Commentary: Update on the Markets

Dollar/FX. Stronger US dollar is a consensus trade, and there's no compelling reason to be contrarian. Rate hikes from the Fed will be dollar positive, but more importantly loose fiscal policy will gin up the economy, and make dollar denominated assets more attractive to international investors. (Both FDI and portfolio flows should increase as a result) This, much more than interest rate differentials in overnight policy rates, will drive up the dollar in the next two to three years.

Notice the sharp contrast in policy out of Mexico, the emerging market hit hardest by the Trump shock. The central bank is hiking interest rates, and brought overnight rates up to 5.75 percent, a full five hundred basis point differential with the United States. However, the Mexican Government continues to cut public spending, which hurts the broader Mexican economy. As such, while holding overnight Peso balances is more attractive than before due to Banixo's rate hikes, holding longer duration Mexican assets, such as stocks or real property, is less attractive because government austerity is slowing the economy. While Mexican authorities remain terrified of further Peso depreciation, under this policy regime, it will be hard for the Peso to regain a strong footing. I expect the MXN to remain in a range between 20-21.5 for next few years.

Bonds.

Yields have shot up since the election. Trump's fiscal splurge will both increase the supply of Treasury securities, and give the Fed cover to hike rates. Both these factors point to lower bond prices and higher yields. However, investors appear overly confident that Trump can deliver a massive spending package. It appears more likely than not that a Republican Congress with acquiesce to Trump's demands, but it seems unlikely that Trump can deploy one trillion dollars of infrastructure spending quickly. Thus, the deficit (and therefore government's financing needs) may be much lower in the next few years than investors expect. This could keep yields lower, and will also weigh on stocks. Under this scenario, a correction in the dollar is also possible. On the upside, Republicans might be able to pass large tax cuts, and politically justify the increase in the deficit by using so called "dynamic scoring." Politics, aside, an increase in the deficit always and everywhere increases private sector incomes, which boosts corporate earnings as consumers spend more. Big deficits will be good for stocks. It would take an unknown event, such as a major war or another financial crisis, to halt this rally.

Stocks.

As stated above, the stock market remains broadly supported by the impending fiscal bazooka about to go off. However, one sector that appears a bit overbought already are regional banks. Dodd-Frank repeal won't help earnings too much. Small banks just can't compete with the scale and scope of larger banks, especially on the technological front. Although many on the right claim that the new regulatory burden on them is higher, the real problem they face is a shrinking customer base as consumers increasingly choose the speed and convenience of the mega-banks. Going forward, I don't expect regional financials to outperform the broader market.