It would be fair to say 2016 was a year of surprises; some of them great, others more challenging. Even early in the year a spate of celebrity deaths lent a rather morbid tone, but it was from the middle of the year onwards that things really kicked off.
Small bad news stories, however they may affect people’s moods generally, do not have any bearing on financial markets. It was the seismic shocks later in the year, such as the surprise vote for the UK to leave the EU and the election of Donald Trump in the US, that could have caused investors pain.
Benefits of hindsight
Months have now passed and we can weigh up the short-term impacts of these events. In hindsight, it is tempting to wonder what all the fuss was about. The UK market rallied handsomely post Brexit, up 12.5%, and the US gained about 8% after Trump’s election.
We seem a long way from the nervous days of the post-financial crisis world, where skittish markets would seemingly baulk at even modestly positive news.
This had led some to question whether markets are becoming immune to macroeconomic shocks. Ultimately, of course, this is not the case. Recent stoicism among market participants implies that news, whether good or bad, is viewed with a greater degree of circumspection than in recent history. It is instructive to asses why this might be the case.
Market pricing should reflect the aggregate of all market participants’ views of the fair value of future income streams from asset classes. Our collective experience of market moves would suggest this does not always hold true.
Nevertheless, given the relatively sanguine market activity around events such as Brexit and Trump, it is tempting to conclude that the market had simply priced in a reasonable probability of the ‘surprise’ outcome and that a relatively minor move in the following trading periods was to be expected.
But we know from data and surveys published before these polls that market participants factored in a much lower probability of the ‘surprise’ outcome than even-odds. Consensus probabilities were between 80-90% for remain and for a Clinton win in the days before both events.
Anecdotally, straw polls at conferences of investment professionals rendered similar results during the period. In the event, public polls were closer to the result, suggesting that the market was overconfident the ‘safe’ choice would win out.
Ultimately, it is incorrect to say the markets were not negatively impacted because there was a reasonable expectation of either Trump or Brexit.
Rational response
Of course, the relatively positive response from markets may be rational. Just because an outcome is a surprise does not mean it has to be bad for business and damaging for shareholder prospects. For example, the UK stock market may have rallied because the benefits of a weaker pound will more than compensate for any deterioration of trade within the EU.
The domestic market is a unique case because it is populated with a global suite of revenue streams listed in the UK. Still, the market’s price movements imply that the weakness in sterling and the translation benefit for foreign currency revenues into sterling outweighs any potential tariff imposition that would result from being outside of the EU customs union.
This calculation requires a lot speculation at this stage as the Brexit negotiations have not started, meaning it is difficult to predict the outcome. With respect to Trump’s election in the US, again, the positive market reaction may be appropriate. Trump made it clear during the presidential campaign that he deemed the prevailing rate of interest in the US to be too low.
While the US Federal Reserve is an independent body and chair Janet Yellen’s term cannot easily be curtailed by the president, Federal Open Market Committee policy does not exist in a vacuum. If the US government acts in a way that makes it difficult to justify a low interest rate, we would expect the Fed to increase rates more rapidly.
Furthermore, Trump has repeatedly pledged to spend more than $1trn over the next 10 years on defence and infrastructure projects. Such activities are positive for both jobs and domestic stocks, particularly as this type of spending will inevitably be aimed at US firms that will both boost business coffers (and tax receipts) and also employment.
An additional benefit from judiciously chosen infrastructure spending is that it should enhance productivity, which has a positive feedthrough for the economy.
