Debt fund.
Manager Richard House has many years of experience in this market, and the choice of dozens of countries in which to invest, which should boost the diversification in the portfolio.
We will also boost our holding in DB X-Trackers MSCI EM Asia Index Ucits ETF, which has been rising nicely, and sell down our holding in the European Investment Trust, as our weighting to Europe is overly high.