There are signs that investors in US markets are resetting their lofty expectations of what President Trump and his administration can achieve.
Political risk in the US appears to be at a higher point now than at any time since President Trump assumed office in January 2017. This is to some extent the result of a tumultuous period in May, which saw allegations of connections between Donald Trump’s presidential campaign and Russian government officials; the firing the director of the Federal Bureau of Investigations (FBI) while the bureau was actively investigating those connections; and the disclosure of sensitive intelligence information to Russian foreign ministers during a closed-door Oval Office meeting.
President Trump hasn’t done much on his own to temper these risks. If anything, his instinctive communication style and unpredictable tendencies have accentuated them. Investors around the globe are learning through experience how Trump’s unpredictable nature impacts financial markets. The worldwide sell-off in equities on May 17, was a recent and dramatic example of this learning experience.
Less than six months into Trump’s presidency, the I-word – impeachment – has started to surface in news reports and political columns, particularly in the US. Some members of the US Congress openly mentioned impeachment in discussions with the media1, although the leadership from both political parties did not appear to go that far yet.2, 3
Impeachment of a US president is a long, messy and politically disruptive process. In the worst-case scenario, the effects would reverberate domestically and globally, impacting the government, the economy and the financial markets. Josh Lohmeier, Head of North American Credit at Aviva Investors, believes impeachment of President Trump should be seen by investors as a low probability tail-risk event rather than an immediate cause for concern.
Of greater importance for investors is the extent to which current expectations for Trump’s policy agenda line up with the reality of the political process. “The market in general was perhaps optimistic about the magnitude and timeline for the president’s proposed reforms,” Lohmeier says. “Any controversies or distractions will likely muddy that view further, but they do not change the need among investors to align their expectations for reform with what’s actually possible.”
Quantifying the effects of unpredictability
So what would a realignment of investor expectations look like, in terms of market performance? To assess the net impact of Trump’s unpredictability, investment markets should quantify three moving components. First, how much fiscal optimism has already been priced into the markets? Second, what are the most realistic outcomes in a stalled political environment and how long would they take to implement? Last, what impact would these changing views have on current market valuations?
To establish a framework for assessing these potential impacts, it is helpful to review what the Trump effect has been so far across global financial markets. Equities, including US, domestic international and emerging markets, gained over 10 per cent in the six months since Trump’s electoral victory.4 In bond markets, yields on 10-year US Treasury notes rose 50 basis points over this time, while US investment grade spreads tightened by 20 basis points.4 These moves were partly driven by optimism over Trump’s agenda; although strong economic fundamentals in the US also aided investors’ expectations.
Lohmeier notes this rally was neither unusual nor unprecedented. In 13 of the past 17 US election cycles, the S&P 500 posted gains between the election day and inauguration day, with a median return of 3.8 per cent. Once a president assumed office, however, investor sentiment changed appreciably: US stocks declined more often than gained in the first three months of the last 17 presidential terms and the median return was negative one per cent.
Impeachment, as the worst-case scenario, could potentially reverse the entirety of the Trump effect on markets, according to Lohmeier. Using a very simplistic example for equities, a reversal back to pre-election levels would represent a significant correction. But it’s important to note stock markets had already appreciated considerably up to that point. For the other possible scenarios, the market impacts would be noticeable but are unlikely to be as damaging.
The Trump effect beyond equities
While US stocks have shown some recent frailty due to heightened political risks, US credit markets have generally been resilient. During the tumultuous period in May, credit spreads in the US investment grade and high yield bond markets barely budged. Much of this can be attributed to continued strong demand for US fixed income from institutional investors attracted to the higher yields available on US dollar bonds. Global investors appear to hold faith in the strength and relative safety of US institutions, as well as the strength of the economy.
“Despite the political noise, there has been little yet to curtail the structural tailwind driving demand for US credit,” says Lohmeier. “That indicates the market remains largely focused on a positive outcome.”
One exception may be the US dollar. The US Dollar Index (DXY), which measures the relative value of the dollar against other leading global currencies, has retraced its entire rise since Trump’s election and then some as of June 15. This is a result of both domestic and global factors.
