Great Expectations

One of my favorite literary quotes is “Take nothing on its looks; take everything on evidence.” I think Charles Dickens would have made one hell of a global macro risk manager because he understood the importance of being data-dependent.


Financial markets are nothing more than an information discounting mechanism, which means they are driven by expectations. It’s been eight trading days since Trump became President-elect and sparked a major sell-off in U.S. Treasuries. The sell-off was based on expectations that a Republican-controlled Washington will enact a number of business-friendly policies and, most importantly, ordain massive fiscal stimulus, all of which will be inflationary.


Experience tells me that the greatest opportunities come when public expectation of an event diverges from the highest probable outcome of that event. Trump’s win is that event, and the public’s expectation that inflation is coming to the States in a jumbo jet diverges dramatically from what the evidence tells me.


When the public wakes up to the reality that Trump’s plan isn’t a slam dunk and that his victory hasn’t improved the U.S. economy one bit, the sell-off in U.S. Treasuries over the last eight trading days is going to auto-correct like the time you sent your daughter a text saying “Grandma is in the garage” and your iPhone changed the message to “Grandma is in the grave.”


Evidence #1: Fiscally Conservative Republicans

Based on looks, investors believe a Republican-controlled Washington will make a cakewalk of implementing Trump’s plans for deregulation, protectionism, tax cuts, and especially fiscal stimulus. Trump is proposing to add $5.3T in debt over the next 10 years, which would push the U.S. debt to GDP ratio to just over 105%. Let’s pretend for a second that crossing the 100% debt-to-GDP Rubicon is no big deal. I mean, the economies of Greece, Bhutan and Jamaica seem to function just fine carrying around a Quasimodo-style hump full of government debt, don’t they?


My political science class was at 8 a.m. during my freshmen year of college, so needless to say my political knowledge is limited, but aren’t Republicans on the fiscally conservative side of the aisle?


A unified-party government doesn’t make it any easier when that unified party is Republican, the party of fiscal conservatism. The newbies in the House of Representatives were elected based on platforms to reduce the Federal debt, not jack it up even more. To that end, just a few months ago the House approved a budget that seeks to cut $7T over the next 10 years, while Trump wants to add $5.3T.


This $12T Grand Canyon-sized gap between Trump’s plan and the House doesn’t mean he won’t be able to enact some stimulus. But the markets are currently priced for perfection, and any amount less than $5.3T will serve as a catalyst for the markets’ auto-correction.  


Another, smaller, piece of evidence that flies in the face of current expectations is that none of the stimulus, no matter the amount, will hit the economy next year. All fiscal stimulus plans are set for 2018 at the earliest, and a lot can happen economically between now and then.


Evidence #2: Election History

It’s not just ideological differences that will cause issues for current inflation expectations: history may have its say, too.


Over the last 100 years, recessions and elections have gone hand in hand. With just one exception, every recession for the last century has occurred close to a presidential election. What’s more, after a two-term president has been replaced, the U.S. has entered a recession within 12 months of the election 100% of the time! History says the U.S. is highly likely to enter a recession during 2017.


Does this mean that there is a 100% chance of a recession next year? No, certainly not. But I have laid out many points of evidence over the last couple of months to support my view that we may already be in a recession, or at the very least teetering on a recessionary cliff. This historical precedence adds one more coin to the recessionary side of the economic scale. I love a good contrarian trade as much as the next guy, but even I’m not crazy enough to fade a 100-year track record like that!


Evidence #3: Consensus

In the span of two weeks we have gone from “inflation” being the least Googled economic term to 85% of investors now believing that inflation is coming in a jumbo jet and bringing higher long term rates with it. Now the market is also pricing in a 92% chance of a Fed rate hike in December.


I get as nervous as a long-tailed cat in a room full of rocking chairs when something in financial markets becomes a forgone conclusion. The events of this year have confirmed that my nerves are warranted when there is a mob mentality. Just hours before the Brexit vote, 75% of people thought there was no chance it would pass. Fast forward five months, and every pundit, poll, and predictive algorithm had Clinton at an 80% or better chance of winning the U.S. election. This continued even during the evening hours as votes were coming in!


Look, I have no idea where inflation or long term rates will be in 12 months, and frankly it’s a waste of time to even attempt such a forecast. But what I do know is that beyond the looks, the actual evidence is telling me that the Treasury markets are very mispriced based on the most likely outcome of the Trump election. Also, as I have said for months, if the market is right and the Fed hikes in December while U.S. growth is still slowing, then they will simply play the role of the Roadrunner, pushing us over the recessionary cliff. Beep, Beep! The best asset to own in that scenario is U.S. Treasuries.


Pause You Who Read This

Now let me be clear, this isn’t a recommendation to buy up Treasuries like a hoarder maxing out her QVC card at 2 o’clock in the morning. That’s the quickest way to find yourself in a center median holding a sign that reads “Will work for food.” There will be a better time and a better price to get LONG Treasuries if things play out the way the evidence is indicating. 


The short-term catalysts for my scenario playing out would be the Fed disappointing in December or the markets realizing that Trump’s all-in plan is realistically more like a half-in plan.


Success or Failure: “I Am Your Blade”

There is certainly a possibility that I am wrong in my assessment of the evidence, but I have a good track record of nailing the bigger macro themes. But as Dickens said, “The success is not mine, the failure is not mine, but the two together make me.”


Managing market risks in real-time is a difficult and complex proposition, which requires a disciplined, multi-factor framework that is dynamic enough to change as the evidence changes. It’s only been eight days, so the best move right now is to watch the evidence, and there will be plenty of it as we close out 2016. In my experience, being mostly on the sidelines for two weeks is well worth it when that perspective allows you to nail the direction of markets for the next six months.

I thank Raoul Pal of Global Macro Investor for bringing the recurrent election-recession link to my attention.