Trump’s bond mar­ket cor­rec­tion

Financial Mirror (Cyprus) - - FRONT PAGE - By Will Denyer

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.

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