Trump versus the bond markets...
| 11 Oct 2018
Pity Jay Powell, the new chairman of the Federal Reserve this month as he eulogised on the US economy and celebrated a 3.7% jobless rate (the lowest since 1969) - only to find a fire storm brewing in the US treasury markets, along with a sharp correction in technology stocks and then a verbal ‘broadside’ from the US President.
More cautious hands might have said that boasting of a ‘remarkably positive set of economic circumstances’ was asking for trouble and forgetting the advice of the Fed’s longest serving Chair1 - namely that the job of a central banker is to “to take away the punch bowl just as the party gets going.”
To be fair to Powell and to the White House, with eight US rate rises since 2015 some ‘punch’ has already gone from the bowl while the recent economic data has been truly exceptional; unemployment at a 90-year low, small business optimism at a record high2 and all achieved with core inflation still at 2% - a far cry from the backdrop of ‘secular stagnation’ that characterised the last years of the Obama administration. The concern for investors is that this renaissance has been fuelled by fiscal spending far later in the cycle and on a far greater scale (currently 0.75-1% of GDP) than any economic text book would ever advise – in short, Trumponomics (as this is being described) is a radical and largely unilateral economic experiment. It seems that what the President is doing is deliberately running the US economy ‘hot’ by injecting, over a decade, $1.5 trillion of tax cuts, nine years into an economic recovery - coupled with robust private investment this will likely lift US GDP growth above 3% for calendar-year 2018.
Unsurprisingly, such a policy does not come without risks; most obviously rising interest rates and bonds yields, a soaring dollar and a potentially spectacular increase in debt (the Congressional Budget Office suggests US debt/GDP could approach 100% by the end of the next decade – a level normally seen only in war time). This year alone the American budget deficit is predicted to be 4.2% of GDP (CBO Long Term Budget), or almost twice the level of the worst case Italian budget deficit for 2019 that is getting Rome into such hot water with the European Commission…
Is there some method in the madness of Trumponomics?
Why, you might ask, take such a risk? Maybe the mid-term election on 6 November is answer enough – more optimistically though there is some sense in this apparent madness. By deliberately overheating the economy, could it generate the capex spending US companies need to incur to generate higher long-term productivity? Faster growth in a very tight labour market means corporate management will simply have to get more efficient - for example, by shrinking IT departments and pushing work to the cloud, adopting AI solutions for sales and robotics for production while calling back retired or part-time workers (and hence improving America’s stubbornly low labour participation rate). All of this is already triggering a surge in US domestic investment (running at a robust 7.1% rate) and should, over time, contribute to improved profits and taxes – making the programme ultimately self-financing, or so the Trumponomics playbook goes…
The arbiter of success will likely be the bond market…
The arbiter of the success of this experiment will likely be the US bond market - and this month we have seen the first warning shot. Yes, the President has shown he can browbeat/persuade Congress to back his tax agenda and is wholly unafraid to give the Federal Reserve advice on interest rates3, but the bond market is a new sort of foe. For a start, a large chunk of US Treasuries is held by foreign investors ($6.3 trillion or almost twice as much as foreigners held in 2008) with China ($1.2 trillion) and Japan ($1.1 trillion) the largest. In the case of the former there is now added uncertainty in that the highly aggressive use of sanctions by the Trump administration may encourage the Chinese to attempt to reduce their ‘dollar dependency.’ This might over time impact the demand for Treasuries from other foreign governments. More generally, bond investors are uniquely sensitive to inflation rates – in this respect the President’s decision to impose sanctions on Iran (regarded by many in the oil industry as among the toughest ever adopted) have already helped trigger a rise in oil prices of more than 25% this year. Nervous foreign investors and rising oil prices have not often been good for Treasuries…
All of the above suggests that the gradual and largely orderly trend of upward bond yields that began in late 2016 will continue. For investors such a move has traditionally led to higher market volatility, as we clearly saw last week, and ultimately material changes in market leadership.
- Equity valuation: Given their lack of dividends and lofty valuations, high-flying growth stocks are arguably among the longest-duration assets in the world. It is perfectly reasonable therefore that they should eventually succumb to rising long rates - note that 2018 was the first year in seven that the forward price-earnings multiple of the S&P 500 actually contracted. As interest rates began to rise from their secular lows in summer 2016 it was initially high dividend stocks and bonds that were the losers, with growth still trouncing value. However, at a certain yield threshold growth stocks lose their immunity to rate rises as we saw this month - so expect a gradual shift in leadership to dividend growth strategies, and look for US outperformance to diminish in 2019 as higher bond yields continue to bite.
- Bonds as a persistent asset underweight: Our most persistent asset allocation call remains an underweight to global bonds. In our view the US economy is simply too robust for so gentle a Fed normalization path - couple this with strongly positive net supply of Treasuries and you have steeper yield curves. To date, the sell-off has been concentrated in the US, Canada and the UK with Europe (excepting Italy) showing only a modest back-up in yields. With ECB bond purchases set to cease this year we expect European bond yields to rise and start to narrow the gap with US Treasuries. This would likely be accelerated if either the EU/Italian budget stand-off was resolved and/or there is a negotiated Brexit agreement.
- Volatility: Notwithstanding a brief surge in February this year, equity volatility had, until this month remained remarkably subdued - trading at around 13, a level well below the 25-year average of 19. However, there is evidence that asset price volatility typically rises as the US rate cycle tightens in earnest (see chart 1), so don’t expect the burst of volatility we saw last February or again last week to be the last. To this end we are holding higher precautionary cash balances in lower risk mandates.
- Bank equity as a bond market hedge: In addition to rising bond yields, US bank profitability is rising, driven by lower tax rates, declining legal bills and record shareholder pay outs. Most firms have also kept a tight lid on costs even as they spend more on technology – with JP Morgan’s chief executive officer stating that the banking industry is entering a ‘golden age’. While not quite as optimistic, we continue to see bank equity as a useful portfolio planning tool and bond market hedge in the US, and increasingly Europe, supported by what are now very substantial and well covered dividends.
- Emerging markets: Momentum has returned in force across several markets this month with seven-year highs in the US 10-year yield and four-year highs in oil, and correspondingly 18-month lows in emerging market currencies. The key driver for all these trends is the President’s ‘America First’ agenda, where the US leads all other business and central bank cycles but also ‘kindles almost every geopolitical fire’. Rising US bond yields have the potential to reverse this in time but we fear the trade battle with China may be longer term and more strategic. Yes, we are now seeing opportunities in emerging equity markets, but this time the recovery may start in Latin America and the EM commodity and energy producers rather than in a China-centric Asia…
1William McChesney Martin Jr. (December 17, 1906 – July 27, 1998) the ninth and longest-serving Chairman of the United States Federal Reserve Bank, serving from April 2, 1951, to January 31, 1970, under five presidents.
2As measured by the NFIB Small Business Optimism Index which goes back to 1974
3Of recent rate rises President Trump stated “I’m not thrilled, because we go up and every time you go up they want to raise rates again…I am not happy about it.” July 2018