Morgan Stanley: US Political Risk Underestimated By Markets

If one were to look at the broad stock market measures since the failure of the Trump health care bill March 24, the stock market has been positive, indicating “the market” may think this to be a non-event. Not so, says a Morgan Stanley report. There is detail in the market data that shows policy concerns, it is just not seen in the broad stock market measures. But in Europe, the talk of political risk to markets is turning around and concerns are going in the opposite direction.

In light of the failure to repeal and replace the “Obamacare” healthcare bill, a negative momentum seems to be growing. The White House is attacking the Congressional “Freedom Caucus” while that group is reportedly looking to put the knife in the back of Reince Priebus, according to Fox Business News’ Charlie Gasparino. The hand-wringing is extending to issues surrounding one-time Trump confidant Michael Flynn asking the Senate Intelligence Committee for immunity – and President Trump encouraging him to talk freely in a tweet.

None of this seems to be rattling the stock market… if one were to judge only by the major indices.

“The modest pullback in US equities suggests little Trump-based optimism has been priced out given the failure of the healthcare reform bill,” Morgan Stanley’s Matthew Garman, Graham Secker, Krupa Patel and  Lillian Huang write in a March 31 report.

But looks can be deceiving.

Looking at the performance of policy proxy benchmarks underneath the US market, they see different results. Their analysis suggests more than an 80% reversal in optimism on infrastructure spending, trade policies and healthcare reform. All that gleeful talk of Republican unity to repeal the Affordable Care Act (ACA, ie “Obamacare”) appears to have faded into a frown.

Furthermore, there has been a smaller but nonetheless noticeable reversal of 64% in pricing of tax reform, according to Morgan Stanley’s analysis. This comes after President Trump met with former Goldman Sachs executives Gary Cohn, now chief economic advisor to the President and Director of the National Economic Council, and Treasury Secretary Steven Mnuchin. The issue of a border adjustment tax looms – one that is expected to benefit US manufacturers but has multi-national corporations, retailers and the former Goldman executives now in government up in arms.

What is left?

There is deregulation. The Trump administration can use the mighty Presidential pen to change the fortunes of deregulation without having to negotiate with Congress. Hopes for the administration to engage in deregulation has dropped the least, only 39%.

European political risk not as bad as it seems and US dollar and euro diverge courses

One component that the Trump administration wants to see remain low is the US dollar. A high dollar valuation makes US exports less attractive. Here the Morgan Stanley team make their number one observation, that the US dollar is oversold. Related to this is that bond markets appear too cautious on Fed rate hikes.

The data is telling a different story than the market.

Morgan Stanley says US dollar positioning is now net short, with the trade-weighted dollar reaching an RSI of <30 for the first time in a year. “Bond markets now price only 2.1 hikes, which looks too low in the context of improving macro data,” the report said. “The last time the ISM was this high, the market was discounting 3.9 hikes.”

The US dollar positioning comes as longs in the euro are at a three-year high, a fact that doesn’t seem to be weighing on European equities. Asset flows have been returning to European stocks as political risks are abating, the report noted.

“Europe’s relative performance has closely tracked the odds of a Le Pen victory in recent months,” the report stated. “With perceived political risks subsiding and stronger earnings momentum Europe has outperformed by 5% in the last month.”