Yields are rising... Are animals spirits at risk?

The market's reaction to Trump's victory was far beyond expectations. It was initially believed that the "Trump trade" was already priced in—or at least partially—since market bets were predicting that Trump had a considerable advantage over Kamala. The so-called "Trump basket" was outperforming the "Kamala basket" in equity markets. However, this assumption proved to be completely wrong. The reaction to Trump's victory was so strong that the S&P 500 rallied even more than it did in 2020, when it broke the record for the best post-election return.

This time, the Trump victory was not as surprising, given that it was seen as more probable. Yet, the market's response was remarkable. Not only did the S&P 500 rally, but there were also notable winners and losers. Among the most notable were Small caps, Tesla and Bitcoin.

Below is the performance of various asset classes since Election Day.

Fear in the equity market also dropped notably. The VIX fell from above 20 to below 15 within just a few days as uncertainty dissipated following the resolution of the election. Nearly all sectors experienced significant returns, led by consumer discretionary, which was boosted by Tesla's impressive rally of 36% as of November 13, 2024.

The Trump trade was executed perfectly:

• Stocks rising: With a Republican sweep, a tax cut is expected in 2026, or at least the risk of higher taxes has been removed. Additionally, deregulation plays a favorable role in equities across various industries. This has resulted in strong reactions, particularly in the financial and industrial sectors, which are among the top performers.

• Long-term yields increasing: Many of Trump's policies, if enacted, are likely to lead to higher prices and inflation. Even though Trump has established a new Department of Government Efficiency (DOGE) to optimize the use of government funds and potentially address the budget deficit or offset tax cuts, long-term yields are rising. This may indicate the return of inflation or a structural shift toward higher growth and inflation rates.

• Stronger dollar index: The dollar has been rallying since the election, with currencies appearing undervalued against it. The "long U.S., underweight everything else" trade remains intact. The potential playbook here is that higher U.S. interest rates will attract more investors to Treasuries, increasing demand for dollars and keeping the currency stronger than many expected.

• Falling oil prices: Deregulation in the oil industry could lead to increased production. If demand does not keep pace with this higher production, oil prices may continue to fall.

• Bitcoin rallying: Trump’s agenda is pro-cryptocurrency. He has announced plans to create a national reserve fund in Bitcoin and has promised deregulation in the crypto space. This presents a significant tailwind for cryptocurrencies, as it signals strong support for the sector.

The strong market reaction to Trump's triumph is truly encouraging. In fact, the S&P 500 experienced its best post-election day rally in history. Animal spirits were unleashed, fueling a risk-on environment.

Animal spirits is a term used to describe market behavior when prices exhibit strong movements and rallies extend far beyond fundamental changes. These types of movements often go higher than anyone might anticipate before eventually reversing lower. Such trends are fueled by human behavior and a “herd bias,” where collective emotions drive significant market actions.

While the Trump administration might be seen as one of the most favorable elections for American corporations, there are still numerous concerns in the market that warrant caution. Issues such as concentration risks, geopolitical tensions, high valuations, government deficits, and challenges in the labor market are just a few examples. Despite these concerns, the market appears overly optimistic about addressing these challenges.

Perhaps Trump will indeed "make America great again," but the road to achieving this will likely be more difficult and painful than investors currently anticipate.

Trump's policies are notoriously difficult to predict or forecast. During his first term, we witnessed how a single presidential tweet had the power to create significant market volatility. Now, with a Republican sweep, Trump has full control to implement the changes he desires. This could bring either greater risks or new opportunities, depending on how effectively these changes are executed.

It is often said that bond markets drive the broader market, so paying attention to their signals is crucial. Currently, long-term yields are rising, which is unusual following a Fed rate cut. Is the bond market trying to tell us something? Since 1966, we’ve experienced various rate-cutting cycles, as illustrated in the chart below.

Focusing on the U.S. 10-year Government Bond Yield, we can observe a clear pattern following most rate-cutting cycles: long-term yields typically decline consistently for at least the next 10 months after the cut. However, this time something different is happening. There are very few instances in history where this pattern has not held—specifically in 1980, 1998, and now in 2024.

This year, we are witnessing a very unusual pattern—one that has only occurred three times since 1966—and it stands out as a significant outlier when compared to historical averages. What could be driving this rise in bond yields? Is it signaling more inflation ahead? A shift to a new era of higher rates across the curve? Greater economic growth than we are accustomed to? Or perhaps a growing deficit problem?

The reality is that no one knows for certain why yields are rising or what will happen next. However, one thing is clear: the implications of higher rates are undeniable. Rising yields lead to higher borrowing costs, which negatively impact leveraged companies, particularly smaller firms, the ones that are leading the recent rally. Higher borrowing costs also influence mortgage rates and, by extension, the housing market.

As for inflation, what has happened in the 2 others similar scenarios?

There is a very low number of observations with varying outcomes. Even if the two outcomes had similar results, the small sample size makes it difficult to draw definitive conclusions based on this data.

Now, regarding inflation, there are two interesting charts that highlight the inflation waves from 1967 and 1972, which bear striking similarities to the current situation since 2020. The resemblance between these waves is quite impressive. This isn’t to suggest that inflation will unfold in the exact same way, but it does provide some valuable perspective.

If we measure these inflation curves from the peak of the first wave, we find that we are now at the same point where the second wave of inflation began in both 1967 and 1972. While it’s clear that the economic and political situations in those scenarios differ greatly from the present, the most recent CPI print has halted the downward trend in inflation that we had been expecting. So, what are the possible outcomes moving forward?

1. Inflation continues to decrease, and the Fed's mandate will shift focus to employment-related issues.

2. Inflation begins to rise again, and the Fed will face significant challenges with both higher inflation and growing uncertainty in the labor market.

The market has been very complacent for a while, pricing in almost perfect conditions. While the U.S. has been growing strongly, other parts of the world have been struggling. For example, Europe has experienced lackluster growth, constrained by structural reforms and regulations that have stifled potential growth. With budget deficits now a major concern, maintaining or initiating growth while reducing deficits—without significant structural reforms—seems very challenging.

The U.S. is undoubtedly in a better position, and this has been the case for some time. However, valuations are stretched, and the market is heavily concentrated. The U.S. now accounts for 72% of the MSCI World Index. Additionally, spreads in the bond market are extremely tight, meaning that exposure to risk is yielding lower returns than it used to.

The renowned investor Howard Marks recently said in an interview with Barron's:

“Probably 98% of the things Trump will do can’t be predicted, and even the consequences of the things we know he’ll do probably can’t be predicted,” he continues. “Anybody who tells me what they think the world’s going to look like two years from now, I’ll bet all my money that they’re wrong. The future is just too damn indeterminate to hang your hat on. John Kenneth Galbraith said, ‘We have two kinds of forecasters, the ones who don’t know and the ones who don’t know they don’t know.’ ”