Many of us in the US have been swept up by what’s come to be known as the “Trump Rally.” The guise for this massive rise in stock prices over the past few months has been the promise of business-friendly tax reform, deregulation and infrastructure spending, among other “shareholder-friendly” initiatives.
The main theme has been one of “America First,” which has elicited concerns about how far protectionist policies may go, and what the impact to our trading partners will be. Still, others wonder how far asset prices will fall if and when the Trump administration runs into problems implementing their agenda – as we’re starting to see.
You may also like Should We Pay Off $20 Trillion in National Debt by Selling Federal Assets?
But I have a question.
If this Trump rally really is predicated on domestic policy changes that will enhance the US economy (almost assuredly at the cost of our trading partners), then why is the rest of world also enjoying this “Trump Rally?” Shouldn’t they be in “Trump Correction?”
Take a look at the chart below to see what I mean. This chart shows ACWI, the ETF that tracks the All Country World Index – an index comprised of equity returns in 23 developed countries and 23 emerging markets.
As you can no doubt see, there has been a massive rally that looks to have its beginnings in early November … is this a coincidence?
Longer-term DTL subscribers who are unfamiliar with ACWI may prefer looking at a more familiar chart: the GDOW. The Global Dow Index is comprised of 150 leading companies from around the world, and includes the 30 Dow Jones Industrials companies.
As you can see, it too has been on a nonstop upward climb since the US election.
So what gives? Are Trump’s policies going to be so novel and miraculous that the entire global economy is set to benefit? Or is this trade perhaps predicated on something other than the new US administration?
Back on February 6th, I wrote an article called, “It’s Not All About Trump” in which I detailed many of the positive economic undercurrents that were in place prior to the change in administration. Nearly all of the themes outlined, including positive trends in personal income, consumer spending, inflation, home prices, employment, manufacturing, earnings and consumer confidence, are all still in effect.
This certainly helps to explain the buoyancy of US equity prices, but it almost certainly isn’t responsible for the gains overseas … so what is?
More and more investors, it seems, are finally coming around to the idea that this is not a “Trump Rally.” Instead, it’s a “Reflation Trade.”
Ask yourself this: Back in 2014, when both US and world equity markets began to slump, what was the main cause? If you said "oil," pat yourself on the back.
Now take a look at the revealing chart below. This chart shows ACWI – the All Country World Index, in the top chart, and the price of oil (WTIC) in the lower chart. I’ve included some blue arrows to highlight prevalent trends, and the blue box highlights the 18-month collapse in oil that occurred from mid-2014 until the beginning of 2016.
Looking more closely at the area inside the box, we can see that the collapse in oil spelled trouble not just for US markets (which were impacted the most), but for the entire globe.
This period of collapsing oil prices put the specter of deflation squarely in our (the world’s) sights, which had many devastating consequences. Aside from erasing significant value from global equity markets, it pushed fixed income prices so high in many markets that longer-term government bond yields went negative. It also ushered in a new era of monetary policy in which central banks were actually targeting negative interest rates.
Read The Risk of Bond Funds in a Rising Rate Environment
Deflation is a major concern not just because of what it does to financial markets, but also because of what it does to economies and wages. While prices coming down may initially seem like a good thing, it quickly causes profits and production to decline, which can drive wages lower and cause layoffs. This non-virtuous cycle continues as those penalized with reduced wages or lack of employment further cut back on spending, causing additional slowing of the economy.
We all know that oil plays a dominant role in the creation and distribution of good and services, but it’s rather amazing to consider the impact that oil prices have on every other aspect of our global economy. In the chart above, you can see clear evidence that the decline in oil prices was the main contributor to a global economic slowdown that took major economies to the brink of deflation.
Thankfully, in early 2016 oil prices did find a bottom, and have since been heading higher. The upward trend in oil prices has been met with a similar rise in global equity prices, as inflation levels continue to rise and the prospect of global deflation fades from view.
In my opinion, it is this move towards reflation that is responsible for not just the US’s impressive gains over recent months, but that of global equity markets.
Looking at the longer-term chart of ACWI presented in the above chart, we can see that the move higher after the election is not so much unique to that event, but simply reflects a continuing trend that had already been in place for over a year.
Now, please don’t misunderstand me as saying that Trump has nothing to do with this rally. His election marked a change in tone and policy that frankly has unleashed a new set of “animal spirits” in the economy – for better or worse.
Check out Are We in the Final Wave of the Bull Market?
What I’m trying to convey is that those who believe this rally is only about Trump and that its fate hangs on the success or failure of his policies … are not seeing the bigger picture.
Behind Trump is a global economy that has been improving for quite some time, and is likely to continue doing so. This improvement has less to do with Trump, and more to do with a general reflation of the global economy, led by a rebound in energy prices.
This should put some of you at ease, while others are likely to remain concerned. If the rebound in oil is the primary factor in this global recovery, what’s going to happen if oil prices head south again?
I think the answer there is rather obvious, but I will say that watching oil is probably a heck of a lot more important than paying attention to all the back and forth in Washington. I too am curious to see what policy changes arise, but those policies are not the only determinant of where asset prices head from here.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
