Following a bear market in 2015 for many parts of the bond markets, 2016 has been more positive overall, despite significant volatility. Spreads on investment grade credit and high yield bonds have tightened, the latter substantially. High yield defaults remain elevated, although this has been skewed by energy sector issuers. A gradual increase in the oil price should reduce some of the pressure on these names. And after a torrid 2015 for emerging markets, the asset class experienced a far more positive ride in 2016, at least until Donald Trump’s victory in November.
A sharp sell-off in government bonds was among the key reactions in financial markets to the election result. With the Republican Party controlling both the Senate and the House of Representatives, president-elect Trump should have the power to advance his headline policies of significant infrastructure spending and big cuts in corporation tax. We should expect follow-through on trade protection measures as well.
TRUMPONOMICS: THE NEW REAGANOMICS?
Much has been made of the similarities between the situation facing Donald Trump in 2017, and that confronted by Ronald Reagan when he took office in 1981. Back then, Reagan inherited a sluggish economy and inflation approaching 15%. His initial answer to this was the Economic Recovery Tax Act, which contained significant tax cuts, lower government revenues, and a reduction in government welfare spending. As a result, US Treasury yields climbed to alltime highs. This was in an era when the debt-to-GDP ratio was just 30%, a far cry from the level of nearer 100% that Trump is inheriting today (see Figure 1).
As a result, the concern is that Trump simply doesn’t have the fiscal headroom that Reagan did to proceed with Trumponomics without spooking the markets. His proposed increased fiscal stimulus is expected to prove inflationary, and if he were to engage in an outand-out trade war, the impact could be even more pronounced, with tit-for-tat trade tariffs pushing up the cost of imported goods.
THE END OF GLOBALISATION?
Trump’s victory and the UK’s vote in favour of Brexit are two of the biggest challenges in recent years to the global economic status quo and have caused renewed debate about the impact of globalisation on the developed world.
On the issue of trade, the move by rich countries to locate manufacturing hubs offshore and the associated loss of jobs in rich nations have both been identified as negative consequences of free trade by populist politicians.
The ‘elephant curve’ (see Figure 2) shows how incomes for the poorest half of the world have grown as fast as those of the world’s richest 1% in the 20 years to 2008. However, incomes for the lower middle class of the developed world have at best stagnated, which may help explain the rise of nationalism across the developed world.
Of course, there are many other factors at play, including protest votes on existing government policy, and immigration related issues. The question that economists now face is assessing the impact that a more inward-looking US will have on the global economy. If countries begin to renege on trade agreements and raise tariffs, we may see a vicious circle of action and reaction, which would ultimately lead to a contraction of global growth. In this environment, everyone loses.
AUSTERITY AND INEQUALITY: NOT JUST AN ANGLO SAXON PROBLEM
Nowhere have the subjects of fiscal austerity and rising inequality been as relevant as in Europe today. Stubbornly high unemployment combined with declining living standards have contributed to rising levels of civil and political instability. Populist and nationalist parties have been able to capitalise on this phenomenon.
France faces an important political test in spring 2017 with its presidential election. National Front leader Marine Le Pen will be trying to take advantage of the positive momentum she has built up to sweep her party to its first victory. While this would require a vast swing, recent events remind us that the rise of antiestablishment parties globally is not one to be underestimated.
The added difficulty for Europe is that its capacity to boost growth and employment via increased public and infrastructure spending and tax cuts is more limited than other economies. High levels of debt are forcing most European countries to rein in spending rather than increase it. Not being able to print money
at an individual country level also requires each European Union member to demonstrate substantial fiscal discipline.
For those mainstream European political parties wishing to claw back votes from their more extreme rivals, the challenge is therefore to improve the living standards of hundreds of millions of Europeans, while preserving the EU’s balance sheet.
2017 AND THE TRUMP EFFECT
As we’ve already noted, Trump’s election means that the US will likely shift to a highly expansionary budget policy. Trump has also proposed a large increase in infrastructure spending and large increases in the defence budget. If this boosts already rising inflation, the Fed may be forced to hike interest rates, which could, in turn, lead to a further appreciation of the US dollar.
The yen and euro appear particularly vulnerable given the continued expansionary stance of monetary policy set by the Bank of Japan (BoJ) and European Central Bank (ECB), respectively. The BoJ’s transition to yield-curve targeting ensures that real yields will drop as inflation picks up, implying that financial conditions will turn increasingly loose as the recovery progresses.
In the UK, Chancellor Philip Hammond’s Autumn Statement confirmed that there will be no budget surplus, there will be looser fiscal rules and lower tax receipts due to weaker average earnings and lower household consumption.
EUROPE’S QE DILEMMA
The ECB’s announcement back in March that it would extend its asset-purchasing programme to include investment grade (IG) non-bank corporate bonds only highlighted the divergent fortunes of the US and Europe.
The flexibility of the programme largely took the market by surprise, and resulted in an immediate and significant tightening of credit spreads. This was not only the case for potentially eligible corporate bonds, but also for the broader European corporate bond markets, including the lower end of the IG risk spectrum.
One key result is that the ECB formally became a new, large and price-insensitive player in Europe’s corporate bond market. As such, it has provided strong technical support for European credit, putting a floor under prices and driving down bond yields further.
A deliberate consequence of quantitative easing (QE) is known as the portfolio rebalancing effect, where private investors, looking to generate positive returns, have been increasingly forced to take on greater amounts of credit risk in order to do so. For many investors, this has meant having to move down, and especially out, along the credit curve in their hunt for positive yielding bonds.
Looking into 2017, market sentiment remains fragile. The yield advantage of US Treasuries over German government bonds is near all-time highs and there is a similar story in the corporate bond market. The more the ECB continues putting downward pressure on European corporate bond yields, the greater scope for investors to move away towards the relatively more attractive yields available in the US corporate bond market.
Europe’s economy was in outright deflation when its asset-purchase programme was launched. Since then, monthly inflation has modestly improved thanks to the recovery in global commodity prices. While it is still far from the ECB’s target of close to but below 2%, the recent stabilisation in energy prices could provide temporary support. Over the coming months, the ECB will be closely monitoring inflation expectations to assess any further need for monetary accommodation.
EMERGING MARKETS: ALL BAD NEWS?
Trump’s victory has multiple implications for the emerging markets. At first glance, the result is clearly negative, given the potential risks from factors such as increased trade protectionism, large fiscal expansion, anti-immigration measures, and foreign policy uncertainty.
However, the impact of a Trump presidency will not be uniform. Several key countries, such as India and Brazil, are relatively closed economically and will prove relatively insulated from US developments. Meanwhile, countries such as the Czech Republic and Hungary are much more dependent on Europe for their exports. Russia too may benefit if the US starts easing financial sanctions against it.
Much attention will be focused on US relations with China. As the biggest foreign holder of US government debt, China may look to reduce its holdings to prevent its currency from depreciating too rapidly versus the dollar. Any imposition of trade tariffs or move to name China as a currency manipulator will be the key events to watch out for.
Although US Treasury yields have so far risen sharply since the US election result, we expect yields to gradually edge higher in a more modest and gradual manner. For a number of emerging markets, this prospect is less challenging than it might have been previously, as they have improved current account deficits and adjusted to having lower overall levels of US dollar-denominated debt.
However, as is always the case for all asset classes, and the emerging markets in particular, much will depend on the newsflow as we go into 2017, and on whether it turns out to be a year as full of surprises as 2016 has been.