The Daily Update - NFPR

Today’s November non-farm payroll release showed 178,000 jobs added which was in line with expectations. The prior month’s reading of 161,000 jobs added was revised down to 142,000.  The unemployment rate fell to a nine year low of 4.6% from October’s reading of 4.9% and the participation rate dropped a little to 62.7%.  Average hourly earnings was an off setting factor to an otherwise expected and rather neutral report as month on month the -0.1% saw a 2.5% year on year number from the 2.8% previous report.

This data release in conjunction with recent Fed commentary makes a December rate rise almost inevitable with the market been pricing in a 100 percent expectation of an increase in rates.  What is more challenging to determine is what a Trump Presidency really means for growth and inflation.

Trump’s rhetoric has so far suggested four main areas for policy to target: tax reforms targeting reductions in corporate and personal income tax, an infrastructure spending program, deregulation and the renegotiation of existing trading relationships.  The balance between the macro measures versus those targeting trade will be important for determining the growth outcome with trade intervention risking a negative hit to growth.  At the outset the macro-measures could well be the main focus delivering an uptick to growth; the OECD is now looking for US growth of 2.3 percent in 2017 and 3 percent in 2018.  But this has to be balanced against the tightening of monetary conditions that is already taking place in markets.

We expect the Fed will respond by tightening more quickly than previously expected to counter any POTENTIAL inflationary impact and longer term, curves should continue to flatten; if the short term growth impact is offset by tighter monetary policy longer term growth will be weaker.  The 10 year treasury yield has already retraced from 1.36% in July to ~2.40% at the time of writing which is a significant amount of tightening in monetary conditions. This is feeding through into higher rates for the consumer: the Bankrate 15 year fixed rate US home mortgage has risen from a yield low of 2.59% on 27 September to 3.2% as of 1 December.  An increase in expectations for growth and interest rates has seen the US dollar index strengthen from ~96 at the start of October to ~101 today representing yet another sizeable tightening of monetary conditions: this trend is likely to be exacerbated while the ECB and BoJ remain in easing mode.

The theoretical framework supporting Stratton Street’s NFA analysis holds that the performance of bonds and currencies of debtors and creditors varies according to whether the world is experiencing a period of reflationary financial market conditions, where capital flows from creditors to debtors, or whether we are in deleveraging phase with capital flowing in the opposite direction.  We expect Trump’s policies will speed up the deleveraging process as the Fed is forced to tighten more quickly.

The US dollar is the world’s de facto reserve currency, thus enjoys an ‘exorbitant privilege’ for this role.  Thus, despite the US being a net debtor with a NFA profile that has deteriorated since the mid-1980s the relationship with the real effective exchange rate is weak.  US monetary policy is a key driver of global capital flows: expansionary US monetary policy post the GFC has supplied the world with ample cheap dollar liquidity but rather than deleveraging and reducing the excesses of this boom period global debt levels have actually risen, a situation made all the worse by insipid global growth.  The IMF estimated that global non-financial sector debt in 2015 reached 225 percent of world GDP. As this cycle reverses it is the weaker debtor nations, with large net foreign liabilities, and reliant on issuing foreign debt in US dollars that will come under the most pressure.  But as with the 2013 ‘taper tantrum’ volatility could temporarily spread to some issuers with stronger underlying fundamentals.

This means that high grade bonds, particularly from creditor nations, remain our favoured position, at least for now. We currently have an A2 average rating in our pure IG funds, and hope to be able to pick up lower grade credits at much wider spreads at some point.