JP’s Journal: Revolting bonds

Last week was certainly action packed. The election of Donald Trump has significant implications for economies and markets. Some of the initial reactions seem rational, others less so.

Books will be written about why President Trump triumphed. But I think that at the heart of it, he appealed to mid America’s aspirations for a better life. His messages hit home with a broad cross section of the electorate, hence the success not just in the electoral college but also in the popular vote. This is a strong mandate.

There are several key changes that are likely. In terms of fiscal policy, we can expect tax cuts. On the spending side, markets are sceptical whether Elon Musk’s $2 trillion efficiency savings are credible. Overall, the response in interest rate expectations looks sensible, with inflation and government deficits likely to rise. US equity prices have risen due to the prospect of lower taxes and a bonfire of regulations. Here, the response looks optimistic as higher real yields will have an impact on equity valuations.

On the question of tariffs, the response in the US has been muted and this is surprising. Tariffs will hurt the US consumer – the key driver of US growth. Higher prices will eat into real disposable income and will keep rates higher that they would otherwise be. In addition, corporate profits may be hit by tighter labour markets as migration is halted. So, there may be an immediate boost from fiscal policy but the longer-term implications look discouraging. This perspective is anchored by historical precedent, where trade wars are mutually detrimental. It may be different this time; onshoring and a more internally focused US economy may buck the trend but in my view it seems unlikely.

There may be an immediate boost from fiscal policy but the longer-term implications look discouraging.   

On the global front, President Trump will ruffle feathers. An aggressive tariff policy, a more isolationist foreign policy, and lukewarm commitment to NATO will have consequences. From a European perspective this is worrying and a strong mandate will embolden the President to deliver on his rhetoric. Weak European growth will be further undermined by tariffs and the demand for more defence spending will strain budgets. The evolving German political crisis is a timely foretaste of what is to come. Germany starts with some advantages – notably a relative low level of debt. But its ‘export’ growth strategy looks outdated in a more  mercantilist world. France and Italy start from a worse position. The coming few years will represent much more of an existential crisis for the EU than either Greek debt or Brexit. The choice is either political consolidation or fragmentation.

In the case of the UK the picture is also stark. The new government’s strategy is based upon kick-starting growth through government spending. This spending has just got more expensive and the world growth outlook has deteriorated. Loose US fiscal policies and higher government spending in the near term may help but will come with heightened inflationary pressures. When the sugar rush wanes, the UK outlook will be challenging. Higher taxes may be needed to deliver pledges in the run up to a general election but if this further undermines business profitability it is likely to be counterproductive.

The US stock market response to the election has been to buy ‘industry’ and sell ‘net zero’. The policies outlined by President Trump sit uncomfortably with the European consensus to move away from fossil fuels. This will be another challenge for Europe. Cheaper energy costs in Asia and the US will give those areas further advantages. Unless Europe can demonstrate quick financial benefits from renewable energy transitions, public support for net zero may decline in the face of economic pressures. The calls on the public purse are going to get larger just at a time when debt markets are starting to revolt.

Almost forgotten were last week’s rate cuts from the Federal Reserve and Bank of England (BoE). Both reduced rates by 25bps, both in line with expectations. Whilst the messaging from the Fed is that rates are still heading down, there is a sense that the neutral rate has moved higher and that this justifies a more gradual response. Indeed, the tone was upbeat with the economy and labour market both described as solid. Looking at a one-year horizon, two rate cuts have been taken off the table in the last month. Despite this, 10-year treasury yields were lower on the week, ending at 4.3%, recovering from 4.5% approached in the immediate aftermath of the election result. In answer to a direct question, it looks that Chairman Powell is up for a fight if the incoming President wants to change Fed leadership.

From the BoE we saw an 8-1 decision to cut base rate to 4.75%. In terms of economic outlook, the UK budget has impacted their forecasts, with activity and inflation being nudged higher. Like the Fed, the emphasis was on gradualism, particularly as service inflation is proving to be sticky. Given that their median CPI forecast is now above 2% in two years’ time a more hawkish stance could be justified, but that outlook is predicated on a lower interest rate profile than the market presently expects. Overall,  the current 75bps of cuts priced into markets over the next 12 months looks reasonable. On the back of these events UK gilts were volatile. Gilt 10-year rates were broadly unchanged at 4.45% but brushed up against 4.6% at one point. Yields on 30-year gilts breached 5% before settling at 4.9% – again unchanged on the week. Credit continued to outperform, although there was little movement in spreads.

Over the last 10 years US equities have given a 13% annualised return, US treasuries have returned 1% annualised. Have bond investors had enough of government profligacy? Not yet, but there is a growing chorus of discontent that should scare governments.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.