We select Trumponomics, the debt ceiling rollercoaster and geopolitics as three main themes to watch in 2017. Federal stimulus may in fact be underwhelming and a stronger dollar and trade wars may further erode the effect of increased government spending. The immense size of government money market funds ($2.2 trillion) may present challenges throughout the upcoming debt ceiling rollercoaster ride. 2017 may also bring multiple geopolitical risks from various parts of the world. Longer duration, higher credit quality and increased liquidity are advised for cash portfolio construction.
Few years in recent memory have rivaled the events of 2016 – from Brexit to the Trump presidency, from multiple terror attacks and a migrant crisis in the fractured European Union to racial tensions and home grown terrorism in the United States. Still, a much feared “hard landing” scenario in China did not materialize and equity investors rode a Trump victory to record high valuations. The Federal Reserve projected four but delivered just one rate hike of 25 basis points. Crude oil futures fell to $26 a barrel in February but almost doubled by the year’s end.
At the start of each year, we typically take stock of some of the major events and trends that we believe will impact the short-term debt markets. It’s no understatement that the one word that comes to mind for 2017 is “uncertainty”, and the year could go very well for the economy and markets, or very badly instead.
Last year, we identified a gradually higher interest rate trajectory, navigating through money market fund reform and a turn in the credit environment as the three main themes. Out of many subjects that qualify this year, we pick Trumponomics, the debt ceiling rollercoaster and geopolitics as our three major themes.
Trumponomics – Great Fanfare or Disastrous Outcome?
In last month’s newsletter, we discussed the likely impact of a Trump presidency on treasury investment portfolios. Many of the details of Trumponomics remain murky, as the President-elect’s announced policy priorities include a retreat from global trade pacts, deregulation of energy and environmental policies, strengthening of cyber security and tightening of work visa programs.
Nonetheless, Trump’s campaign pledges and new cabinet selections signal the introduction of a fiscal package consisting of tax code reform and increased infrastructure spending. The rollback of financial regulations, labor laws and Obamacare, and a possible intent to influence Federal
Reserve policies by governor appointments also may be on the agenda, although of lesser priority.
The new administration’s economic initiatives may impact short-term debt markets on both the interest rate and credit fronts. Short-term rates were expected to move higher regardless of the presidential election outcome. Following the Fed’s rate hike last December, the market currently expects two to three more hikes in 2017. Quick nominations of the two vacant seats on the Federal Reserve Board may tilt the central bank’s bias to a more aggressive Fed, but more than three rate hikes in 2017 is unlikely unless there are clear signals that the economy is rapidly overheating.
Longer-term interest rates, on the other hand, remain a wild card. At face value, Trump’s potential spending and tax cut proposals will widen the Federal deficit and stimulate the economy, which normally lead to higher inflation and bond yields. Ironically, a Republican controlled congress may significantly water down the new administration’s spending proposals. Also, recall that the 10-year benchmark Treasury yield has climbed by more than a percentage point on the prospect of Trumponomics and such a lofty increase in a short time has left a high hurdle for rates to climb much further.
Turning our attention to industry groups, broadly speaking, more heavily regulated industries such as banks, energy and healthcare companies may have improved prospects over the next four years. Export-reliant industries and those employing high-skilled foreign workers such as technology companies may suffer the consequences of a stronger dollar, trade barriers and labor shortages. Many borrowers in the short-term debt markets tend to be multinational corporations, who must face the tug of war of both the benefits and downsides of Trumponomics. We caution that the potentially bifurcated outcome of the Trump administration complicates portfolio analysis and decision-making. One will likely have to wait through the first 100 days of the new administration before a clear picture of its direction becomes apparent.
Portfolio implications: We think the positive effect of Trumponomics is largely reflected in current market conditions and this may leave room for negative surprises from failed proposals or underwhelming efforts. We have a more conservative outlook than the two to three interest rate hikes in 2017 projected by the Federal Reserve, expecting two at the most. As a result, we remain comfortable with taking limited duration risk by extending out on the yield curve within short-term parameters. On the other hand, a reversal in rates from market disappointment may coincide with credit spread widening and poor market liquidity. We prefer to target higher quality names for long positions on the curve and we remain more defensive with respect to duration for lesser creditworthy issuers.
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