U.S. equities rallied to new highs after Donald Trump’s election, with equity investors wanting to believe that fiscal stimulus, tax cuts and a lighter regulatory touch will boost the economy. Bond markets moved in the opposite direction, with interest rates rising in response to expectations that reflationary policies will create a stronger economic recovery and higher inflation. Ten-year Treasury yields rose to 2.6%, up sharply from the 2016 low of 1.36% reached in the post-Brexit turmoil. Longer-term government bonds, municipal bonds and investment-grade corporate bonds were among the victims of the bond market rout. Bond proxies that were winners earlier in the year, such as utilities and real estate investment trusts, also lost ground post-election.
“I Want to Believe”
Investors are anticipating that the “pragmatic and market-friendly” economic version of Donald Trump will prevail over the “anti-growth and protectionist” version of Trump who often appears in late night Twitter rants.Investors are enthusiastic about economic growth under Trump and bullish about the prospects for equities, while demonstrating considerably less enthusiasm about the prospects for bonds.
Following are some observations about what may actually occur during Mr. Trump’s presidency.
“Curb Your Enthusiasm”
Investors may have unrealistic expectations about economic growth, and may need to temper their enthusiasm; Trump’s tax and spending proposals will face significant obstacles in Congress. Although Republicans control both houses of Congress, Tea Party members in the House of Representatives may object to measures that dramatically increase the Federal budget deficit. Trump’s thin margin in the Senate may also force compromise over certain issues.
Tax reform will create winners and losers, with special interest groups fighting hard to protect deductions and subsidies that favor their constituents. Trump’s spending plans sound promising, but a shortage of “shovel-ready projects” and the complexity of his public-private partnership initiatives may cause fiscal stimulus to have a greater impact in 2018 than in 2017.
U.S. economic growth was 3.2% in the third quarter, and is expected to be reasonably strong to end the year. Unemployment continues to decline and wages are rising, though the relatively low labor force participation rate reflects an aging population and a high level of discouraged workers who have left the workforce.
The Fed “dot plot” signals plans for three rate increases in 2017, though Fed Chair Janet Yellen has signaled that she is open to having the economy run a little “hot” and to allow inflation to rise above the Fed’s 2% target rate. Some analysts speculate that the inner circle of the Fed – Yellen, Vice Chair Stanley Fischer and New York Fed President William Dudley – are expecting to raise rates only twice in 2017.
If Fed tightening leads to a strong dollar, the Fed may not need to raise interest rates too much to cool the economy. Ultimately, the three “D’s” — debt, demographics and the dollar — may impair economic momentum despite Trump’s best intentions.
“Dude, Where’s My Drone?”
Events beyond the bubble of Washington may disrupt Trump’s economic agenda. China’s seizure of a drone may be the first in a series of “proportionate” reactions to perceived provocations from Trump.
Concerns about China’s militarization of the South China Sea may be an early test of Trump’s foreign policy reactions, as will increasingly close ties between China and countries such as the Philippines that were historic allies of the United States. It seems inevitable that North Korea will “act out” soon after the inauguration, testing Trump while South Korea is in a state of political chaos.
Vladimir Putin is also likely to explore how friendly Trump will be toward Russian interests, a test for Trump and his non-traditional selection for Secretary of State, Rex Tillerson.
Foreign policy challenges could interrupt the equity rally and renew the appeal of bonds as a safe haven in an uncertain world.
Some Strategies for Income-Oriented Investing
Bonds, though perhaps not that appealing on the surface today, do offer a hedge against downside economic risks. In a rising interest rate environment, some segments of the bond market are more attractive than others. Given uncertainty about the pace of interest rate increases and the possibility that rates could reverse during periods of geopolitical stress, a diversified approach is desirable. So below are some observations on different bond classes.
Government bonds: U.S. government bonds offer higher yields and a better value than was the case earlier in 2016, with the two-year Treasury above 1.2% and the 10-year Treasury at approximately 2.5%. Shorter-duration government bonds are less vulnerable to a rise in rates, so risk-conscious investors may want to emphasize shorter-term bonds until there is more clarity about economic and policy momentum. Some global bond investors are saying, “Buy bonds, not bunds,” as German and most Euro-area government bonds don’t appear to offer much value relative to U.S. government bonds.
Municipal bonds: Municipal bonds, an important but typically sleepy corner of the bond market, are at the center of feverish speculation. Rising interest rates have been a factor in the muni selloff, but speculation about tax reform is also a factor. A fall in the highest personal tax rate would reduce the attractiveness of municipals relative to taxable bonds, but the market reaction to that possibility seems excessive. The greater risk for municipals, and probably the more significant factor in the recent sell-off, is the potential for tax reform that significantly reduces the tax rate for taxable bond interest and could dramatically change the competitive landscape for municipal bonds.
Investment-grade bonds: Corporate bonds are vulnerable to rising rates, though many large companies locked in long-term borrowing at low interest rates. Corporate spreads are low while balance sheet fundamentals are deteriorating, which usually isn’t a good combination for investment-grade bond returns! However, the search for yield by savers starved for income may prop up the valuations of investment-grade bonds in 2017.
High-yield bonds: High yield is helped by a strong economy, and offers a meaningful return premium relative to government bonds. Volatility in high yield is closer to equities than to investment-grade bonds, and default rates are quietly rising. Selectivity is very important, particularly given the uncertain environment expected in 2017.
Emerging markets bonds: Selectivity is also very important for advisors considering emerging market debt. Countries with a high proportion of U.S. dollar debt relative to GDP, such as Malaysia and Indonesia, may be vulnerable if the dollar continues to appreciate in 2017. Fundamentals in the emerging markets universe appear disconnected from the bond market, as emerging markets debt spreads haven’t widened alongside the increase in developed market interest rates.
Bond proxies: Dividend-paying stocks offer the appeal of income and growth, though the reach for yield into utilities and telecommunications stocks may not pay off in 2017. In a growth-oriented environment, the market may favor dividend-growth oriented companies that can grow revenues and earnings when inflation drives interest rates higher.
Changes to the market outlook are likely to be driven by a few key economic and geopolitical considerations, including tax and spending initiatives, trade policy, immigration changes, and global geopolitical developments. The euphoria of the recent equity rally may fade as Trump faces the limitations of presidential power, and uncertainty builds about the specifics of his governing priorities and ability to implement policy. Likewise, the bond slump may slow, as yields rise more gradually if economic growth is less robust than hoped and geopolitical events disrupt the path forward.