The Trump "reflation" boost to yields
Donald Trump’s victory in the US presidential election win has accelerated the move higher in bond yields that began in the September quarter. The early move higher in yields was mostly driven by generalised ‘reflation’ sentiment – the idea that global growth is rising and rebalancing to a better mix where a weaker US dollar and higher commodity prices aid emerging markets at the same time as the developed world grows close to trend. Slightly elevated growth prospects and some rebasing effects are expected to push headline inflation rates modestly upwards.
Trump promises to lift growth above trend through a combination of tax-cuts and increased infrastructure and defence spending. This fiscal stimulus and greater protectionism for US industry (and likely retaliation by other countries) should be inflationary. There are risks that the pump-priming reactivates the recently subdued volatility in the US cycle, driving an overshoot and then an earlier but harder recession. There are also questions about the efficacy of placing more debt (which will fund the fiscal expansion) on an already-considerable debt load. Nonetheless, assuming Trump proceeds with much of what he has promised, the near-term economic implications are relatively clear.
While US bond yields are higher and the US dollar stronger, credit markets have been more or less indifferent to the Trump news. On the one hand, stronger growth boosts operating cash flow while, on the other, higher funding costs may ultimately offset this benefit. Markets also remain wary that the assets supported by the low-volatility carry-friendly environment – including credit – are susceptible to higher bond yields. Already in equity markets, indeed well before the US election, a big rotation from bond proxies to cyclical and value stocks was underway.
There are probably two key takeaways for bond investors from the reflation and Trump developments. The first is a likelihood of a global uptick in nominal growth next year, the first since 2010. While longer-term structural headwinds to higher bond yields remain, this at least suggests some cyclical upside. The second is that a shift in emphasis from monetary to fiscal policy is likely to be underway. While this seems clear in the US (even though at this stage we’re not yet sure of the Federal Reserve’s response to Trumponomics), it’s also possible elsewhere. Reflation and recognition by central banks of limits to unconventional policy support a gradual retreat from monetary accommodation and, combined with the rise of populism, a refocus on fiscal expansion. Alongside higher nominal growth, a changed bond demand-supply picture would also support higher yields.
Set against a backdrop of expensive valuations, these developments make bonds vulnerable, though arguably markets have moved to price some of the effects. From a low of 1.35% in early July, 10-year US Treasury yields have risen by more than 1.00%, a considerable move and one not dissimilar to that of the taper tantrum of 2013. This time around, however, there is probably more substance to the move, as it is driven by fundamentals and not just a policy shift. Additionally, while the move over the past few months has been sizeable, it’s only taken bond yields back to their levels at the start of the year.
Accordingly, we’ve broadly held our positions. We remain short duration relative to benchmark by about a year, split between the US (subject to cyclical upside), Germany (where valuations are most extreme) and Australia (on a combination of expensive valuations and possible cyclical inflexion). This duration underweight has been contributing a little over half of the value we’ve added versus benchmark over recent months, with the other contributors being our exposure to yield-curve steepening and our positioning for inflation-linked bonds to outperform conventional bonds. We have reduced our steepening exposure as longer-dated bonds now offer somewhat better value. However, we’ve increased our inflation-linked exposure a little further in the US (where there is the most obvious cyclical upside to inflation) and in Australia (where inflation protection is a little cheaper).
Credit remains a waiting game. Having pared our exposures considerably in the June quarter, we are running a small, high-quality, domestic-only absolute exposure, which represents only a very modest overweight position versus benchmark. Our caution regarding credit is due first to valuations of credit assets being mostly on the expensive side of fair and second to the prospect of some market indigestion should higher rates, aided by the removal of central-bank support, see investors retreat from what has been a great asset class since the global financial crisis. With recession mostly a distant prospect, we’d likely view wider spreads as offering a better-value re-entry point.
Cash remains reasonably elevated, though we’ve used some to build our inflation-linked exposure over recent months. This, combined with our interest-rate and credit positioning, leaves us defensively positioned and focused on protecting capital as markets adjust to developments.
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