As the world continues to recover from the ‘surprise’ outcome of the US presidential elections, US Treasury yields have backed-up with the 10 year closing on Friday at a yield of 2.15%. Although much higher than the low of 1.36% set in July, we are now back close to the levels seen at the beginning of January 2016.
Trump’s election victory is bringing forth a lot of speculation on the next administration’s possible economic policies and their consequences. These exercises are fraught with uncertainty in part because Trump as a candidate spoke so little about what his policies would be. A few themes are likely to remain intact now that election posturing is finished and so some thoughts are worth considering. Some of the main items on the agenda supposedly will include: renegotiating trade agreements including NAFTA, curbing immigration, health care reform (again), deregulation notably for small businesses, repeal of Dodd-Frank, tax cuts and most significantly fiscal stimulus presumably in the context of infrastructure spending. Some of this agenda, however modified, is likely to move forward in 2016 because America has voted for ‘change’. Recall that each of the previous 8-year US presidents (Reagan, Clinton, Bush and Obama) was replaced with someone who was diametrically different in some sense from their predecessor, so the populous expects and Congress must deliver something new.
The Trump agenda is mixed bag of supposedly pro-growth policies for the short run that unfortunately could have very negative consequences for the economy’s long term potential. Not surprisingly, much of the market’s initial reaction seems to focus on the short view, especially the prospects for infrastructure spending. Markets have responded by raising inflation premiums on long term bonds. Although a growing consensus of economists now believes infrastructure spending is a viable anecdote for secular stagnation, some caveats are noteworthy.
When an economy is operating close to its potential, as is the case with the US economy today, an outsized initiative on infrastructure is ill-advised. The projects rarely provide jobs for the long-term unemployed or those who lack the requisite skills for such work. Moreover, the extra stimulus is likely to cause some inflation with a lag of about one year if it pushes the economy above potential. In a world where deflation still lingers, the risk is not so much a reversion to high inflation but rather the persistence of inflation from operating the economy ‘too hot’.
A longer term view is necessarily far more uncertain. The most controversial issues – namely, protectionism on foreign trade and restrictions on immigration – also are the most detrimental to the US long term growth prospects. Indeed, free trade – as opposed to globalization of production – and immigration including undocumented migrants from Mexico have been the most important engines of growth over the past two decades. Closing the doors the flow of goods, services and workers is one of the surest ways to raise domestic prices, undermine domestic demand and stifle competition that is the lifeblood of innovation. An aging workforce already has taken a huge toll on US potential growth which the Federal Reserve staff now estimates at only 1.8%. Because a nation’s demography changes very slowly absent immigration, a closed door policy in effect would doom the US to low potential growth for decades, not just during this incoming administration. The same, of course, could be said for Europe and Japan where demographics have played a major role in limiting the growth in domestic demand over the past 20 years. And demand is by far the most potent driver of business investment; bank regulations play a minor role by comparison.
Although nothing will transpire overnight and the wheels of change will grind slowly, with little economic impact until the latter end of 2017 and into 2018, the potential infrastructure boost has seen industrial metals outperform with copper taking the lead; 3 month futures are up almost 18% so far this month. This will no doubt give a further boost to Southern Copper 7.5% 2035, a holding within our global portfolios. Although this bond has sold off with other bonds, we are well off the low of 88 set earlier this year, with bonds trading at 115 or a yield to maturity of 6.14%. The Baa1 rated bond continues to offer exceptional risk-adjusted expected return of ~19%, a very attractive yield and 3.6 notch credit cushion.
With so many unknowns, it is clear that markets are finding it very difficult to make a definitive call at this juncture and for this reason we expect asset classes will continue to be volatile. We therefore believe that having a suitable mix of AAA positions alongside the credit spread component is the best way to be placed currently.