Tim Alt, Portfolio Manager at Aviva Investors Americas, notes that the Trump effect was the leading reason behind the dollar’s appreciation in the immediate post-election trade. “None of the expectations for Trump were priced into the market at the time of his electoral victory. This was a dollar-specific movement for a short period, with other factors on the global stage essentially remaining equal.”
Since Trump’s inauguration, the currency markets have gradually walked back their expectations on what the administration would be able to accomplish from a fiscal stimulus standpoint. “The agenda was always going to be difficult to achieve within the timeframe,” says Alt. “Given the recent distractions, any progress on the fiscal front will likely take longer.”
Unlike the post-election rally, Alt explains the year-to-date downward move is not just about the dollar. “While we have seen US political uncertainty increase, we’ve also had strong economic growth data emerge in the rest of the world and less political uncertainty, particularly following the outcomes of the French and Dutch elections.”
There have also been other reasons to diversify away from the US dollar and seek returns in other markets and asset classes. For example, emerging markets have become more attractive for many international investors because, as Alt notes, emerging economies have experienced recent pick-ups in growth while interest rates have declined and inflation remains under control.
“Developing markets were most at threat when the dollar was strengthening,” Alt says. “But as the dollar stabilized and stopped rallying, emerging market assets appeared to offer better opportunities.”
All possibilities on the table
The official procedure for impeachment as outlined in the US Constitution requires an official investigation by the House of Representatives, followed by a formal trial in front of the US Senate. With both chambers under the control of Republicans, Trump’s political party, it seems highly unlikely impeachment proceedings would even get started in the current Congressional term (through the end of 2018.) Still, further allegations of political collusion between the president’s associates and foreign interests, or surprise decisions or announcements from Trump himself, could keep the talk of impeachment burning and provide fuel for a potential risk-off trade.
Another possibility is a Trump resignation. Compared with impeachment, resignation would be quicker and simpler. Republicans would continue to hold the White House and both chambers of the US Congress, and with Trump removed, could refocus on the core items of their legislative agenda. However, the president has characterized himself as a fighter who doesn’t quit, so resignation seems just as improbable as impeachment.
As of now, the most likely scenario is that Trump continues in office; after all, he has emerged victorious despite daunting odds before, whether through the Republican presidential nomination process or in the US general election. The main question investors are grappling with is whether Trump will find it increasingly difficult to steer his policy reforms and fiscal proposals through a wary Congress.
“Investors may grow impatient with an even slower pace of reform,” says Lohmeier. “The optimism built up in the market may turn to frustration, which would be bearish for risky assets.”
It is worth noting that the equity rally in the US has largely stalled since the beginning of March. This could represent the realization among investors that expectations exceeded the reality of the political process. Lohmeier sees a renewal of volatility in financial markets as a potentially refreshing sign, however.
“The litmus test is how markets respond to further uncertainty. Will investors become desensitized to the unpredictability and maintain their lofty but unrealistic expectations, or will there be higher volatility even in a sideways market as investors become more aligned to the political reality?”
 “The Memo: GOP talk of impeachment highlights Trump’s troubles” The Hill, May 18, 2017. http://thehill.com/homenews/administration/333976-gop-talk-of-impeachment-highlights-trumps-troubles
 “Pelosi: Democrats need to 'curb their enthusiasm' over Trump impeachment” Washington Examiner, May 18, 2017. http://www.washingtonexaminer.com/pelosi-democrats-need-to-curb-their-enthusiasm-over-trump-impeachment/article/2623507
 “GOP leaders play it safe as Trump scandals grow” Politico, May 25, 2017. http://www.politico.com/story/2017/05/25/republican-leaders-trump-scandals-238787
 Source: Bloomberg. US equities represented by the S&P 500 Index; International equities the MSCI World Index; Emerging markets the MSCI EM Index; US investment grade the Bloomberg Barclays US Credit Index.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at June 22, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St Helen’s, 1 Undershaft, London EC3DQ. Authorised and regulated by the Financial Conduct Authority and a member of the Investment Association.
This article is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this article. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this article.
Issued by: Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and is an Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.
Compliance code: 20170705_02