On May 17, US markets reacted sharply after news reports that a special counsel has been appointed by the US Justice Department to investigate President Donald Trump, and that Trump had asked the former head of the FBI, James Comey, to scuttle an investigation into his former national security adviser, Michael Flynn. The reports raised questions about Trump’s ability to push through his economic agenda and added to nervousness about political stability in the US. I recently participated in a Q&A session with my colleagues in Boston, to share some insights on the risk of an impeachment process and possible market implications. The summary that follows includes comments from Paresh Upadhyaya, Director of Currency Strategy, US, Michael Temple, Director of Credit Research, US and myself.
Impeachment: Still speculative, but USD already under pressure
The talk of impeachment remains speculative and on the margins. The appointment of a special counsel suggests a long investigation is underway that could take months if not years to come to a conclusion. We would estimate the likelihood of impeachment this year is only 10% with a modest rise to 20% in 2018. Nonetheless, the situation remains highly fluid.
The currency markets were the first asset class to dial back expectations of full passage of Trump’s economic agenda since mid-January. The failure to repeal and replace Obamacare in the first pass triggered downside expectations of lower corporate and personal income tax cuts. The political woes of late accelerated declining expectations of Trump reforms.
Therefore, the US dollar (USD) is at November 2016 levels vs the euro. It has been a perfect storm leading to a much stronger euro. Fading expectations of a much stronger US growth trajectory due to receding expectations of Trump’s economic agenda, an unwinding of European political risk premia following elections of mainstream candidates in Netherlands and France and expectations of a hawkish pivot by the European Central Bank is fueling a resurgent euro.
The odds are rising for a cyclical turn weaker in the USD cycle. A long-term convergence in G10 monetary policy and weakening relative medium-term US growth prospects are key drivers behind a likely turn. We expect a cyclical weakness in the USD to be modest and more likely against the G10. The outlook versus emerging markets is mixed.
Equity Market: A possible correction but bull market still intact
Short-term, US equities could decline further if the Trump administration is unable to deliver on tax reform, deregulation and infrastructure spending as promised. However, we believe the underlying fundamentals of the markets remain strong as evidenced by double-digit earnings growth in the first quarter of this year, low interest rates and ample liquidity in the banking system. This leads us to conclude that the bull market is intact. Market corrections can occur during long-term uptrends in equities. We typically view these corrections as buying opportunities.
Market corrections tend to be sudden and can be severe and hard to predict. We believe a 5-10% correction could occur this year given the likelihood that Trump economic policies will at a minimum be delayed, and also due to increased geopolitical risks in Syria and elsewhere. Emerging and European markets are likely to decline more than US equities, in our opinion, given their recent performance. Barring a drastic change to the outlook for the global economy and earnings growth, however, we would likely view any correction as an opportunity to add to the positions we hold.
Fed Policy: No change to the near-term path of rate rises
At this stage, we do not expect the Federal Reserve (Fed) to change the near-term path of rate rises. While the market expectation of a rate rise in June has declined to a 90 percent probability of a 25 basis point (bp) hike from a near 100 percent certainty, the Fed will be focused on the degree to which the current volatility in the financial markets affects the real economy and employment in particular. For that to happen, the volatility, caused by the recent political uncertainty, would have to be prolonged and more extreme. At this point, it is too early to tell whether this will be the case. In the meantime, we believe that the economy remains solid, employment trends strong, consumer and business confidence at high levels, suggesting―for the moment―a resilient economic backdrop that will be relatively unaffected if this situation is resolved within a reasonable time frame.
Credit markets have only been modestly impacted by the volatility in equity and rates markets. Credit availability continues to be plentiful for the majority of issuers in the investment grade, high yield and bank loan markets, although at the margins, availability has been declining for the lowest quality segments of the market, including CCC-rated bonds, subprime auto issuers and some areas of the commercial real estate market. At this point, we do not expect the current political uncertainty to have a meaningful or lasting impact on the cost or availability of credit.