November 15, 2016. By John Wolfsberg:
The bond market has witnessed a significant back up in yields as a result of the surprising win by Donald Trump in last week’s Presidential election. Going into Tuesday, the market had been positioned for a Clinton win, but as results came in traders scrambled to unwind trades and reposition portfolios (similar to the BREXIT vote result in June) in preparation for a very different policy agenda. At present, the market seems to be taking the position that many (if not all) of Trump’s campaign proposals for growth will be enacted as promised and will lead to higher debt, deficits, and inflation.
In light of these events, we thought we would (very) briefly discuss a few of Trump’s proposals and potential implications regarding the following:
Income Taxes
Trump has proposed a reduction in both corporate and individual income tax rates. The proposal is hoped to spur growth as U.S. corporations would be in a better position to compete with foreign companies that are currently subject to lower tax rates. Individuals would see their disposable income increase thus increasing their spending power. The move would also incentivize U.S. corporations to repatriate more of their profits to the U.S. as it is earned rather than leave it overseas to avoid the higher rate. In addition to the drop in corporate rates, a one-time tax of 10% is being proposed as an incentive to repatriate existing cash (prior earnings) currently held overseas (estimated by some to be as high as $2.6 Trillion). The market’s concern is that the additional disposable income for individuals could lead to higher prices (read inflation). In addition, a reduction in tax rates of this magnitude (corporate from 35% to 15% and individual maximum rate from 39.6% to 33%) would significantly reduce revenues and potentially increase deficits.
Foreign Trade
Trump has proposed a potential tariff on imports in an effort to level the playing field with other countries, specifically those viewed as manipulating their currency in order to make their exports cheaper. Such a tariff would likely put upward pressure on import prices and potentially lead to trade wars or a worsening of trade relations.
Infrastructure Projects
One of the cornerstones of Trump’s campaign is infrastructure spending. His proposal to spend $1 trillion over the next 10 years on infrastructure projects would create jobs and spur growth across a variety of industries. The obvious concern here is the overall cost of the program and how it would be financed. While there has been some discussion on potential revenue sources (for example a one-time repatriation of foreign cash by corporations at a 10% tax rate) the plan still lacks significant details on funding and projected revenues. Accordingly, the market is viewing this proposal as virtually a dollar for dollar increase in debt.
Immigration
Another key component of Trump’s campaign is his stance on immigration. While perhaps not having as material an impact on the market as his other proposals, any reduction in this pool of lower wage workers could have the unintended consequences of increasing costs in sectors where there is a concentration of such workers.
Market Reaction
We have a couple of thoughts with regard to the market’s view of Trump’s proposals and their implications. First, the market seems to be assuming that all of his campaign proposals will be enacted in full, which is probably unlikely in our opinion. While some of the proposals may get pushed through (in some form) many are short on details and may be difficult to justify after looking at the true cost of the program. While Trump should benefit from a Republican Congress, he will likely see resistance from those members reluctant to add to our national debt. Second, (and we have talked about this in the past), the U.S. has a wall of debt coming due over the next 5 years (approximately $6.5 trillion) which will have to be refinanced. Every basis point increase in interest rates means higher financing costs for the U.S. thus adding to the overall debt burden. The investor base for U.S. Treasuries is aware of this and would likely demand higher yields as this debt is refinanced thus exacerbating the problem. We would expect both Congress and the President to consider this when proposing any program that would lead to additional debt issuance or deficits.
Conclusion
There are many more questions than answers at this point with regard to these proposals and how they might impact growth, our nation’s debt, inflation, and ultimately interest rates. For now, the market is taking a “sell now and ask questions later approach”. Looking ahead, much will depend on the priorities of the new administration and details associated with these proposals…structure, costs, funding etc.
While our portfolios are not completely immune to the back up in rates, we have kept our durations below that of the benchmark which has helped during the recent sell-off. Our allocation to short-term bonds and/or ultra-short bond funds does provide us with “dry powder” should interest rates continue to move higher. We will continue to monitor the market and deploy funds during sell-offs we feel are excessive.