Politics is a touchy topic right now, so we will preface this update with a disclaimer that our comments aren’t for or against one political point of view or another. Instead, we feel that this is a great opportunity to think through the current and potential effects the inbound presidential administration of Donald Trump is having (and likely to have in the future) on the market and why that presents some profit opportunities for option traders.
As we have discussed previously, inflation, interest rates and the dollar rose significantly following Trump’s election, which is a trend that is now starting to look overextended. An expected shift in trade policy with emerging markets has also had a big effect on the market, which seems to be growing in importance.
We feel that these two issues can be profitably leveraged by option traders.
Interest Rates, Inflation and the Dollar
Immediately following the election, stocks and interest rates rallied. This move was triggered by expectations for pro-business policies (especially for banking) and promised increases in government spending, which should drive inflation.
If rates are rising while competing sovereign rates (Europe, Japan, etc.) are falling or flat, then we would expect the dollar to rise in value, which is what happened. In the currency market, a bullish or bearish dollar doesn’t equate very well with “good” or “bad” because a rising dollar can be good for consumers (and retailers) but also bad for U.S. exporters and multinationals who are now less competitive internationally.
For example, some of the big multinational winners — Archer Daniels Midland Company (NYSE:ADM), Procter & Gamble Co (NYSE:PG), The Coca-Cola Co (NYSE:KO), etc. — earlier in 2016 didn’t participate in the rally because their dividends and foreign earnings were damaged by the spike in the dollar’s value.
The opportunity at this point is to take advantage of periods when assets sensitive to the dollar (or the dollar itself) are overextended. We believe that there will be a “reversion to the mean” in the first quarter, where the dollar will fall and some of the oversold multinationals will rebound. If we are correct, the ride will likely be a bumpy one, but one that should be worth the risk.
Emerging Markets
Most of the proposed changes to U.S. trade policy are targeted at emerging-market nations, which is adding to risks already affecting these economies. For example, as you can see in the chart on the next page, emerging markets (top) tend to have an inverse correlation with the dollar (bottom). One of the causes of this relationship is the role the dollar plays in financing emerging-market industries. A more expensive dollar means that capital is more expensive for expansion and production.
Even if we are right about the dollar reverting to the mean, we think that adjustment will be mostly related to the dollar’s value against the majors (euro, yen, pound, etc.) and not emerging-market currencies.
A stronger dollar also tends to depress commodity prices because those are valued in dollar terms. Emerging markets (Russia, China, Mexico, Brazil, etc.) are the source of many commodity products, and those exports become less profitable in dollar terms, but more expensive domestically, in these market conditions.
Fig. 1 — Emerging Markets and the Dollar
Finally, trade relationships between the U.S. and emerging markets are not all as one-sided as the one with China. For example, while the U.S. imported $270 billion from Mexico in 2016 (excluding December), U.S. firms exported $212 billion to Mexico over the same period.
Fears of a damaged U.S.-Mexico trade relationship have already sent the Mexican peso into a freefall, which is bad for U.S. firms as well as Mexican companies. U.S. goods are already much less attractive to Mexican buyers without any changes to trade laws.
It’s hard to find a large public company in the U.S. that is not doing at least a little business in Mexico, and there are obviously many that have very concentrated exposure to the country. For example, while railroads have been appreciating as a group on the back of higher energy prices and rising rig counts, the decline in the peso has hammered Kansas City Southern (NYSE:KSU), which does significant business shipping goods and commodities to and from Mexico.
As you can see in the next chart, the relationship between Mexico’s currency and KSU is extremely tight.
Fig. 2 — USD/MXN versus KSU
This is just one example of the issues companies with emerging-market exposure are facing. Relationships like this exist for U.S. firms doing business with other emerging markets like China, South Korea, Singapore, Brazil, Turkey and India. We believe this creates opportunities for option traders to profit from downside shocks to U.S. firms exposed to this uncertainty.
Whether you like or dislike President-elect Donald Trump, his administration is likely to have a profound impact on market prices. We expect that to be especially true in the first and second quarters of 2017 when traders learn more about the specifics of his plans and how quickly he can implement those goals.
From a short-term option trader’s perspective, this is probably good news regardless of personal, political bias. Uncertainty and change brings volatility and profit opportunities, and we are very enthusiastic about that aspect of 2017.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
