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Three ways Trump could impact the bond market in 2017
Payson Swaffield, Chief Income Investment Officer
Boston - Donald Trump's surprising victory was a game changer for the markets. His election sparked the kind of change in investor psychology that we have not witnessed since the end of the financial crisis.
The immediate reaction in the bond markets was a move higher in rates and inflation expectations, coupled with a rally in U.S. stocks and a decline in equity volatility (as measured by the CBOE VIX Index).
Looking ahead to how the rest of 2017 may play out, we see three interrelated trends in the bond market as the Trump presidency unfolds:
Trend #1: Interest-rate volatility is back and "lower for longer" may be over
U.S. rates were rising prior to the election, which in part reflected heightened inflationary expectations. Trump's path to victory included promises for growth-oriented policies including corporate tax cuts, fiscal spending on infrastructure projects (potentially debt-financed) and deregulation. In combination, these could further boost real growth and inflation.
But we don't know the extent of potential infrastructure spending, or how quickly it may take place. The same can be said for tax cuts and deregulation, which can be contentious and complicated. Such uncertainties are likely to drive volatility in rates. We can't be sure, for example, whether the recent surge in long-term rates has temporarily gotten ahead of itself - we have seen a number of false starts at the long end of the curve.
Trend #2: The credit cycle is likely to be extended
The same growth-oriented policies are also likely to extend the credit cycle in the U.S., which has been in the later innings for some time. With the improving economy, default rates in U.S. corporate bonds (both investment grade and high yield), floating-rate loans and municipal bonds are likely to be relatively low and stable over the coming year.
Trend #3: A potential "field day" for fixed-income active management
Prior to the election, global central banks were the only game in town. They provided liquidity through managing interest-rate yield curves (down) and boosting the prices of risky financial assets, while depriving markets of their important price-discovery function. With interest-rate uncertainty elevated by Trump's election, markets must start acting like markets again, weighing sources of risk and return in a variety of scenarios.
The uncertainty is compounded by Trump's protectionist talk. Ultimately, other countries could retaliate with protectionist measures of their own; such policies could undermine global (and U.S.) growth, spur inflation and weigh on financial markets.
As a result, we feel that Trump has expanded the range of outcomes - both good and bad - from the muddle-through progress that has been the case in recent years. With pro-growth policies, the possibility of pushing past 3% nominal U.S. GDP growth becomes a likelier scenario, but so does a possible economic contraction stemming from trade wars that would lead to reduced global trade. Naturally, such considerations will bear on how aggressive the U.S. Federal Reserve will be in raising rates, following its decision on December 14 to lift rates by 25 basis points.
In a nutshell, an environment with a broader range of potential outcomes - as opposed to one dominated by central bank policies - provides active managers a better opportunity to add value, particularly in less-efficient income sectors, which often overreact to changing market factors. Manager value-add can be both defensive and opportunistic. On the defensive side, I view floating-rate loans, shorter duration, absolute return and bond laddered strategies as attractive, while potential opportunistic moves include muni bonds and emerging market debt.
Bottom line: I'm hopeful that Trump's policies will land on the pro-growth side, and that the sound arguments against sweeping protectionist policies will prevail. A more volatile interest-rate environment is all but inevitable, but we believe the impact on fixed-income portfolios can be managed and mitigated.
An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. As interest rates rise, the value of certain income investments is likely to decline.