"Nobody knows anyone, not that well" said Tom Regan, protagonist in the Coen brothers' Miller's Crossing, my favourite movie of all time.
The quote has come to mind repeatedly in the past week in reference not only to the U.S. electorate, but to the forecasting ability of experts in politics and markets. The lesson of recent weeks is that no one knows anything, not really. And, while there are always unknowns in markets – Federal Reserve policy has been a big market driver in recent years, for example – the sheer number of powerful market forces that could break in different directions in the weeks ahead threaten to overwhelm and paralyze investors.
For clarity, and maybe sanity's sake, my strategy is to separate the things we do know from the important information we've yet to receive.
Divergent economies a known
One thing we know is that the U.S. economy is strengthening. October retail sales surprised to the upside when reported Tuesday at 0.8 per cent, and September's results were revised higher. Wage growth for October also exceeded forecasts at 2.8 per cent year over year as consumer spending power improves. The Atlanta Federal Reserve's GDPNow indicator, which provides a real-time estimate of U.S. GDP growth using all available data, now indicates a solid fourth-quarter economic expansion of 3.3 per cent, up from 3.1 per cent on Nov. 9.
We know with near certainty the Fed will raise interest rates on Dec. 14 while the Bank of Canada's next move is more likely to be a rate cut rather than a hike. The consensus economist forecasts form a 94-per-cent chance of a Fed rate increase next month, according to Bloomberg.
In Canada, economists see a zero per cent chance of a rate hike before March, 2017, and a 9.1 per cent probability for a decline in central bank rates. The central banks are leaning in opposite directions and this is likely to put downward pressure on the loonie. Global investment assets will gravitate to U.S. bonds – and away from Canadian assets – as Fed policy pushes bond yields upward. Canada is not alone, higher Treasury bond yields are likely to see the greenback appreciate against most global currencies.
Markets expensive, but Trumpflation an unknown
We know that North American markets are expensive in price to earnings terms and top-line sales growth has been hard to find. The current trailing price-to-earnings ratio for the S&P/TSX composite index is 22.4 times, well above the 10 year average of 18.4. The S&P 500's price-to-earnings ratio is 20.4 times compared with the 10 year average of 16.8.
We also know that markets have spent the majority of the past eight days preparing for stronger U.S. growth and inflation. Rate-sensitive equity sectors such as utilities and real estate have been hammered in favour of base metals and industrials – market segments that benefit from accelerating economic growth.
Is this "Trumpflation" trade sustainable? The answer to that question has to go in the "things we don't know" category. Heightened inflation expectations are, to a significant degree, dependent on the stimulative success of the president-elect's infrastructure spending initiatives. There are reasonable doubts about how much fiscal spending will actually occur.
The proposed infrastructure plan focuses on private investment, but the Tea Party faction of the Republican Party will oppose any government deficit spending vociferously. The new administration has also been floundering in its efforts to build a White House staff – Politico writer Daniel Lippman described the transition efforts as "amateur hour at Trump Tower" in a CTV news appearance – which suggests the resulting cabinet may struggle to organize the passage of required legislation.
For Canadians, many of the most important unknowns fall from the "inflation or no inflation" question. To the extent that higher U.S. interest rates reflect economic acceleration and rising consumption, there are domestic positives. Canadian export growth, for instance, will help the domestic recovery. U.S. expansion would also increase commodity demand and prices, and the profits for Canadian mining and energy producers.
On the flip side, Canada Mortgage and Housing Corp. has warned in no uncertain terms that Canada's housing market is vulnerable to sharply rising interest rates.
Gluskin Sheff economist David Rosenberg, for one, is skeptical that inflation will take hold on either side of the border. Mr. Rosenberg wrote that bond markets are reacting as though "somehow, Donald Trump will be able to do what central bankers everywhere for the past seven years have found so elusive." CIBC chief economist Avery Shenfeld is similarly nonplussed, writing that even if the new president's large corporate tax cuts and spending initiatives actually occur, it will only boost 2018 U.S. growth by 0.2 percentage points.
Future of NAFTA
Mr. Trump's campaign vow to "tear up" the North American free-trade agreement provides another important unknown for investors. I noted above that Mr. Trump's infrastructure plan will face hurdles in Congress, but he has carte blanche to change or cancel trade agreements according to the Peterson Institute for International Economics, a Washington-based non-profit research organization.
Canadian economic data for the post-election period is not yet available. When released, there's little doubt Canadian export sectors will report little or no investment in expansion – they will need assurances the U.S. market will remain accessible before committing new capital. In this way, the new administration is already hurting the domestic economy.
My best guesses
I can attempt to outline the most likely scenario for investors, but readers should be aware I'm holding all of my opinions lightly in respect of recent events.
For me, the highest-probability future sees the U.S. economy strengthen, but for the infrastructure plan to disappoint in terms of scale and stimulative effects. In this event, interest rates and yields will be higher, but not enough to cause the economic meltdown described in the CMHC's worst-case scenario. There will be some, but not unbearable, pressure on indebted Canadian households and income-generating equity sectors.
This may just be hope talking, but I do not believe substantial changes will be made to U.S. trade policy where Canada is concerned. Mr. Trump's previous statements strongly suggest that Mexico is the real target for anti-trade legislation. There is also the issue of complicated supply chains – Canadian firms providing parts and services for U.S. industry. Taxing Canadian imports would disrupt these processes, and many U.S. companies will lobby against broad protective measures.
The U.S. election outcome, and the market aftermath, underscore the lesson that the future is largely unknowable, no matter how confident the pundits sound. Big changes appear to be under way. Markets are now more worried about inflation than deflation, and it's entirely possible that the 34-year bull market in bonds is over. Very few active investors have any experience with a prolonged rising rate environment, and most of us would be in unfamiliar territory with no map for guidance. In this case, the best performing markets sectors in recent years – low volatility, steady-but-low-growth dividend payers – are likely to be among the worst performing. U.S. consumer discretionary, industrial and transportation stocks will likely outperform.
There is also a chance the recent bond market sell-off is just another head-fake and equity markets will resume their slow grind higher with bond yields falling. Like the Japanese markets and economy since 1990, the search for growth could remain elusive.
Investors must be prepared for multiple outcomes, remaining flexible, open-minded and alert to change.