Thinking Through the Market Response to the Election
Why are stocks and the U.S. dollar up while bonds and gold are down post-election? Trump has pledged to cut taxes and boost spending on infrastructure by as much as $500 billion. His proposals would increase the nation's debt by $5.3 trillion, the non-partisan Committee for a Responsible Federal Budget has estimated. There are two competing views of the impact of this policy.
Thinking Through the Market Response to the Election
Why are stocks and the U.S. dollar up while bonds and gold are down post-election? Trump has pledged to cut taxes and boost spending on infrastructure by as much as $500 billion. His proposals would increase the nation's debt by $5.3 trillion, the non-partisan Committee for a Responsible Federal Budget has estimated. There are two competing views of the impact of this policy.
The Druckenmiller View
Stanley Druckenmiller, the legendary manager of Duquesne Capital, has turned optimistic. Six months ago, he saw nothing but pain for the economy: in a presentation to the Sohn Conference in early May, he said that while the Fed appeared to have no endgame, markets did and it would be a crash. He suggested that everyone should liquidate their equity holdings and buy gold, which was his "largest currency allocation."
Speaking to CNBC this morning on the topic of the post-Trump election economy, Druckenmiller appeared to flip his entire worldview, stating that he is now "quite, quite optimistic" on the U.S. economy following the election of Donald Trump. "It's as hopeful as I've been in a long time." He noted that "I sold all my gold on the night of the election" because "all the reasons I owned it for the last couple of years seem to be ending". His expectation is that inflation is now set to spike, forcing money out of safe assets like gold and Treasuries and into the US Dollar.
As a result of the Trump presidency, Druckenmiller said he now has a "large bet on economic growth. I'm short bonds, Bunds, Italian bonds, U.S. bonds." The trade reflect his expectation of higher deficits and stronger growth. In other words, he is betting that another surge in debt will benefit the economy.
The performance of markets since the election tells us that many investors are following Druckenmiller's line of thinking. Trump economic policy implies more inflation and a faster pace of Fed rate hikes next year, resulting in a stronger dollar. The expectation is for looser fiscal policy and tighter monetary policy which is now being priced into the markets.
The Ray Dalio View
The other view is that of Bridgewater's Ray Dalio. In an extraordinary presentation to the New York Fed on October 5, 2016, he warned that the world economy is approaching the end of a debt cycle. Dalio noted that the debt bubble was not eliminated during the financial crisis of 2008 and it has since grown to staggering proportions. "The biggest issue is that there is only so much one can squeeze out of a debt cycle and most countries are approaching those limits." He pointed to the likelihood of massive losses in the bond markets, predicting that a jump in yields at a time of record global debt will lead to enormous losses across all asset classes, not just bonds, resulting in an economic depression.
Dalio argues that interest payments are already beyond the capacity of the economy to service. More debt is not the answer to a problem of excessive debt that is already choking economic growth despite record low interest rates. As rates move higher, Dalio expects to see mounting pressure on public and private finance, ending in a reset of enormous proportions.
In his analysis, Dalio warned about the potential losses if interest rates rose by just 1%. "If interest rates rise just a little bit more than is discounted in the curve it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate used to calculate the present value of their future cash flows. That is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive." He further noted that "it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets, that would send them all much lower."
Using a Goldman calculation, the estimated impact on the $40 trillion U.S. bond market of a 100 basis point shock to interest rates would be a loss of $2.4 trillion.
Dalio further adds, "when we do our projections we see an intensifying financing squeeze emerging from a combination of slow income growth, low investment returns and an acceleration in liabilities coming due both because of the relatively high levels of debt and because of large pension and health care liabilities. The pension and health care liabilities that are coming due are much larger than the debt liabilities in most countries because of demographics - i.e., due to the baby-boom generation moving from working and paying taxes to getting their retirement and health care benefits."
Dalio provides a simple explanation for why the system is unsustainable: debt is fundamentally a liability even though it is treated as an asset by those who "own" it. As a result, "holders of debt believe that they are holding an asset that they can sell for money to use to buy things, so they believe that they will have that spending power without having to work. Similarly, retirees expect that they will get the retirement and health care benefits that they were promised without working.So, all of these people expect to get a huge amount of spending power without producing anything. At the same time, workers expect to get spending power that is equal in value to what they are giving. They all can't be satisfied."
We may now be getting the bond market crash Dalio expected. Yesterday, holders of U.S. Treasury paper lost an estimated $337 billion, according to Bloomberg. The 10Y and 30Y Treasury yields jumped the most in percentage terms on record. The benchmark U.S. 10-year yield jumped 20 basis points Wednesday, the most in a single day since July 2013. European bonds were slammed yesterday as well: the yield on 10-year German bunds rose as much as eight basis points to 0.28 percent, its highest since May 2, while the yield on similar-maturity U.K. gilts rose for a fourth day to 1.35 percent, the most since June 23. Italian 10-year bond yields added nine basis points to 1.84 percent, and those on Spain's climbed seven basis points to 1.35 percent.
We should know soon who is right, Druckenmiller or Dalio. We are betting on Dalio. If he is right, we will see record levels of default and massive money creation from panicky central banks which will put a premium on the safety of gold.