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The Trump show risks turning ugly for investors

As political discord in Washington intensifies, so are investor fears over richly valued equity and corporate bond markets.

Hopes of a Republican-controlled Congress delivering tax cuts, infrastructure spending and deregulation have steadily faded since Donald Trump entered the Oval office in January.

The currency market has already given its verdict. Having leapt higher right after the election, the US dollar has fallen sharply this year. Meanwhile, a rally in the small, domestically focused US companies seen as the biggest beneficiaries of corporate taxes cuts and a stronger economy has fizzled.

Now, further signs of the divisiveness of Mr Trump’s seven-month old presidency is worrying investors already troubled by warning signals that Wall Street stands on the cusp of its first big correction since early 2016.

“At these valuation levels, the rubber band is stretched pretty tight and it could snap,” says James Norman, president of QS Investors, who adds they have been shifting clients to high dividend-paying stocks with low price and earnings volatility in the consumer staples, industrials and technology sectors, such as Kimberly-Clark, Dow Chemical and IBM, to insulate against a sudden downturn.

Conspicuously, the central bank has taken notice of the lofty level of asset prices that in the case of the S&P 500 have been led by technology and healthcare sectors and also pushed the Nasdaq up more than 15 per cent this year. The minutes of the July meeting of the Federal Reserve noted that “vulnerabilities associated with asset valuation pressures had edged up from notable to elevated”.

Fund managers surveyed by Bank of America Merrill Lynch say equities are overvalued by the greatest margin since 1998. And while second-quarter earnings season was strong, companies reporting better than expected earnings and sales were not rewarded with the typical “pop” in their shares — a further indication of angst over valuations.

For Mr Norman, Mr Trump has come full circle from being seen as a positive figure for markets to a potential liability.

“There are a number of things coming up where we need leadership — the debt ceiling is a perfect example,” Mr Norman says, referring to the need for Congress to raise the Treasury’s borrowing capacity in the coming months and avoid a potential default. “There is no shortage of things that people are concerned about with this administration in terms of getting things done or preventing things from happening.”

In recent weeks, the combination of sabre-rattling between the US and North Korea, and Mr Trump’s comments in response to a rally of white supremacists in Charlottesville, Virginia, that ended in deadly violence have triggered two sharp bouts of equity market selling.

Harsh words from members of Trump’s own party were compounded by the highly publicised departure of chief executives from his business councils and their subsequent dissolution. At the end of last week, Steve Bannon, Mr Trump’s nationalist chief strategist, was shown the door.

For some investors his exit is the latest example of chaos in the White House, where a handful of high-profile positions have changed over the past month. Others regard it as a sign that the discord in the West Wing could be diminishing. Most agree it is too soon to know.

“There is a line between political and economic risk,” says Terry Simpson, a multi-asset strategist at BlackRock. “[Last week] has proven that it is hard to separate that risk. The message [Trump] gave on some social issues was not in agreement with what many Republicans believe. That may hinder the passage of some pro-business policies and that may stall the rally.”

While blue-chips have outperformed, with the S&P 500 adding 8 per cent this year and setting record highs, it mainly reflects the weaker dollar and improving global growth the helped drive back-to-back quarters of double-digit earnings growth.

“[The S&P 500] is not sitting up here, because of excess optimism about Trump,” says Steve Chiavarone, portfolio manager at Federated Investors. “It is sitting up here because of earnings growth. That has afforded the market the luxury of being patient about events in Washington.”

Patience is wearing thin.

“After Charlottesville,” Mr Chiavarone adds, “[Trump] was catching as much criticism from the right as the left, which called into question whether we get anything done.”

Cracks are showing in the credit market, too. Junk bond prices have slipped amid the political wrangling and a deluge of new sales by companies. Premiums investors demand to hold the riskier bonds has surged 40 basis points since the start of the month, according to Bloomberg Barclays Indices.

Reflecting the “buy the dip” mentality across most markets, credit portfolio managers have been shopping in the sector at times of such weakness. Money has poured into US fixed income markets this year, forcing investors to put it to work. An economic downturn, they say, would be necessary to unhinge the market.

“The only things that I could see making a significant move would be a higher probability of a recession, which seems like a stretch, or an inflation surprise,” says Kathleen Gaffney, a portfolio manager with Eaton Vance. “As noisy as the political winds are, the fundamentals and the rationality of capitalism can continue to move [markets] forward.”

Notwithstanding the recent crescendo of political discord, some investors still have faith that Congress will strive to make headway on tax reform — if for no other reason than to preserve their jobs. Midterm elections for Congress beckon in 2018, which could increasingly hang over both Democrats and Republicans if they have not accomplished anything.

James Sarni, managing principal of Payden & Rygel, says that even the campaigning ahead of the election could begin to move markets.

“It has clear implications for some of these issues being discussed: tax reform, regulatory reform, infrastructure spending,” he says. “We’re going to be coming to a point where there will be a game changer and one of the potential game changers is midterm elections.”

Additional reporting by Robin Wigglesworth in New York