The election of Donald Trump as US president drove global bond yields higher and credit spreads tighter over the December quarter, as investors factored in stronger growth and higher inflation as a result of his proposed spending, tax and trade policy changes. US Treasuries underperformed, aided by a Federal Reserve that hiked the US cash rate by a quarter point as expected in December and appeared a little more upbeat, while the European Central Bank extended its asset-purchase program. Australian bonds broadly matched Treasury moves, with the rebound in commodity prices through 2016 reducing the likelihood of further easing by the Reserve Bank of Australia. Credit spreads tightened, especially in the US.
As 2017 begins, investors remain focused on Trump’s reflationary agenda. For the most, the mood is buoyant, as the expected US lift courtesy of expansionary fiscal policy comes as global economic growth is rising. While Trump’s fiscal and trade policies have yet to be enacted, and their effects won’t be revealed in the hard data until late 2017 at the earliest, US consumers and businesses are optimistic that the policies will lift demand, increase inflation (including of wages), provide a short-term boost to productivity and bolster profits. For the rest of the world, the notable beneficiaries of reflation should be the commodity producers – including Australia – that have recently suffered large terms-of-trade losses, so long as commodities continue to rise alongside a stronger US dollar, in contrast to the 2014-15 experience.
While investors are focussing on the positives, there are risks Trump fiscal plans will lift the amplitude but shortens the length of the US cycle through feedback effects via rising rates and the stronger US dollar (including its impact on emerging economies). The Fed’s policy response (and that of other central banks) will be critical in managing these interactions. After years of undershooting on inflation objectives, central banks are likely to welcome stronger nominal growth and a more balanced policy mix. But they will remain wary of diminished policy elasticities against increased debt loads and of financial-stability risks (each of which argue for higher rates to position for the next downturn).
Longer term, it’s not clear yet how government and national accounts are balanced. Fiscal expansion will increase government debt loads as well as likely lift interest rates. Reform of the corporate tax system and domestic deregulation may lift US productivity growth a little, to somewhat offset the drag of higher debt load and rates. The sustained response of business investment and the extent to which protectionist policies are pursued (limiting long-run growth at home and abroad) remain key unknowns. It’s simply too early to tell whether Trump is simply a short-term boost or a longer-run productivity-lifting revitalisation of the US economy (with minimal negative externalities).
An uplift for 2017-18 and beginnings of a shift in emphasis from monetary to fiscal policy are probably the two key takeaways for bond investors from Trump’s reflation proposals. Beyond Trump, recognition by central banks of limits to unconventional monetary policy and growing populism support the refocus on fiscal expansion elsewhere. However, with greater risks now that central banks step away from supporting markets (at least to the degree that they have over the past few years) and with political risk increasing, market pricing for higher volatility does seem complacent.
While bond yields have already risen considerably from mid-2016 historic lows, expensive valuations and the Trump reflation developments suggest bonds are still vulnerable. Accordingly, we’ve broadly held our interest-rate 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 contributed 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 exposure versus benchmark. Our caution regarding credit is due, firstly, to valuations of credit assets being mostly on the expensive side of fair and, secondly, to the prospect of some market indigestion should higher rates, aided by the removal of central-bank support, prompt investors to 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 levels in the Portfolio remain reasonably elevated, though we’ve trimmed cash holdings a little 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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