- Donald Trump’s election as U.S. president has raised the prospect of tax cuts, increased spending, and higher growth and inflation in the U.S.
- This could lead to higher yields in the U.S., while yields in most of the rest of the world look set to remain low.
- Emerging markets may be hit hardest by higher yields in the U.S., while Europe faces a year of uncertainty as a series of elections test the extent of growing anti-establishment sentiment.
- U.S. floating rate loans and high yield bonds look set to offer the best value in the current environment, but it should pay to adopt a prudent approach overall, focusing on selective, high-conviction positions.
Donald Trump’s victory in November’s U.S. presidential election led to a dramatic sell-off in fixed income amid anticipation that his proposed infrastructure spending, tax cuts, and regulatory reforms will lead to higher U.S. growth and inflation. Yields on U.S., UK, German, and Japanese government debt rose from record lows, wiping out more than USD $1 trillion from global bond markets as the dollar surged and U.S. equities rallied. Political developments are expected to continue to dominate bond markets in 2017—not just in the U.S., where attention will be focused on whether Trump can deliver on his campaign pledges, but also in Europe, where a number of elections will gauge the extent to which populist forces are a threat to the established order. The heightened uncertainty that this creates will necessitate a cautious approach to fixed income, with highly selective country, sector, and currency positioning.
The impact of the new Trump administration’s policies on the U.S. economy will not be the only factor influencing global fixed income markets in 2017, but it will likely be the most important one: the U.S. bond market is the deepest and most liquid in the world, and anything that happens there will inevitably have a major impact elsewhere. It is widely believed that Trump’s plans to spend USD $1 trillion on infrastructure and cut taxes will lead to higher growth and inflation. However, the U.S. economy is already healthy and is getting stronger, with unemployment below 5%. Prices and wages were rising prior to the election; any further stimulus that Trump injects is likely to increase those inflationary pressures.
As things stand, the Fed is expected to make two to three rate hikes this year. If inflation picks up quicker than expected, the Fed could come under pressure to hike more aggressively, although the weak global economic environment may ultimately persuade it to adopt a more restrained approach. But even a relatively modest hiking cycle will set the U.S. on a different path to most of the rest of the world, where historically low yields persist in many fixed income markets.
The monetary policies that created this situation are reaching the end of their useful life. As Figure 1 shows, the amount of debt on central banks’ balance sheets has risen to enormous proportions, and political patience with accommodative monetary policy is wearing thin as it has notably failed to deliver the growth it was supposed to. However, we continue to expect yields in most developed markets outside of the U.S. to remain low for some time to come.
The Bank of Japan (BoJ) has explicitly stated its intention to anchor its sovereign rates through “yield curve control.” Essentially, this will involve using targeted quantitative easing to keep 10-year government bond yields at zero, thereby maintaining a steep yield curve as Japanese short-term bonds remain anchored in negative territory. Steeper yield curves typically increase profits for banks, which in turn leads to greater economic activity and inflation. However, the BoJ’s move is expected to only have an incremental impact on the sluggish Japanese economy.
Yields in Europe also look set to remain low as the Continent navigates a year of political uncertainty amid a backdrop of growing anti-globalization sentiment. The Netherlands’ Freedom Party, France’s National Front, and Germany’s Alternative for Germany will compete in their respective countries’ general elections, and while none of them are expected to win, the populist forces they represent could cause considerable turbulence. Overall, Europe looks likely to register moderate growth in 2017, and while the European Central Bank decided to slow the pace of its monthly corporate bond purchases from €80 billion to €60 billion from March, we do not expect this to lead to a significant spike in yields given an absence of inflation pressures.
Prior to the U.S. election, emerging markets looked well positioned coming into 2017. Local currencies had stabilized, inflation had come down, and central banks were either lowering rates or tightening less aggressively. However, Trump’s victory—and the expectation that it will mean higher U.S. rates and a stronger dollar—changed that. Emerging market bonds sold off sharply following the election, and the signs are that the Trump tantrum will not end soon. A stronger dollar will make it more expensive for overseas borrowers to service their debt commitments and may lead to capital outflows as money rapidly returns to the U.S.
It is possible that the Organization of the Petroleum Exporting Countries (OPEC) deal struck at the end of November to cut oil production will benefit emerging markets, particularly Brazil and Mexico, by putting a floor under oil prices. Before the agreement, the prospect of a continued oversupply of oil was a significant headwind for emerging markets as it threatened to keep the price of a barrel below USD $45. If the deal holds, however, the price may settle in the low to mid-USD $50s in the first half of 2017. After that, the benefits of the deal for emerging markets fades as the higher price may simply encourage more drilling in the U.S. and other non-OPEC countries. Overall, any opportunities to invest in emerging market debt are likely to be tactical than strategic in nature.
In a challenging environment such as this, it pays to consider the full range of the fixed income universe. Figure 2 reveals how different segments of the fixed income market responded when U.S. Treasury yields rose by 100 basis points or more. It shows, for example, that floating rate bank loans performed well in periods of rising rates. This is unsurprising as floating rate notes do not have a fixed rate but are tied to a cash benchmark, giving them a potential advantage over fixed rate bonds in a rising-rate environment. Most of the floating rate loans underwritten over the past five years carry a Libor floor of around 1%, which means that if Libor rises above this level, coupons are reset higher. Moreover, as floating rate loans have a duration of close to zero, they can reduce the overall interest rate sensitivity of a portfolio. We expect floating rate loans to perform well this year.
U.S. high yield also looks well placed for positive returns in 2017. High yield bonds sold off along with the rest of the global bond market in the wake of Trump’s election, but risk premiums have not risen and companies look set to continue issuing bonds—suggesting that the market retains a positive outlook for the U.S. economy. Defaults in high yield bonds are not expected to rise meaningfully this year thanks to higher oil prices arising from the OPEC deal, while their shorter duration is expected to provide some downside protection against rising yields at the long end of the curve.
Within high yield, the technology sector has strong potential value. Corporate tax reform should provide more free cash flow for capital spending, and technology applications are expected to be high on companies’ priorities. Trump’s infrastructure spending plans could also boost the metals and mining sector, particularly as the president-elect has pledged to take a tough line on steel imports.
Heavy borrowing among investment-grade issuers over the past five to six years has led to a deterioration in credit quality within the asset class. If rates in investment-grade corporates rise again close to 4.5%, the sector may begin to offer value again. However, for the time being, the yields and spreads available in investment-grade bonds do not offer significant opportunities at the broad sector level.
The interplay between monetary tightening in the U.S., a relatively firm anchoring of Japanese and core European bond yields, and expected volatility in emerging markets in 2017 will provide opportunities to exploit the move in spreads between international markets as well as the shapes of the yield curves. Global investors will benefit from blending different country cycles together and, in particular, from exploring opportunities beyond traditional benchmarks. Overall, though, U.S. credit looks set to offer the most potential if the new Trump administration delivers on its pledge to spend heavily on infrastructure, cut taxes, and reduce regulation. Until there is further clarity about how a Trump-led U.S. economy will perform, however, it will pay to adopt a prudent approach, focusing on selective, high-conviction positions and embracing the global opportunity set.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of January 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
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