Every so often, an event turns the market’s prevailing narrative on its head. The election of Donald J. Trump as President of the United States is one such event.

In the aftermath of this election, financial markets have priced in expectations of a fiscal stimulus, higher interest rates, rising inflation, and a stronger U.S. dollar. The impact of these shifts is most notable in bonds and currencies: Bonds have suffered a global sell off, with rates on 10-Year U.S. Treasuries up roughly 0.4% to their highs of the year, while the dollar has rallied nearly 3% on a trade-weighted basis. Equity headlines are less dramatic: The MSCI All Country World Index was roughly flat, but that masks a regional rotation, as U.S. equities were up more than 2% and emerging markets down roughly 6%, with sizeable shifts along market cap and industry lines.

Frankly, we were not well-positioned for this outcome. At our monthly asset allocation meeting held the Friday before the election, we saw confirmation that emerging market growth continues to strengthen, with signs of near-term economic improvement in the United States and Europe. We discussed the election and its potential impact, and decided to hold off on increasing risk in the portfolios until it was over. But we maintained our existing exposure to emerging market equities, bonds and currencies, which cost us in relative performance after the election.

Following the vote, we convened a reassessment of our views, and concluded that over the near term, the fastest, most efficient way to mitigate the downside was to hedge our emerging market currency exposure. Over the longer term, we believe economic conditions and valuations remain favorable for emerging market equities and debt relative to opportunities in many developed markets, and will continue to manage these exposures dynamically.

Further, the Trump victory and continued Republican control of both houses of Congress opens the door for fiscal stimulus, something that seemed unlikely in the event of a divided government. In turn, fiscal stimulus makes it easier for the Federal Reserve (the Fed) to raise rates on a sustained basis, which would likely strengthen the dollar further. Given this shift, we decided to move the portfolio from neutral to about 5% long the dollar.

Additionally, our overall positioning is as follows:

  • Neutral total equity exposure, with small overweight positions in the United States and emerging markets versus an underweight position in Europe.
  • Continued exposure to low-duration income assets, primarily loans and catastrophe bonds.
  • Neutral overall duration, with a preference for U.S. and emerging market debt over Europe and Japan.

Over the past several years, the market narrative has been one of a modest but sustained global recovery, with supportive monetary policy helping to counterbalance the global deleveraging process. Interest rates have remained low and risk assets such as equities and credit have outperformed. The Fed’s plans to raise rates have been stymied by capital flows and dollar strength, in turn prolonging the cycle.

At this point it is probably too early to declare that narrative dead, but it certainly is challenged. Much depends on the size and composition (tax cuts versus infrastructure spending) of any stimulus package. Over the near term, it seems possible that relatively expensive assets—U.S. equities and the dollar—become more expensive. But if policy shifts lead to a higher interest rate or higher-inflation environment, we would expect greater volatility and a more challenging investment environment overall.