A lot has changed since early November. Global growth looks better and more synchronized than initially assumed, with upside surprises in the eurozone and China. Financial conditions look better, with real yields falling, despite two U.S. Fed rate increases. Earnings are starting to accelerate, with broad-based improvements expected across regions.
Meanwhile, U.S. policy action has disappointed, with the challenges to healthcare reform pushing back our—and the market’s—timetable for when tax policy changes could happen, if at all.
If global growth is fine, and U.S. policy disappointments weaken the dollar and yields, how much of a problem is it really?
Our inclination is to think that those first three positives outweigh the final negative, a reason why we have recently raised our weight in U.S. equities by 1% and pushed back our expectations of a “fade.” But is that fair? After all, fiscal policy was a key part of many bullish storylines. At a recent investor roundtable in New York, “U.S. policy action” was cited as the most positive catalyst for markets, by a wide margin. Almost daily, we read about the underperformance of “Trump trades” and what it foreshadows for markets.
But what if it's less important? What if, with the benefit of hindsight, “less is more” when it comes to policy action?
No Harm in Doing Nothing?
We'd venture that this is a less controversial statement than it seems. Year-to-date, U.S. equities are up 7% and global equities are up 8%. U.S. high-yield bond spreads are 34 basis points, or hundredths of a percentage point, tighter; cover spreads are 21 basis points tighter, and emerging-market credit excess returns are at 3.6%. By any historical measure, that's a good start to the year—and it’s been achieved with one of the lowest periods of realized volatility, for either equities or credit, on record.
If this combination is the price of a legislative logjam, we'll take it.
Indeed, the lack of legislative progress has revealed a silver lining. Various “Trump trades” have given back their postelection gains. U.S. Treasury yields have fallen by 33 basis points from their post-election highs, and inflation expectations are back to levels seen right after the election. As yields and the dollar have fallen, along with policy expectations, emerging markets and carrytrades have gained more support.
This might not be the pattern we expected initially, a reason why we’ve shifted beta toward emerging markets in recent months. But it highlights a key dynamic: If global growth is fine, and U.S. policy disappointments weaken the dollar and yields, how much of a problem is it really?
All this comes before admitting that policy action was never a clear-cut positive. For U.S. tax reform to be anywhere close to deficit-neutral, it will need to raise revenue in ways that will create clear losers (border-adjustment tax, limits to interest deductibility, etc.). If it doesn’t include those offsets, we're looking at one of the largest fiscal expansions in U.S. history, during a time when the unemployment rate is close to record lows. This would raise some uncomfortable market questions.
‘Less Than Feared’
My colleague Michael Zezas and our U.S. policy team ultimately think that a limited version of tax reform will get passed by the first quarter of 2018. But, a lot of uncertainty remains. Probability-weighted, we think that the results pose mild risks to U.S. high-yield and municipal bonds, and this is one reason why our year-end 10-year Treasury forecast is only 2.50%. But for U.S. stocks and emerging market fixed income, these outcomes seem more manageable.
Saturday, April 29th, marked the 100th day of the new U.S. administration. We’d expect a good deal of discussion on the lack of legislative progress, and don’t expect the timetable on tax policy to surprise positively from here. This may be cause for political hand-wringing. But for markets, we’re inclined to think that it may matter less than feared, thanks to improving global growth and the easy financial conditions that the lack of policy action makes possible.
Instead, it is what central banks do over the next six to nine months that may pose a bigger risk. Much remains to be seen.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Apr 30, 2017) series. Ask your Morgan Stanley representative or Financial Advisor for the latest macro and strategy coverage and reports. Plus, more Ideas.
