Second-order effects are the real risks to Trump Trade

Bloomberg.- The “Trump Trade” that underpinned global markets for the last few months is at risk of falling apart. The reasons can be linked to concern that President Donald Trump will fail in his plan to repeal and replace Obamacare, raising doubts about his ability to push through anytime soon items deemed more important for markets, such as tax cuts, regulatory reform and infrastructure spending.

Less understood are the second-order effects that could cause the Trump trade to reverse at even quicker pace as a result of tighter global financial conditions, price developments in China and emerging-market capital flows. To understand why, you need to go back to the origins of the Trump trade.

Figure 1: Trump Trade in terms of Total Return

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Source: Bloomberg. Trump Trade Total Return Index is calculated as a portfolio of equally weighted positions (33%) in the Dollar Index future, Dow Jones Index future and 10-year Treasury note future. Volatility Total Return Index is a weighted average of VIX, Move and CVIX indices.

Trump’s election victory sparked bets that his pro-growth business policies would finally spur inflation not only in the U.S., but globally as well. Around the same time as the elections, data showed a decisive turn higher in China’s producer and export prices, adding to the notion that a global reflation was underway. Short term borrowing costs in Asia and Europe rose as a result. Expectations of multiple interest-rate hikes by the Federal Reserve began to be priced into markets by traders.

While the dollar initially followed along by strengthening, it started to weaken once 2016 became 2017 amid speculation that Fed rate hikes could temper U.S. economic growth. That, combined higher borrowing costs, led to tighter global financial conditions. Suddenly, investors were starting to question their optimism for stronger global economic growth, further weighing on the dollar, commodities and producer prices.

Figure 2

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Source: Bloomberg

Ironically, one of the prime beneficiaries of the Trump trade has been emerging markets, mainly because of the expected bump in global growth. Estimates are that more than $350 billion of committed foreign investor capital has flowed into emerging markets since the election. But the recent doubts about U.S. fiscal policy has caused investors to take a second look at the high emerging-market valuations. If some of the money that flowed into emerging begins to flow out, that might cause their currencies to drop and the dollar to rise. A stronger dollar might restrain the U.S. economy and put further pressure on the Trump trade. Flows out of exchange-traded funds that focus on emerging markets show this may already be underway, especially in China.

Figure 3

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Source: Bloomberg. The Bloomberg Emerging Markets Capital Flow Proxy Index provides a high-frequency estimate of the ebb and flow of investment flow into and out of the emerging markets. The index is a weighted average of the following indicators: commodity price trends {SPGSCI Index} (10%); EM equity-market performance {MXEF Index} (30%); EM bond market spreads {JPEMSOSD Index} (30%); and the EM carry-trade performance {FXCTEM8 Index} (30%), with a base period of January 7, 2005 = 100.

Then there are commodity prices to consider, specifically those of metals and iron ore. Since late 2015, the upward move in China’s PPI was almost entirely explained by the Base Metal Forward Index. This is a weighted series of metal commodity futures. The forward index has begun to turn lower for a variety of technical reasons related to supply. Because China’s PPI (and export prices) has a weight in developed market import price indices, a drop in PPI may dampen the trend of global reflation witnessed since early 2016.

Figure 4

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Source: Bloomberg. Bloomberg Forward Global Base Metal Index Index Base is calculated with the following weightings. LME Aluminum LMAHDS03 45%, LME Copper LMCADS03 25%, LME Nickel LMNIDS03 2%, LME Lead LMPBDS03 12%, LME Zinc LMZSDS03 15%, LME Tin LMSNDS03 1%

The Trump trade is mainly thought to be viewed as a U.S. domestic affair. The ultimate source for the trade is global reflation driven by the dollar, financial conditions and Chinese prices. All three seem in reversal, which means the Trump trade may be scaling back regardless of whether a new healthcare act is passed or not. For investors it means a period of rising market volatility could be ahead.

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