by Asset Allocation Committee

The rapid rise in longer duration Treasury yields since the presidential election has been surprising.  As of December 8, the 10-year T-note yield was approximately 2.40%.  Although President-elect Trump’s policies will probably be inflationary, it is still unclear how much of his arguably vague plans will get passed.  It is possible the FOMC will become more hawkish and we have seen some increase in rate hike expectations.[1]  Still, our 10-year T-note model is putting the fair value yield at 1.85%.  Assuming fed funds at 1.25% still only raises the 10-year rate to 2.20%.  Taking oil to $60 and assuming the 1.25% fed funds only raises the fair value yield to 2.27%.  Only when assuming steady oil, fed funds at 1.25% and German bunds at 1.25% (up from the current 33 bps) does the yield even reach 2.40%.  The current spike in yields can be best justified by assuming a significant jump in inflation expectations.

In our yield model we use the 15-year average of CPI as a proxy for inflation expectations.  This assumption comes from the work of Milton Friedman, who postulated that inflation expectations are derived over a long-term time frame.  We realize our calculation is a proxy but have refrained from using more market-based expectations because of their lack of predictability.  If one assumes that nominal rates are the sum of the expectations of real rates plus inflation forecasts, inflation forecasts are very important to predicting nominal interest rates.

If the lifetime experience of inflation is important, then what is the most important age?  We estimate that 60 is a reasonable age; the average age of the Senate is 61 years, the current FOMC average is 62 and the average age of an S&P 500 CEO is 57.[2]  Simply put, it’s around the age of 60 that people come into power in politics and business.  We believe that their personal experiences color the expectations of any investor and so using 60 as an influential age makes sense.

This chart shows the adult experience of inflation for a person turning 60 from 1932 to the present.  To reflect the adult experience, we use the average annual change in CPI from ages 16 to 60.  Note that inflation experience rose into the late 1940s and stabilized into 1960, when it fell sharply.  This was the generation that entered adulthood during the Great Depression.  It is interesting to note that as rates began to rise in the mid-1960s, the inflation experience steadily rose as well.  Essentially, the rise in rates coincided with the rise in inflation experience.  However, after peaking in 1981, bond yields began a steady drop into the current year despite the relatively high level of inflation experience.  On the other hand, T-note yields exceeded the inflation experience of 60-year-olds in absolute terms until 2002.

This chart shows the actual inflation rate compared to an average 60-year-old’s adult experience of inflation.  In general, bull markets in bonds tend to occur when the actual inflation rate is persistently below the average rate.  Bear markets happen when the opposite condition is in place.  Currently, the actual inflation rate is still well below the average rate, suggesting that the bull market in bonds should have more time to run.  However, our worry is that the average 60-year-old is unusually sensitive to inflation fears and thus may overreact to the incoming president’s policies.  In other words, inflation expectations may become unanchored rather quickly, forcing the Federal Reserve to turn unexpectedly hawkish.  Thus, we are taking a more cautious stance on fixed income into 2017, expecting higher yields and greater duration risk.  At the same time, we will be closely monitoring the economy in light of less accommodative monetary policy.  Most recessions occur because the Fed tightens too much.  We don’t expect that to become a problem until late next year or early 2018 if the Fed continues to raise rates.  So, for the upcoming year, we expect a weak fixed income environment.

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[1] For example, the two-year deferred Eurodollar futures, which measure three-month LIBOR two years into the future, have jumped nearly 50 bps since the election.

[2] http://fortune.com/2015/12/13/oldest-ceos-fortune-500/

by Asset Allocation Committee

Last week, we discussed the likely implications of President-elect Trump’s policies on the debt markets.  This week, we will look at the impact on the dollar.  Since the election, the dollar has generally moved higher.

Using the Bloomberg dollar index, a broad-based currency measure, the dollar rose nearly 5% after the election.  There are a number of arguments behind the rise.  Trump campaigned for fiscal expansion, which could include both infrastructure spending and tax cuts.  The expected fiscal expansion could lead to tighter monetary policy and this particular combination is usually thought to be bullish for the dollar.

This box describes the expected outcomes from the interplay of fiscal and monetary policy.  This is a rough guide; the actual outcomes are mostly driven by the degree of policy adjustment.  In the early 1980s, the combination of real fed funds of nearly 8.5% and a fiscal deficit of almost 6% of GDP led to a very strong dollar (the “Volcker dollar”).  Market behavior may be anticipating a repeat of this outcome.

However, this assumption depends on the FOMC moving to tighter policy, almost a “hard money” stance of the Volcker years.  Simply put, we don’t know for sure whether this will be the outcome.  We believe that there is a political struggle in the Trump administration between the GOP establishment and right-wing populists.  To personalize the sides, we view it as Speaker Paul Ryan versus Steve Bannon.  The FOMC has two open governor positions.  If Ryan’s wing of the party wins, we will likely see the Fed change into a hard money central bank, which is a quadrant two outcome on the above table.  On the other hand, if Bannon’s wing wins, it is possible that we will see doves appointed to the Federal Reserve.  That scenario could lead to a quadrant four outcome, which would be quite different from what the market expects.

The policy situation isn’t the only supporting factor for a stronger dollar.  It is estimated that over $2.0 trillion is held by U.S. companies offshore in order to avoid corporate taxes.  If corporate taxes are reformed, at least some of this money will come back home which would lift the dollar.  If Trump were to put up trade barriers as promised, the current account deficit would shrink, which would reduce the supply of dollars and boost the dollar’s value as well.  Thus, for now, we expect the dollar to get the benefit of the doubt and it will likely continue to appreciate.

