Trump’s bond market correction

The new US leadership was always likely to inherit a bond market correction. Now, the Republicans’ clean sweep in winning control of the White House and both houses of Congress significantly increases the odds of a deep bond market sell-off — which in turn will be likely to knock equities down a few notches from their current valuations and which could ultimately result in recession.

A bond market correction was already on the cards, for three reasons:

1. Bonds were way overbought this summer.

have corrected by a significant amount already, yields have further to rise. While they it is likely

2. Markets are about to get an inflationary wake-up call.

The base effects of sub-$30 oil last January and February, along with big increases in Obamacare premiums, are likely to push headline consumer inflation up to 2.5-3% YoY in the first two months of 2017. While one might usually look past these influences as temporary noise, the higher headline numbers may focus attention on the third, and most important, reason we have been short duration…

3. Underlying US inflation really is accelerating

— the median consumer price index component is up 2.5% YoY — and this cycle is getting “long in the tooth”. This assertion is not only based on the amount of time that has passed since the last recession (although eight years of extreme monetary activism, and the cumulative damage it has likely done to the efficiency of capital allocation, does call for heightened caution), but also on the fact that a lot of economic slack has clearly been wound in. This is particularly evident in the labour market and housing vacancies.

Whether the economy tightens further from here is an important question. Recently, demand for new hires and private investment growth have both weakened to the point that they are very close to sending recession signals. If growth continues to soften, recession could pre-empt a further bond market correction. But if growth holds up—as recent PMI numbers suggest it might—then the labour market will get even tighter, inflation measures will rise further, and a pronounced bond market correction will become increasingly likely. Either way, equities are likely to correct as the Goldilocks scenario comes to an end.

Now the Republican clean-up in the US election only adds to the risk that a rise in inflation expectations will cause a bond market correction. There are three reasons for this:

1. Public infrastructure spending will cause consumer prices to rise.

One can argue that US bridges are in desperate need of repair or that a big wall along the southern border really will be “a beautiful thing”. But that doesn’t change the fact that investment in public projects will direct resources away from present consumption. In a hypothetical free market with a fixed money supply, investment need not push up the price of consumption goods, as demand for present goods falls in parallel with the rise in investment (in such a system, investment has to be funded with savings). However in today’s world, US politicians, and Republicans especially, are unlikely to pay for a “yuuge” infrastructure spending bill entirely with taxes. Instead, the government is much more likely to borrow the capital and, one way or the other, finance much of this debt with money created out of thin air, either by the central bank or by commercial banks. With the funding coming from the finance gods, consumers will be free to maintain their existing consumption habits. Sounds great. But the problem is that the provision of consumption goods now has to compete for resources with the government’s public works projects. With demand for present goods unchanged, but supply restrained by competing projects, the price of present consumer goods (which is what CPI and PCE price measures focus on) will rise. If we were in the middle of a deflationary death trap (where lower asset prices force fire sales to deleverage balance sheets, leading to even lower asset prices, and more fire sales...) one might argue that this inflationary boost could be helpful. But the last deflationary death spiral ended in March 2009 when the government removed the mark-tomarket rules on banks. Today, we have rising inflation measures, tight labour markets, increasing corporate leverage, punchy asset valuations, expanding credit etc... It hardly feels like a deflationary death trap. Today, an increase in deficit spending is likely to push inflation measures — and bond yields — higher.

2. Less cheap labour in the US will also put upward pressure on prices.

If Donald Trump follows through with his promises to deport an important chunk of the US workforce, his move is likely to drive up labour costs. Some of that increase will be reflected in narrower corporate margins, the rest will be passed on to consumers through higher prices.

3. Protectionism would

drive up

prices.

Trump’s surprisingly conciliatory acceptance speech, in which he told the world that he plans to negotiate and trade fairly with other countries and “have great relationships”, raises hopes that Trump the President will prove to be much less protectionist than Trump the campaigner (this could explain much of the market’s post-election bounce). That being said, if he does go ahead and i mplement his protectionist promises, it will work to drive up consumer prices in the US. Most obviously, tariffs would directly drive up the cost of imported goods. On top of that, a contraction in global trade would likely drive down the value of the US dollar. This is because global trade is largely financed in US dollars, so if the working capital requirements of trade fall, so does demand for dollars. A decline in the US dollar would further push up the dollar price of imports.

Trump and the Congressional Republicans may eventually “make America great again”. After all, there is plenty of scope for improving government policy. And judging from the equity market moves of the last few days and discussions with clients, there is a surprising amount of optimism on this front. However, my concern is that in the next 12 months, markets are going to have to digest a significant rise in yields, perhaps on both the short and the long ends of the curve (this may have already begun). Given that median leverage on the S&P 500 is near its 2000 peak and equity valuations are punchy, I worry that equity markets will not take kindly to a major rise in yields. Remember 1987?

So, how to invest in the coming months? For now, I continue to recommend reduced equity risk exposure (say 30-40%), and short duration on fixed income portfolios. Investors might hold some US banks as part of their conservatively-sized equity allocation, as despite their recent outperformance, banks are still only trading at about 1x book value. And if the yield curve steepens further, banks should continue to outperform.

With the market already moving in ways that favor this portfolio, the question is: when to change tack? According to Charles Gave’s bond valuation tool, which is based on the trailing structural growth rate and current short rates, bond yields could easily rise another 50bp— putting the 10 year at 2.65%. At that point, investors may want to begin tactically extending duration, perhaps first bringing duration back in line with the fixed income benchmark and then gradually adding duration if yields rise further from there. At the same time, I would begin to reduce equity exposure further — including taking profits on bank shares — as fixed income will have become relatively more attractive and the odds of an equity market correction and/or recession will have been pushed up by the rising cost of capital.