Judging by recent market action, it is becoming apparent that traders and investors are getting if not tired, then displeased with having to trade what boils down to one of two narratives: Trump Reflation Trade On, and - as has been the case recently - Trump Trade Off. As much is apparent in the latest weekly kickstart note from David Kostin who writes that with the market struggling to readjust its expectations for US government policy following the move away from health care reform, client conversations make clear that investors fall into two camps:
- The first group worries that the failure to “repeal and replace” the Affordable Care Act is a sign that other items on the policy agenda are less likely to be enacted than they had hoped.
- The second group is encouraged about the shift in focus to tax reform as the new top priority for the administration.
Here Goldman notes, that despite the recent stumble by the Trump administration, its D.C. economist Alec Phillips continues to expect legislation late this year through the FY2018 budget resolution that will use dynamic scoring and some deficit expansion to reduce the statutory corporate tax rate. He views many of the additional reforms that have been proposed as less likely.
However, as Kostin cautions, from an equity market perspective, recent performance reflects an ongoing transition from post-election hope to an acceptance of political reality. Below, Kostin explains why the bank is increasingly souring not only on stocks (recall it downgraded global equities two weeks ago), but also on the broader economy:
Our S&P 500 outlook this year argued that the index would rally to 2400 in 1Q on hopes for earnings-friendly policy changes, but gradually decline to 2300 as investors recalibrate expectations to reflect the challenges of current politics in Washington. Although the S&P 500 has retreated from its record highs at the start of the month, it rose by 6% in 1Q 2017; its riskadjusted return (return/realized volatility) was the best since 2013.
Even more than the modest decline at the market level, performance below the surface highlights a moderation of investor policy optimism. Our basket of S&P 500 stocks with the highest effective tax rates – the most likely beneficiaries of potential tax reform – has unwound all of its sharp post-election gains in the last two months. Similarly, small-caps, which rallied by 16% in the month post-election on hopes of faster growth, lower taxes, and less regulation, have lagged the S&P 500 by 390 basis points this year (+6% vs. +2%). Both the tax basket and small-caps rebounded this week.
Infrastructure beneficiaries have also retreated, but remain above their pre-election levels, and well above levels before both candidates advocated increased spending on the 2016 campaign trail. Despite their 10% decline in the last two months, Construction Materials stocks trade at a 28x forward P/E multiple and remain 20% above their prices one year ago.
Skeptical investors have also withdrawn most of the “deregulation premium” from the share prices of banks stocks and other financials. Hopes for less regulation, which our Banks analysts estimate could boost their 2018 earnings estimates by nearly 20%, lifted share prices more than 10% higher than justified by the rise in Treasury yields. This deregulation premium has collapsed sharply in the last two weeks (Exhibit 2).
Despite the political uncertainty, the backdrop of strong economic data has helped drive and sustain the equity market rally. Our economists’ MAP index of data surprises broke into positive territory in mid-November and this week reached the highest level since 2013. The data reflect the pace of real US economic growth rising from 2.1% in October to 4.3% in February. This marked the strongest reading of our Current Activity Indicator (“CAI”) since 2006 and alone could explain the rise in equities to record highs (Ex. 3).
The contribution of “soft” data to the recent economic surge suggests that the Trump trade and growth trade are not truly independent. Survey data such as the ISM and regional Fed manufacturing surveys have driven most of the CAI improvement in recent months. In contrast, “hard” data have improved much less and generally continue to reflect the 2%-3% pace of growth they exhibited prior to the election. This divide suggests that rising policy uncertainty may also pose a risk to the economic data.
Although the pace of economic activity remains strong, both the macro data and the performance of growth-sensitive equities suggest the acceleration is behind us.
The CAI rose sequentially in each month from Oct. through Feb., but preliminary data show a modest step down in March. Recently our basket of cyclical industry groups and our sector-neutral Dual Beta basket have each lagged peers, apparently also reflecting a modest economic slowing. Our economists’ 2017 real GDP growth forecast of 2.2% suggests this deceleration will likely continue unless policy tailwinds emerge or nascent “animal spirits” lead to self-sustaining spending and investment.
What does all of the above mean for near-term market dynamics? As Kostin concludes, supply/demand dynamics add uncertainty to the near-term outlook. Goldman's sentiment Indicator currently reads 86 (out of 100), signaling less stretched positioning than in recent weeks.
The good news: the resilience of intraday equity prices and the still-low level of implied volatility suggest that investors remain eager to “buy the dip.”
The not so good news: the first major week of the 1Q reporting season will start April 17, and more than 75% of S&P 500 companies are now in their buyback blackout windows. With the largest source of demand for US equities – corporates – barred from discretionary repurchases for the next few weeks, there will be less support for share prices if disappointing economic or political news triggers market weakness.
And with overall economic data rolling over rapidly....
.... it is only a matter of time before that other Goldman warning, about a sharp drawdown in equities, is confirmed as well.