What is hurt by a stronger dollar?  The two asset classes most at risk from dollar strength are commodities and emerging markets.  Since the election, commodity prices have been mixed; the Bloomberg commodity index is actually higher since the election, up 2.7%.  Industrial metals are up 6.4% over this time period and energy is up 5.9%.  At the same time, gold is down 7.4%.  The MSCI Emerging Market Index is down 2.8% since the election.  If the dollar continues to appreciate, these asset classes will likely face further declines.

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by Asset Allocation Committee

Trumponomics looks as if it will be a combination of fiscal stimulus, trade restrictions and deregulation.  It looks very likely that environmental regulations will be reversed and there have been promises of financial deregulation as well.  The first two will likely reflate the economy.  Proposed deregulation may help hold down energy prices but financial services are not a major contributor to inflation (only about 0.24% in CPI) anyway.

With reflation on the horizon, we have seen a rise in the 10-year yield.  Even though we would expect a retreat in yield during the next recession, it is likely that the secular bond bull market that began in the early 1980s is coming to a close.

The chart above shows the 10-year T-note yield from 1921.  Perhaps the most important issue to remember is that when the last secular bear market began after the lows were made in 1945, the next peak took 36 years.  It took eight years before yields doubled.  Although the regulatory environment is different, it takes a while for bond yields to reach really high levels.  Still, the tailwind for financial assets that this bull market represents is noteworthy.

This chart shows the 10-year T-note yield and the cyclically adjusted price/earnings ratio (CAPE) that was developed by Robert Shiller.  The CAPE deflates earnings and stock prices and then averages earnings over a decade, generating a P/E that is designed to capture the underlying trend in real earnings.  Note that the P/E rose from 1950 to 1965 even though rates rose.  However, as inflation steadily increased, interest rates and the P/E moved in opposite directions.  Casual observation suggests that rates above 4% and rising lead to a lower multiple.

How high will interest rates rise?  Our broad 10-year T-note model puts the fair value yield at 1.75%.

The model uses fed funds, the 15-year moving average of CPI (an inflation expectations proxy), the yen/dollar exchange rate, oil prices and German bond yields.  The most important variable keeping the fair value low are German bond yields; removing those from the model boosts the fair value yield to 2.42%.  In a less globalized world, the impact of foreign rates might be reduced, so there is a concern the model is underestimating the fair value yield.  However, as long as capital flows remain open, the impact of lower German yields should be a bullish factor for long-duration Treasuries.  In addition, if we assume a 25 bps hike in fed funds next month, the fair value yield would increase to 1.84%.

Overall, a case can be made that the recent spike in long-duration yields is overdone, at least in the short run.  On the other hand, as we discussed in the most recent WGR, if the U.S. retreats from the superpower role, inflation expectations will likely rise and weaken the case for holding long-duration instruments.  We continue to closely monitor the fixed income markets but it does appear that the long bull market in Treasuries may be coming to an end.

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by Asset Allocation Committee

The Trump victory has significant ramifications for the economy and markets.  The president-elect’s platform is somewhat ambiguous, which isn’t all that unusual; candidates want to build in some degree of flexibility that a detailed platform can reduce.  Despite this lack of clarity, there are elements that are emerging that offer a guide to the policy changes the new administration will likely implement.

We believe the key to Trump is his campaign slogan, “America First.”  Trump made it abundantly clear that he intends to conduct policy from the standpoint of whether it is best for America.  Although the term “America First” harkens back to an earlier movement,[1] Trump’s version appears broader, including both domestic and foreign policy.

So, what does an America First policy mean for the domestic economy?  Trump has promised both fiscal stimulation and trade restrictions.  The combination of these two policies contradicts the accepted economic orthodoxy since Reagan-Thatcher, which adopted globalization.  However, combining the two supercharges the domestic impact.  Why?  Because under conditions of globalization, some fiscal stimulus is lost to imports.

Globalization and deregulation began in earnest in 1978.  This chart shows the contribution to GDP from imports on a three-year average basis.

The pattern of imports clearly changes in the late 1970s, becoming a persistently larger drag on growth but also more volatile.  On average, from 1950 through 1977, imports reduced GDP by 31 bps.  From 1978 to the present, the average loss to imports nearly doubled, to 61 bps.  Trade restrictions will tend to add to real GDP; if Trump can reduce imports to the pre-1978 years, it would consistently add about 30 bps to GDP.  If fiscal stimulus adds 60 bps (the average that government spending alone added in Reagan’s first term), real GDP could rise nearly 1% per year.  This analysis does not include any rise in consumption that might coincide with changes in the income tax code or investment from reforms in corporate taxes.

Simply put, the combination of fiscal stimulus and import restrictions could lead to a sizeable boost to growth.  The downside to the policy is that it would certainly be inflationary.  One of the key elements to containing inflation over the past nearly four decades has been through globalization.  Trade impediments shift the aggregate supply curve toward the origin, meaning that price levels are higher at the same level of output.  But, in an economy that is struggling to boost price levels, the impact of higher inflation will be benign, at least for a while.

Higher inflation will raise interest rates.  We expect monetary policy to remain accommodative in the face of rising inflation due to political pressure on the Federal Reserve.  The dollar will likely rally because trade restrictions reduce the global supply of the U.S. currency, driving up the price.  The deflationary impact of a stronger dollar will be reduced because of fewer imports, although the imports that do arrive will be cheaper.

We will continue to monitor the progress of policy in the coming months.  But, in terms of asset allocation, our committee has started to address these changes and will be reacting in due course.

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[1] The earlier America First movement, led by Charles Lindbergh just before Pearl Harbor, was designed to keep the U.S. out of a European war.