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What's deflating the "Trumpflation" rally

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The stock market’s epic post-election uptrend has given way to the most persistent sell-off since 2011. U.S. large caps stocks have fallen in 10 of the last 11 sessions. Bank stocks are leading the way down, off nearly 11 percent from their March 2 intraday high.

The turnabout has been fueled by last week’s failure by President Donald Trump and Republicans in Congress to advance legislation to repeal and replace Obamacare after resistance by both conservative and moderate GOP members in the House of Representatives, along with all of the Democrats.

As a result, the “Trumpflation” trade -- driven by hopes of aggressive pro-growth policies by President Trump, including deregulation, tax cuts and infrastructure -- spending is being unwound. 

As Mr. Trump shifts his focus from health insurance to tax reform, the dream of quick action is giving way to the dark realities of political gridlock, even with single-party control of both the White House and Congress. As both GDP and corporate earnings grow tepidly, investors had pushed stock prices higher via stretched valuations justified by a rosy political outlook that no longer appears accurate.

Trump's next challenge: tax reform

A re-rating is underway suggesting stock prices could accelerate to the downside in the weeks to come.

Tax reform is set to be equally if not even more contentious than health care because of biting issues surrounding the need for spending cuts to offset the cost of proposed tax cuts.

It’s important to remember a big reason the Trump-Ryan health insurance effort failed was very the negative analysis of its budget and coverage implications by the bipartisan Congressional Budget Office. Once the CBO showed the dramatic drop in coverage levels, all the political momentum was lost.

Similarly, Trump’s current tax cut plans -- even with a generous “dynamic scoring” boost to future GDP growth -- are expected to result in a major increase in the national debt. The hard-right Freedom Caucus in the House that torpedoed the health insurance bill is very likely to resist such a fiscally irresponsible move without offsetting spending cuts and revenue hikes.

This, in turn, will unleash more cans of political worms. Democrats will attack spending cuts -- already proposed in areas such as housing support. And revenue hikes have focused on a possible “border adjustment tax” on imports that retailers are rallying against.

Add it all up, and it’s very likely that these big issues won’t be resolved until the very end of the year or into 2018, if at all. And let’s not forget that the national debt limit will become an issue in the fall, heightening the stakes.

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Trump campaigned on a pledge to “drain the swamp” in Washington and reform areas that, admittedly, need reform while taking on the special interests. Instead, at least for now, it looks like the swamp is draining him. For Wall Street, as well as the millions of Americans who supported Trump’s campaign, this is a major disappointment.

Keep an eye on the U.S. dollar, which has already largely reversed its post-election rally (chart above). The dollar’s strength is a proxy for how aggressively foreign investors are pouring money into U.S. shares and other assets. A break of the 200-day moving average (red line), which hasn’t happened since last July, would quicken the losses in U.S. equities.

It’s no coincidence that as American stock prices have weakened in recent weeks, global investors have jumped into emerging market shares, which are outperforming U.S. large-caps with a strength not seen since last summer. 

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