A Donald Trump presidency is the only certainty. What is left uncertain is how policy and geopolitical risk will change and how the markets will digest those changes. We are seeing a higher stock market after being down over 800 points in the futures market last night. The yield curve is steepening with the prospect for higher inflation, at a minimum resulting from higher fiscal spending, lower taxes and as a result, higher deficits (and potentially higher trade barriers). It is also likely steeper given the expectation for a more hawkish Federal Reserve and the potential for increased business investment due to the expectation for reduced regulations and increased spending domestically (e.g., infrastructure). The US dollar is expected to strengthen.
The emotional element of the election allowed policy changes to take a back seat; therefore, we await policy decisions and importantly, announcements in regards to appointments and departures. With the composition of the House and Senate, it will be seen how President Trump works with fellow Republicans and how supportive they are to his initiatives. Generally, we note the following as it relates to various sectors within the Fixed Income markets:
After an initial flight to quality that drove the yield on the 10-year Treasury note down to 1.7%, yields are higher on the day with the 10-year yield increasing 21 basis points to 2.07%. The yield curve is steepening and inflation expectations are rising as a result of a potentially more aggressive Federal Reserve, possible increased Treasury issuance to fund higher deficits, and reduced demand from foreign investors. As a sign of higher market implied inflation expectations, break-evens on 10-year TIPS are up 12 bps on the day. Whether or not rates stay at these levels will depend on longer-term economic activity, actual inflation data and changes in the make-up of the Federal Reserve board. While the make-up and stance of the Federal Reserve is uncertain looking ahead to next year, futures markets continue to price in an 80% probability of a ¼ point rate increase at the December meeting.
The tax-exempt market has reacted pretty much in line with the sell-off experienced in the Treasury market. Relative valuation metrics have remained relatively unchanged versus taxables, but investors will be paying very close attention to any prospects for tax reform. With Republicans now in control of both houses of congress and the presidency, there will be an expectation to see lower tax rates, but their impacts on relative valuation levels will not likely be felt until the market receives better clarification on the extent and magnitude of any tax-policy changes.
Change in the political landscape will most affect the regulatory environment for structured securities. We anticipate less regulation which should increase the general availability of credit. More importantly we may finally see some clarity of the government’s role in the mortgage market. Fannie Mae and Freddie Mac could be consolidated or unwound and a system for sharing credit risk between taxpayers and private capital to be explicitly established.
We await key appointments and policy related announcements before making changes to our investment strategy within Corporate credit. We have been positioned for stability in commodity prices and low global growth and rates, and that remains generally unchanged although there is a higher degree of uncertainty around growth (positive and negative) as well as slightly higher rates today. For instance, while reduced regulations and government gridlock would be positive (e.g., Energy, Banks), inflation and/or changes to global trade would negatively affect cash flows for many industries (e.g., Consumer Staples, Technology). While widening initially, investment grade Corporate bond spreads have tightened as higher yields attract buyers.
Equities underlying the broad convertible market are exhibiting a wide reaction to political developments on the home front, with an overall move that is in line with the 1% gains posted by domestic market indices. Rising interest rates are a headwind to valuations, but partially offset by an improving tone in credit markets. We would note the strength in small and mid-cap equities which, in total, represent nearly half of the US convertible market. Looking ahead, the prospects for increased infrastructure spending, rising business spending, and higher interest rates would be supportive of increased new issue supply in the convertible sector as issuers seek lower cost, less dilutive sources of growth capital. We would welcome an increase in primary market activity for purposes of optimizing the risk/reward profile of portfolios.