Since the U.S. election two weeks ago, investors, worldwide, have placed enormous bets on a major shift in U.S. economic policy. They have positioned themselves for higher growth, higher inflation, and a Federal Reserve that will most likely raise short-term rates next month, setting off a potential series of rate increases over the next 12-18 months.

The results of this kind of thinking has been swift: major U.S. stock indices have reached all-time highs; long-term bond yields have backed up by 50bps; and the U.S. Dollar index reached over 100, the highest rate in over a decade. The last two  developments carry the greatest risk for investors (  see Table 1 and Chart 1).

Table 1 Bloomberg World Bond Index

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Chart 1 U.S. Dollar Index

Let’s look at how these two developments impact the U.S. and its major trading partners.

On the Domestic U.S. Economy.

The rising U.S. dollar and interest rate increases are a one-two punch that have the effect of tightening financial conditions for U.S. corporations . U.S. exports are now less competitive and the cost of capital is increasing.  This combination eats into corporate profits. Profits for the S & P 500 companies have been on a decline for the past 3 years, and, this will put additional pressure on profit margins.

There will be further pressure felt from the worldwide slow down in trade. That slow down will now likely continue in the wake of protectionist sentiment that is now sweeping many parts of the world.

On the U.S. Major Trading Partners.

The currency re-alignments have been dramatic everywhere. The Yuan steadily devalued  under the watchful eyes of the Chinese authorities. The Japanese Yen has depreciated and this will give a boost to Japanese exports. Finally, there is a lot of speculation as to when the U.S. dollar will reach parity with the Euro, after nearly a 40 per cent decline in value over the past 5 years. These developments create considerable headwinds for U.S. exporters.

On Emerging Markets.

Perhaps, the greatest impact from the re-alignment of currencies and higher interest rates will be felt in the emerging markets.

First, these nations have assumed huge increases in U.S. dollar dominated debt over the past decade. Now, the value of that debt is more costly in local currency and also more costly to service. In other words, funding in hard currencies will become more expensive for emerging markets.The funding squeeze could lead to a sharp exit from risky assets with repercussions throughout the world.

Secondly, there has been a huge capital outflow, especially from Asia, as domestic currencies weaken and wealthy nationals seek to send their savings overseas. In particular, according to Bloomberg $ 500 billion has left China this year. This creates a vicious cycle of money leaving the country, putting downward pressure on the currency which, in turn, encourages more capital outflows. Given that there was a stampede of funds flowing into the emerging markets during 2009-2014, this reversal can be quite destabilizing for the domestic economies.

With U.S. domestic financial conditions tightening and trade prospects weakening in the developed and emerging markets, U.S. equity investors should take heed.