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Politics is the new economics

  • 11May 17
  • James Athey Senior Investment Manager, Fixed Income

It will surprise none of you to hear that President Trump is central to the simplistic suggestion encapsulated by this headline.

In a nutshell, the White House failed in its first attempt to navigate the Republican-controlled Congress. The repeal and replacement of the Affordable Care Act (also known as Obamacare) ran into trouble early on. The right-wingers formerly known as the Tea Party (and now rebranded as the Freedom Caucus) were not satisfied with the scale of the entitlement spending reduction proposed by Trump’s Obamacare substitute – the American Health Care Act (AHCA).

The controversial legislation was narrowly approved by Congress at the second time of asking, by a vote of 217 to 213, but without the support of a single Democrat. It may yet run into further obstacles when it goes to the Senate. A number of Republican Senators have expressed strong reservations; and given that the Republicans hold a slender 52-48 Senate majority, the Act may well encounter further obstacles in the upper house.

The initial withdrawal of the legislation was immediately leapt upon by much of the media as evidence of Trump’s incompetence and House Speaker Paul Ryan’s incompetence. It provided material evidence, they claimed, that Trump was a fish out of water, unable to pass a single line of his proposed legislation. Given these very same people have been the ones telling us that the only reason 10-year Treasury yields are as high as 2.5% is that the market expects gigantic fiscal stimulus, the “obvious” conclusion to draw was that equities were a screaming sell and bonds were a screaming buy. From my perspective, this logic is flawed.

It is not just because of expected fiscal stimulus that U.S. Treasuries are higher than a year or six months ago. While we did see equities fall and U.S. Treasuries rallying, the magnitude of the moves was fairly unimpressive. Over March as a whole, the S&P 500 Index was generally flat. Bonds followed a similar path; while 10-year yields moved from 2.35% to 2.62% during March, they closed the month at 2.4%. This is hardly a convincing unwind of The Great Trump Reflation Trade of 2017.

The rise in yields since the middle of 2016 represents a confluence of factors: rising inflation, improving cyclical recoveries in the Eurozone and, not least, the massive stimulus thrust into the system over in China. Be careful on that front, though, because the Chinese are slowly tightening monetary policy. The chances of a misstep are a clear and present danger. If China also tightens fiscal policy, we could feel those ripples as they make their way across the financial system and, ultimately, the global economy.

Having dragged each other down after 2008, economies are now dragging each other up.

For the time being, I am still bullish on the global economy. The most powerful dynamic here is the self-fueling, synchronized and thoroughly virtuous global economic recovery. Having dragged each other down after 2008, economies are now dragging each other up as higher growth, higher inflation, and – most importantly of all – improving confidence drive pro-cyclical behavior. In such an environment, Federal Reserve interest-rate hikes act as a confirmation of a better world. We believe Trump only needs to achieve a small portion of what he has promised on the economic policy front for the results to be significant.

March’s European Central Bank (ECB) press conference was going swimmingly, with President Draghi skillfully avoiding any difficult questions, until near the end when he seemed to acknowledge that actually there were all sorts of conversations going on behind the scenes – including whether they could or should change the forward guidance or hike rates.

A few ECB Governing Council members subsequently got their hawkish views out there and thus we saw rising yields, including in those bonds with short maturities attached to them. The euro rallied as investors viewed the market like one headed for policy normalization. This, too, is likely to pass. Draghi couldn’t allow all this normalization talk, so cue a raft of doves backtracking.

And last but not least: the UK Prime Minister May signed and sent The Letter that officially notified Brussels of its intention to withdraw from the European Union.

To the surprise of some, data continues to suggest that the economy is okay. Inflation is increasing, but as yet that hasn’t stopped the UK consumer in his or her tracks. In part, this is down to the UK consumer being a hardy breed. I also subscribe to a theory that consumers have options. They don’t need to sit idly by and accept food inflation. Aldi and Lidl, the two German uber-discounters, are rapidly gaining market share. Given that they are roughly 20% cheaper than their rivals and yet continually win awards for the quality of their food, this feels like a pretty attractive and rational option. Unfortunately, macroeconomics doesn’t allow for consumer preference behavior so this is likely to be ignored.

I may be wrong but I’m still pretty sanguine about the UK’s economic prospects. However, most other market players and observers aren’t. So Gilts* continue to perform far too well in my view, and in spite of the lack of evidence of a material slowdown, sterling remains in a tight trading range.

We did get one vote for a rate hike at the Bank of England’s March meeting, but Kristin Forbes is leaving soon anyway. So hopes for any rate rise may need to be placed on hold indefinitely.

* Gilts are bonds that are issued by the British government, and are the U.K. equivalent of U.S. Treasuries.

Important Information

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Ref: US-080517-31589-1