Mr. Trump Meets Mr. Market

Most people probably caught the wild swings in the Dow and S&P 500, from a five percent drop in futures trading overnight to a 1.1 percent higher close, with most of the action in the 30 minutes before the market opened.

Small cap stocks, which gained 3.1 percent during the trading session are particularly interesting because their relative performance to large cap stocks can be viewed as a signal of ‘risk-on’ or ‘risk-off’ periods (times when investors move to riskier assets in anticipation of gains or lower risk assets when expecting losses).

Another risk-on/risk-off indicator is the CBOE Volatility Index, or VIX, which dropped by more than 23 percent yesterday, signaling that investors are pricing in less volatility.  It had been marginally higher than average heading into the election, but not much above normal levels.

Foreign markets weren’t as strong, partly because the dollar gained versus foreign currencies throughout the day, following the same knee-jerk reaction as stocks.

An ETF that tracks the MSCI EAFE index of developed stocks was essentially flat, but if you take out the currency effect, they were about two-thirds of a percent higher.  Foreign stock indexes shouldn’t trade too much based on US elections, but the currency-adjusted move higher is a positive sign.

(It’s better to evaluate sentiment using an ETF instead of an index when looking at overseas markets since the foreign markets close shortly after we open and the ETF continues to trade as the market processes new information).

An ETF tracking the MSCI EAFE EM index of emerging markets stocks fell more sharply, falling -3.23 percent.  The stronger dollar accounts for only about a third of this change, since the currency-adjusted performance of these stocks was -1.96 percent.

Although I didn’t do a full attribution analysis, the loss in emerging markets isn’t a surprise at all because China makes up about 22 percent of the index, which fell around two percent (depending on the index) given the likely changes to trade policy in the coming years.

A number of sectors and industries saw dramatic changes, from the -10 to -25 percent losses in hospital stocks to the sharp gains in banks, biotech, construction/engineering and construction materials, which gained 4.84, 7.75, 8.91 and 10.63 percent respectively.

Outside of hospitals, the worst performing broad sector were interest rate sensitive: REITs and Utilities, which lost -2.28 and -3.68 percent respectively.

While the bond market shifts were less dramatic in absolute terms, they were more dramatic compared to standard changes in the bond market.

The 1.1 percent gain in the S&P 500 is a run-in-the-mill shift without knowing what happened in the premarket, but the -0.99 percent loss for the Barclays Aggregate bond index was a three standard deviation event.

If it’s been a while since you’ve taken statistics, you should only expect a change of this magnitude 0.25 percent of the time.  In trading, that’s about once every 17 months or so: it happens, but not often.

The 10-year bond yield, which was as low as 1.71 percent overnight initially, jumped from 1.88 percent on Monday to 2.07 percent yesterday.  It was the largest one-day change for the 10-year yield in three years.

Part of the reason for the big move in yields was a fairly dramatic increase in inflation expectations.  On Tuesday, markets were expecting inflation over the next decade to come in around 1.73 percent, but upon digesting the election results, those expectations moved higher to 1.85 percent.

That may not sound like much, but inflation expectations don’t move this much over such a short period very often (it was a two standard deviation event, so only about five percent of the time).  The change in inflation expectations is largely based on his proposal to spend $1 trillion on infrastructure to stimulate the economy.

While medium and long-term bond yields rose sharply, the markets expectations for a Fed hike in December were largely unchanged, with an 80 percent chance of a hike before and after the election.  Just as before, expectations for hikes after December are pretty low.

That could be partly explained by possible changes at the Fed.  Chair Yellen’s term expires in February of 2018 and Trump could potentially fill two of the open seats sooner than that.

There will be much more to consider in the coming days, but as I noted yesterday, there is a lot of noise in the short-run.  Just as before, we aren’t advocating changes at this point, but as the risks and opportunities shift, we may as well.

In the meantime, I like to recall a statement that our own Ryan Craft made a few years ago: most of what we see in the short run is just ‘watching volatility.’