All evidence suggests that President Donald J. Trump is not ready to put down the bludgeon. On Monday, Trump signed an executive order to pull out of the Trans-Pacific Partnership, that the United States had signed but not ratified. He then announced his intention to renegotiate Nafta. And he all but declared a trade war against China. Given the architecture of global supply chains, a trade war with China would in effect be a trade war against all US trade partners; or at least those in the Western Pacific. A major disruption of global supply chains is a significant risk factor for global markets. US firms have come to rely rather heavily on offshore production and are themselves at risk.
Yet, the bull run in US equities shows no signs of letting up. The S&P 500 hit another all-time high today. Even before the election, stocks were clearly overvalued. What is going on here?
For months before the election, markets rose when Clinton’s fortunes improved and fell when Trump’s likelihood of reaching the White House increased. Wolfers and Zitzewitz estimated that a Trump victory would reduce the value of global equities by 10-15 percent and significantly increase expected stock market volatility.
On election night, markets initially reacted in line with the prediction. But then a strange thing happened. Markets reversed course within hours and the great Trump rally began.
The Trump trade is being justified by the promised tax-cuts, infrastructure program and pro-business agenda. But these were common knowledge well before the election. Why did markets change their mind?
I had a very interesting conversation about this with the historian Adam Tooze. He said he was not surprised. In his view, financial markets are reflexive in that market participants’ subjective beliefs determine market outcomes which in turn shape participants’ beliefs and so on. In Soros’ formulation,
The participants’ views influence the course of events, and the course of events influences the participants’ views. The influence is continuous and circular; that is what turns it into a feedback loop.
As I understood it, Tooze has a thicker notion of reflexivity in mind. Specifically, market participants, strategists and commentators construct narratives to make sense of market developments. These narratives gain currency though a complex intersubjective process that is only vaguely comprehensible. They dominate the discourse for a while and at some point that cannot be predicted in advance, they relinquish their hold on the collective imagination in favor of another narrative.
This is pretty much as far as it gets from modern asset pricing. The central insight of modern asset pricing theory is that investors are compensated for bearing systematic risk and not idiosyncratic risk (which can be diversified away). An asset pricing theory in the modern sense tells us what constitutes systematic risk. A theory is entirely pinned down by specifying a vector of systematic risk factors called the pricing kernel.
For simplicity, assume that we have a single risk factor in the pricing kernel, m. Expected excess return of an asset will then be the product of the asset’s beta (the covariance of the returns on the asset with m) and the price of risk (determined by market-wide risk aversion). In the standard Capital Asset Pricing Model, for example, the price of risk is assumed to be constant and m equals the return on the market portfolio, so that the expected excess returns on a stock or a portfolio of stocks is proportional to its market beta. In contemporary intermediary asset pricing models on the other hand, the systematic risk factor is shocks to the leverage of US securities broker-dealers (Wall Street).
We should, of course, expect political risk to be priced in. Especially in times of heightened expected system-wide political instability—say due to the risk of a near-term trade war between the world’s two largest economies—expected excess returns on risky assets should be high. That is say, asset prices should be lower than otherwise warranted. Where, then, is my Trump instability premium?
I am near-certain that Tooze is onto something when he posits that participants’ emplotment of market developments reflexively drive market movements. But such narrative-driven fluctuations are bound to reverse sooner or later. When the Trump trade finally reverses, we are bound to see a large risk-off as the pendulum swings the other way and the market reprices to give me back my instability premium.
Bonus: Banks are leveraged bets on the economy. Banks stocks therefore tend to overperform the market in upswings and underperform them in downswings (their beta is greater than 1). But that’s actually only a small part of the story. The big part of the story is that because banks borrow short and lend long, the profitability of their marginal loan depends on the term spread. And the term spread has widened dramatically as part of the Trump reflation trade. And then, of course, you have the reassurance of adult supervision in the White House.