Markets crying that inflation is coming

We have just witnessed one of the most incredible spectacles in financial markets you will ever see.

Source: Bloomberg

Very few predicted a Republican clean sweep. One US investment bank had this outcome at a 6% probability in their trading playbook around the event. I admit I had succumbed to the various election probability models on offer from various pollsters and aligned my strategies around these. Never again it seems, the social change happening in the developed world is for all to see, and one has to wonder about the French and German elections in 2017. A win for Marine Le Pen in France or the AfD party in Germany may not result in a one day sell-off as it will radically increase the prospect of a break-up of the European Monetary Union (EMU). A worry for another time.

What we have seen in financial markets has been breath-taking and led by the US fixed income market. Like many, I had been concerned market participants would be worried about Trump’s relationship with the Federal Reserve and a number of their key trade partners (such as China and Japan), but again this concern is for another time. Right here, right now, traders have viewed the combination of a cut in corporate tax (equating to around 0.5% of GDP), sizeable infrastructure spend (I’ve seen numbers between $500 billion to $2 trillion) and a corporate tax repatriation window providing a massive boost to Foreign Direct Investment (FDI). Throw in trade barriers (such as a 45% trade tariffs on Chinese goods) and a move to bring production back to the US means that prices will increase (inflation) and in-turn the Federal Reserve (Fed) will have to be more aggressive in tightening policy in 2017. Trump will borrow and build – it’s what he has done his whole life and it’s what he will do as President of the United States.

The US ten-year treasury closed Tuesday’s trading session at 1.85%, but fell 14 basis points (bp) to 1.71% during the panic and pandemonium in Asia when it was clear that Florida was not going Clinton’s way. It is now at 2.06%, so an incredible 35bp reversal! US five-year inflation expectations (again, I’ve looked at the bond market) have increased to 2.10%, a huge 17bp increase and US inflation expectations are now at the highest level since August 2015. The US yield curve has steeped dramatically (longer maturity bonds have sold off more than shorter maturity bonds) and US financials have flown as a result, with the financial sector up 4.3%.

The prospect of a Fed hike in December fell below 50% in Asian trade yesterday, as traders saw the uncertainty of a Republican clean sweep as cause for concern. However, this probability now stands at 82%, so with equities finding buyers, the Fed have been given a green light to hike. More importantly though, the interest market has got excited about the prospect of inflation (driven by fiscal stimulus) and is now pricing in not just one full rate hike in 2017, but a 16% chance of a second. We have seen three and a half quantitative easing (QE) programs from the Fed since 2009 and now ‘Trumpnomics’ and fiscal stimulus is going to finally create growth...let’s see.

The S&P 500 is up over 1%, and it’s hard to remember whether the S&P 500 futures have ever traded down to their daily limit (of 5%) only to finish in positive territory! We have also seen buying in commodities, with incredible gains in iron ore futures (+9%), steel futures (+2.6%) and copper futures (+3.4%). US crude has rallied 5.5% from its low and this all means huge gains for Aussie stocks today.

As things stand, the ASX 200 is eyeing an open at 5331, so a gain of 3.4%. The Nikkei 225 should open 1000 points or 6% higher, led by a huge reversal in the JPY (USD/JPY is up 450 pips from the low of ¥101.20). BHP is likely to open 10% higher (based on its ADR), while CBA should push over 3% higher. Gold stocks may struggle given spot gold is $65 off its session high of $1337.

Given the monster sell-off we are likely to see in Australian fixed income, I would expect sharp underperformance in any stocks that trade as a quasi-bond. Sectors like REITS, staples and utilities may struggle today, but for today, the combination of huge gains in materials, fiscals and energy should push the ASX 200 3.4%. If it closes at that level, it would be the strongest gain since 6 October 2011.

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