John Pattullo, Co-Head of Strategic Fixed Income, looks at the effects of the Trump victory on the financial markets so far. He provides his assessment of the ‘Trump impact’, whether this entails a lasting regime change, and what it means for inflation and growth going forward.
The Apprentice: no time to be a hero in fixed income markets
Like many people, my knowledge of US politics is driven somewhat by that excellent TV series, the West Wing. While watching Donald Trump’s victory speech early morning on 9 November, it certainly felt like another Netflix blockbuster coming to a climactic end. Unfortunately, we all need to wake up and pinch ourselves as the new series is just beginning.
Some of our American colleagues seemed to be going through the same bereavement — anger/acceptance/bargaining process — that some of us felt post Brexit. When Mr Trump states he wants to “make America great again”, he needs to add ‘at the expense of the rest of the world’. By stealing growth via trade barriers for example, he is trying to undertake reshoring1, or import substitution, to the benefit of US citizens. Understandably, emerging market currencies and equities have sold off.
Too rosy a picture
Unlike Brexit, where interest rates and sterling fell on the longer-term impacts of the vote to exit Europe, the US’s response was an aggressive sell-off in government bond markets, a much stronger dollar and equity trades aimed at benefiting from a return of growth and inflation; all on the prospects of the new resident for the White House.
I am not convinced the whole world will grow faster under Mr Trump. More likely, it will grow less fast but heavily skewed towards the US and away from both Europe and Asia. We have written substantially about peak everything; eg, demographics and trade, as well as de-globalisation, digitalisation and the lack of productivity — so there was never that much growth to be shared around.
The markets are of course discounting the future but some of the moves seem quite heroic to an old sceptic like me. Longer-maturity bonds have sold over aggressively into this ‘regime change’; the popular defensive, expensive equities have been sold in favour of banks and ‘wall building’ cement makers.
We have had huge sympathy for many years with the ‘lower for longer’ theory (lower growth, lower inflation, lower interest rates). However, after February’s China growth shock and oil price slump, it had become much more widely accepted. The deflationists2 leapt on the lower oil price and ‘headline’ consumer price index (CPI), ignoring core CPI3, which wasn’t doing much. Then after the oil price rally of late summer, it was the turn of reflationists4, who also leapt on the oil price and headline inflation number, again ignoring core CPI.
Time to recut our cloth
For a month or so pre Trump, the equity market was turning to value, cyclical and financial stocks at the expense of bonds. We were fairly dismissive. Trump changed this. Nobody can tell whether this is a regime change or not, but for now the market has bought the regime change, so we are not fighting it. A good fund manager accepts the situation and recuts his cloth. We have reduced interest rate sensitivity (duration)5 materially across the funds we run as the outlook for bonds looks worse, with the possibility of stagflation6. The outlook for US equities looks better but arguably worse for emerging markets and Europe.
In six months or so, we should have a better idea. We may be living in some Trump-utopian dream, or be back to secular stagnation7 with extra stagflation on the top. Additionally, European growth and political instability is a constant worry. This axis has worsened post Trump.
Economic growth under a good, bad or maverick Trump?
So here is our take. We seem to be heading towards a suboptimal place for bond investors. We expect a little more growth and inflation for the US, and higher bond yields (lower prices) in the short term. We have been both amazed and appalled at the extra growth forecasts most city economists and strategists have presented in their latest models. Most suggest extra growth of 0.3-0.5% for a year or two — whether under good, bad or maverick Trump. All expect a similar pickup in inflation.
We find these forecasts somewhat underwhelming. Why? Fiscal8/infrastructure spending may be hard to implement and may be overemphasized. Fiscal multipliers9 tend to be high in recessions but not with low unemployment. The US has structural unemployment in Republican Rust Belt states, not mass deficient unemployment. In addition, tax cuts are leakages on the system and have low multiplier effects.
It is debatable how much the Republican Congress will allow Trump to do. The bond sell-off and the strength of the dollar will tighten financial conditions as well. In addition, the illegal alien repatriation proposal, and most importantly his trade policies, could be hugely counterproductive. Further, this will put up import prices, which will act as a tax on consumers and raise prices — the wrong sort of inflation.
No need to be a hero
Thus, going forward we like loans10, being senior secured and floating rate; we also like large, non-cyclical11 domestic facing US high yield12 bonds with short maturities. We like ‘reason to exist’, large franchise banks in the US and the UK and dislike emerging markets, the periphery of Europe and European investment grade13 corporate bonds.
That’s about it. Don’t be a hero and let the carry14 (interest income) do the hard work. In six months’ time bond yields could well be higher, which may present itself as an opportunity to extend duration (interest rate sensitivity), assuming the Apprentice’s honeymoon period has faded.
1. Reshoring: transferring business operations that were moved overseas back to the home country.
2. Deflation: a sustained fall in the prices of goods and services, and thus the opposite of inflation’
3. Consumer price index, CPI: a measure that examines the price change of a basket of goods and services over time. It is used to estimate ‘inflation’. Headline CPI or inflation is a calculation of total inflation in an economy, which includes items such as food and energy, whose prices tend to be more prone to change (volatile). Core CPI or inflation is a measure of long-run inflation and excludes transitory/volatile items such as food and energy.
4. Reflation: in simple terms this refers to a return of inflation.
5. Duration: how far a fixed income security or portfolio is sensitive to a change in interest rates. It is expressed as a number of years. The larger the figure, the more sensitive it is to a movement in interest rates.
6. Stagflation: a relatively rare situation where rising inflation coincides with anaemic economic growth.
7. Secular stagnation:excessive savings act as a drag on demand, reducing economic growth and inflation.
8. Fiscal: connected with government taxes, debts and spending.
9. Fiscal multiplier: when money is spent in an economy, the spending results in a multiplied effect on economic output. Fiscal multiplier is the ratio in which the change in income is affected by government spending.
10. Secured loans: a loan where the borrower has promised to give the lender certain assets if they fail to make repayments.
11. Non-cyclical:companies/industries that provide essential goods, such as utilities or consumer staples. While cyclical businesses produce goods and services that consumers buy when confidence in the economy is high, non-cyclicals produce items and services that consumers cannot put off regardless of the state of the economy, such as gas, food and electricity.
12. High yield: companies that are deemed to have a higher risk of default on their debt by credit rating agencies, who assign them a lower credit rating than investment grade corporate or government bonds. To compensate for the increased risk, the debt issued by these companies pay a higher yield.
13. Investment grade: companies that are deemed less risky by credit rating agencies, as they believe there is a strong likelihood that the company will be able to repay its debt.
14. Carry: (in the context of this article and video) interest income or coupon, a regular interest payment that is paid on a bond. A coupon is described as a percentage of the face value of an investment. For example, if a bond has a face value of £100 and a 5% annual coupon, the bond will pay £5 a year in interest.
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