2016 posed many challenges for the global financial markets. In the US, however, a rocky start to the year, Brexit, a surprise Trump upset, nor the Fed raising interest rates could prevent equity indices from hitting all-time highs before year-end. High-yield bonds also marched higher throughout the year, while the lone weak spot was the Treasury market.
For most of the past 35 years, the bond markets have been in a deflationary mindset and the yields on US Treasury bonds declined (and bond prices rose).
- The Fed’s war against inflation was a rousing success in terms of eliminating the inflationary psychology that created havoc in the economy in the 1970s.
- More recently, after the 2008/2009 financial crisis, quantitative easing certainly played a major role in reducing rates.
To ward off a deep recession or even a depression, central bankers globally bought trillions of dollars’ worth of government and corporate bonds with the intent to reduce interest rates in an effort to stabilise economies and promote growth. However, to date, many countries failed to achieve their growth objectives. Over the past few years, fears of a recession and event-driven economic risks resulted in a steady bid for government bonds - despite all-time low (and at times negative) yields and record duration levels. And it is the low yields and high duration that have led us to keep the overall portfolio duration as short as possible in the Nedgroup Investments Global Cautious Fund. The fund held a higher-than-normal level of cash and short maturity bonds for much of this period. The bond market, broadly speaking, was providing little reward for record levels of risk - not the best scenario for income investors.
The populist wave that emotionally swept Great Britain a few months ago also swept across the US… and now Donald Trump is President. Fears of immigration and stagnating economic growth turned out to be the keys to ‘victory’ for a frustrated populace both in the US and abroad. While both Brexit and Trump were shocking results to most people focused on current events, there is a historical precedent. This type of sentiment seemingly occurs every several decades or so, and the good news is that we, the people, manage to eventually move past it and survive. There will be concerns, there will be market machinations, and there will be stress and maybe even some strife, but we will survive somehow, someway.
With both bond and stock market prices near all-time highs prior to the election, we thought that something had to give. Either global growth needed to gain some traction along with inflation, supporting the argument for high equity valuations but also resulting in higher interest rates (lower bond prices). Or, global economies would continue to slow, justifying the argument for high bond prices and low yields, resulting in lower equity valuations (with the third alternative being stagflation.) The jury is still out on what impact the new president of the US will have, but the markets, at least in the past month, believe they have already found their answer.
The two graphs above show the dramatic move in the 10-year US Treasury bond yield and price. In the month after the US presidential election, the yield on the benchmark Treasury bond rose 60 basis points (or 32%) from 1.86% to 2.46% as the price on the 10-year bond fell by roughly 4.00%. This is a real-time example that the assumed safety in bonds does not exist as it did in the past. Trump’s campaign rhetoric regarding protectionist trade policies and his promises to revive the US economy have catapulted growth and inflation expectations globally. The US equity indices, stuck in a high-level trading range since 2014, made a clear break-out to all-time highs by year-end, while cyclical and commodity stocks, both benefitting from higher price inflation, led the way.
Once security prices rise, so too should the expectation of corporate earnings. Fundamentally, we believe there should be some sort of a rational relationship between a stock’s market price and its underlying earnings. Taken a step further, broad stock market levels should have a relationship to the underlying earnings of companies in aggregate. From a bottom-up perspective, we see individual companies that are trading much higher than their historical averages and much higher than their current earnings or returns on capital can justify. So within this context, we are seemingly in a period where something needs to give. Either interest rates need to rise and asset prices need to fall, or earnings need to rise to justify current valuations. That is as far as we are willing to go in terms of making any type of prediction about the broad markets. But within a period like this one – where many assets are not priced rationally – we would contend that the market is more sensitive to any situation that could increase volatility – be it Brexit, a Trump presidency, a slowdown in China or a conflict in the Middle East. The value of predicting the exact event that will cause volatility to us is minimal, irrelevant in some ways. What is relevant is that the Nedgroup Investments Global Cautious Fund is prepared to deal with future volatility.
Hopefully Trump can make a difference and develop policies that will stimulate growth. The US and other global economies need growth desperately at this point in time. Global debt levels have not been mentioned much over the past month, but this problem will not go away anytime soon. Trump is not working with a clean slate, having started off $20 trillion in the hole (not including entitlements). This matter of incurred debt is critically important to everyone from a global standpoint as record levels of debt are held by countries, corporations and individuals. Ideally, the global economy will muster some growth and we can generate enough revenue to deal with these staggering debt burdens. This is the most optimistic view. But a rapid increase in interest rates is typically not a good thing for those who have excessive amounts of debt. So the global economy will continue to walk this tightrope between growth and debt for a while. We require growth, but we require sustainable growth. We could use higher interest rates, but as long as they do not go up too fast. How the world economy grows is almost as important as its need to grow.
Whether the markets are right or wrong about Trump and the potential success of his policies, the impact will be minimal with regard to the day-to-day research effort for the Nedgroup Investments Global Cautious Fund. We will continue to monitor our investable universe for any volatility in stock or bond prices. We expect with the recent decline in bond prices, we should be able to eventually find some value in the shifting fixed income markets. Again, we do not believe it is necessary to predict Trump’s impact on the markets, but we do believe it is vitally important to be aware of the shifts in the markets and attempt to capitalise on any inefficiency that may arise in our investable universe. This recent change in inflationary psychology could be a major shift. We could be at that long-promised inflection point that finally brings about an end to a 35-plus-year US, bond market rally. If so, then we welcome the volatility this shift could provide.