November 2016 – Monthly Commentary
The landscape for fixed income changed dramatically with Donald Trump’s election victory. While polling was close going into the election, the market seemingly priced-in a Clinton victory and a continuation of the steady, albeit modest economic growth of the Obama Presidency. Instead, investors reacted swiftly to the change in leadership concluding that Trump’s rhetoric will translate into profit growth and an accelerating economy. Industries that have seen the strongest reaction are banking, building, mining, transportation, and manufacturing. Stock prices in those sectors have jumped in anticipation that infrastructure spending will accelerate, government regulation and intervention will lessen, and climate change control efforts will fall by the wayside.
While investors took stock prices higher on the news, bond prices plunged in anticipation of more deficit spending and higher inflation. Trump campaigned on spending $1 trillion dollars on infrastructure rebuilding, paid for by private funding. It remains to be seen where that funding will come from. The most likely source is the U.S. bond market either directly through Treasury notes, Municipal bonds, or some hybrid. With the U.S. debt standing at approximately $20 trillion and the government running a $500 billion annual deficit, investors concluded that it’s going to be impossible to keep rates ultra low in the face of a growing supply of new debt. Further weighing on bond prices has been a reacceleration of economic activity since summer’s end. The economy continues to generate jobs at a brisk pace, wages are rising, manufacturing is expanding, consumers are consuming and with the election out of the way, a degree of uncertainty has been swept aside.
One of the big questions of the Trump Presidency is how he will behave towards the Federal Reserve. During the campaign he repeatedly berated Fed Chair Yellen for her excessively loose monetary policy, saying that she should be “ashamed of herself” for penalizing savers with ultra low interest rates. Since the election, he has been mum on monetary policy and the Fed chief. He may have changed his mind on low interest rates, realizing that easy money would be beneficial to his plans to accelerate economic growth. His pre-election economic advisory team of Larry Kudlow and David Malpass have both been critical of the Fed for holding rates at emergency levels. That wise advice may be diluted now that Trump is seeking the council of Jamie Dimon, Lloyd Blankfein and other Wall Street CEO’s. They are likely to advise Trump that Yellen’s game plan of gradually raising interest rates will be beneficial for all, as income returns to the bond market, but not at a pace that slows growth. He will also have an opportunity to shape monetary policy with his filling of the two vacant Fed Governor positions. Given the current make up of the committee, we hope he opts for individuals with industry experience rather than the academic economists that have been favored in recent appointments.
What seems nearly certain is that the Federal Reserve will raise the Fed Funds rates in December for the second time in two years. We warn, as we did last year, raising interest rates two weeks before year end is risky, and creates trading distortions in already thin, illiquid trading. Last year the initial reaction to the well-telegraphed rate hike was slight downward pressure on equity prices. That is until the first trading day of the New Year when stock prices collapsed, trading down by more than 10% by mid month. That’s not to suggest that we’re forecasting a correction in stock prices. We raise the subject to illustrate the risks inherent in policy changes made during periods of illiquidity. Looking into the New Year, we intend to be vigilant in risk management, as the country adapts to the New President and what is likely to be a dramatic departure from the last eight years.