The "Trump trade" – U.S. economic optimism driving the commodity, banking and transportation sectors that dominate the S&P/TSX composite higher – was great for domestic investors. The trend, however, appears to be fading fast.
Banks stocks on both sides of the border were among the main beneficiaries of the recent rally. The rally that began in the summer of 2016 accelerated sharply after the U.S. election. Since Nov. 8, 2016, U.S. bank stocks jumped 21.4 per cent and the S&P/TSX bank index (not shown in charts) jumped 11.5 per cent, and that doesn't include dividends.
The relationship between economic optimism and bank stocks lies in the steepness of the yield curve. Longer-term bond yields rise along with growth expectations and this increases the difference between short-term and long-term borrowing rates. Because banks borrow funds at short-term rates, and lend them out at longer term levels, a steeper yield curve means higher profits.
The first chart, below, shows how this has worked over the past two years. The KBW bank index has moved roughly in line with the difference between U.S. two and 10-year bond yields and the connection between the two lines on the chart intensified in the wake of the U.S. election.
More recently, however, the yield curve has flattened but bank stocks have remained elevated. This increases the likelihood of a correction in bank stocks. (Although not shown on the chart, the pattern for the Canadian bank index is almost identical, although a bit more muted.)
The 'Fortress America' strategy also appears to be rolling over. First noted by Bespoke Investment Group macro strategist George Pearkes, the relative performance of U.S. small-cap stocks and emerging-markets equities is a way to track the market's belief in Mr. Trump's United States-first trade strategy.
Small-cap stocks generate the majority of revenues domestically and are thus more sensitive to U.S. economic growth. Strong performance by emerging-markets equities indicates that global growth leadership is offshore in the developing world. The second (middle) chart below simply divides the value of the iShares Russell 2000 ETF (tracking the U.S. small-cap index) by the unit price of the iShares MSCI Emerging Markets ETF. A rising line means U.S. small-cap outperformance.
Small-cap performance relative to emerging-markets stocks has been improving steadily since September, 2014. After Nov. 8, 2016, the small-cap ETF spiked higher on hopes that fiscal spending initiatives would result in a rapid acceleration in the U.S. economy. Beginning on Dec. 21, 2016, this optimism began to fade and the falling line on the chart highlights outperformance of emerging markets stocks that continues this week.
The third, bottom chart shows how the trade weighted U.S. dollar – the value of the greenback relative to the currencies of its major trading partners, including Canada – has closely tracked 10-year Treasury yields.
As mentioned, rising economic-growth expectations are reflected in longer-term bond markets through higher yields. These higher yields attract foreign capital as global bond investors look to maximize portfolio income, and these foreign investment inflows push the U.S. dollar higher.
As with the other two charts, it appears the rising bond yield/strong dollar trade is rolling over as economic optimism is adjusted lower.
There are numerous signs that the postelection economic and market exuberance is overdone. It's possible that this merely means a short-term correction before the reflation trade of higher yields, commodity prices and cyclical market sector outperformance continues. The longer this correction continues, however, the more likely that the "lower for longer" bond-yield forecasts are largely accurate and markets return to the slow-growth environment of the postfinancial crisis period.