The post-election euphoria in the stock market continued in December, lifting indices to just below all-time record highs. The catalyst for the buying has been investor expectations of a more favorable business environment and, with it, accelerated profit growth. Bond investors, on the other hand, have been grappling back and forth on President Elect Trump’s impact on the economy and the markets, engaged in a seeming circular logic. Consensus seems to agree that Trump’s infrastructure plans, while vague, will be stimulative to economic growth. However, as always, the “devil is in the details.” If he is going to pay for the spending by stepped up borrowing in the bond market, which seems likely, then the additional borrowing is also likely to have a crowding effect and push interest rates higher. However, a sharp rise in interest rates would be detrimental to economic growth and could cause stock prices to fall. When economic growth slows and stock prices fall, the Federal Reserve usually steps in pushes interest rates lower. The Fed has added to the confusion by indicating that there will be three rate increases in 2017. Just last fall the committee stressed that rate hikes would be gradual and measured. We have long believed that the Fed has fallen behind in normalizing interest rates and think that rate hikes should have been earlier and more frequent than the cumulative 50 basis points we’ve seen since 2015. Now it seems that several, if not the majority of the FOMC has come to the realization that interest rates are way too low, especially if Trump is going to open the Keynesian floodgates.
That brings us back to the circular logic troubling bond investors. We mostly agree with the thought that added deficit spending is likely to push rates higher. Despite claims otherwise, the annual budget deficit has not registered less than $400 billion since Obama took office and is forecast to rise steadily under current assumptions. Assuming Trump finances the $1 trillion infrastructure build out with debt, rates are going to need to rise to attract buyers. Also, assuming that Trump is successful in getting “shovels in the ground,” he’ll be doing so at a time when the United States is arguably at full employment, average hourly earnings are rising at the fastest pace in six years, and inflation is steadily ticking higher. Given those circumstances, it’s easy to understand why bond investors are worried. Following the sharp rise in interest rates after the election, 10-year rates have drifted lower in the New Year, retracing about 25% of the rise since November. We think that the downward drift will be temporary and expect that we’ve now entered into a rising rate environment. Moreover, we think that rates will rise in a backing and filling fashion, with yields ultimately stabilizing at higher levels until investors fully understand Trump’s policy. A pattern not dissimilar to the way bonds traded before Quantitative easing and the Fed’s manipulation of interest rates. While there’s no doubt that higher interest rates will be less stimulative and likely to have unintended consequences, we think that the economy is on strong enough footing to continue to grow. The one wild card is the stock market. As we mentioned earlier, stocks have rallied sharply since the election on expectation that earnings will accelerate. Should that not come to pass, stock prices are likely to fall back to a more normalized P/E multiple.