Yes, the Bond Selloff Can Continue

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The unexpected outcome and potential consequences of the U.S. presidential election continue to shake financial markets. Nowhere is this more so than the U.S. bond market.

Yields on the 10-year Treasury are up 50 basis points (bps, or 0.50%) since the election and nearly 100 bps from the July lows, as bonds sold off. This marks the fastest rise since the so-called “taper tantrum” in 2013, when expectations of an increase in interest rates by the Federal Reserve triggered a bond selloff.

After such a sharp selloff in bonds, we could arguably see markets settle down and prices stabilize for a bit. But over the long term, I would argue the selloff in bonds—and corresponding rise in yields—will continue for two basic reasons:

Higher nominal GDP growth going forward

Whether the new administration’s policies lead to faster economic real growth (after inflation) is an open question. But they are almost certain to lead to faster nominal growth, which includes inflation. This is important because over the long term it is nominal growth that drives rates. Going back to 1962, nominal growth has explained roughly 35% of the variation in U.S. 10-year Treasury yields (see the accompanying chart). Roughly speaking, 10-year yields increase 50 bps for every one percentage point increase in nominal growth.

treasury-yield-nominal-gdp

Today, nominal growth is slightly under 3%. To put that number in perspective, prior to the 2008 financial crisis nominal growth averaged better than 7%, including during recessionary periods. A modest rebound back toward the upper end of the post-crisis range would thus suggest a rise in 10-year yields back to approximately 5%. While an increase that high is unlikely given structural headwinds (such as demographics and the deflationary impact of technology), it suggests yields still have further to rise.

More bonds to sell

In recent years, bond prices have been supported by a dearth of bonds coupled with strong demand from institutional investors. Banks, insurance companies and pension funds will continue to need long-dated fixed income instruments, but supply is starting to grow.

Both corporate and household debt are now rising at or near the fastest pace since the financial crisis. On the corporate side, the conservatism that marked most of the post-crisis environment has given way to a willingness to add to debt, often to fund buybacks and dividends. For U.S. households, although debt growth remains well below average, borrowing rose by 4.4% annualized in Q2, only the second time since the financial crisis that growth eclipsed 4%. And over the long term, federal borrowing is also likely to grow and deficits increase, absent entitlement reform. The Congressional Budget Office forecasts a baseline projection of an $814 billion deficit by 2021; and that does not include the potential impact of a large tax cut.

To be clear, relative to the 60+ year average of around 6%, 10-year Treasury yields are still likely to remain low. Nevertheless, in an environment of heightened duration, or volatility, the backup in yields will still cause considerable pain, unfortunately. I would continue to advocate that investors should underweight bonds and bond market proxies, such as utilities and consumer staples. Instead, faster nominal growth suggests more reliance on value stocks, which tends to perform best when growth is improving.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

What a Trump Presidency Could Mean for Bond Markets Long Term

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It’s hard to miss that Donald Trump’s surprise win in the presidential election, coupled with the Republicans gaining a majority in Congress, has already impacted bond markets. Bonds sold off in the days following the election, on expectations that higher growth—and inflation—are ahead. A key question on investors’ minds now: What could the election results mean for bond markets over the long term?

The outcome introduces many uncertainties regarding the future path of economic and monetary policy, legislation and international relations and trade policy. But there are some tentative points we can make about the implications of a President Trump and Republican Congress for fixed income markets.

Key trends already in place are likely to accelerate.

We are probably going to see a significant shift from monetary policy stimulus to fiscal policy initiatives, particularly in the area of infrastructure investment at the federal level. This may well aid in accelerating the pickup in inflation levels that already appeared underway before Nov. 8, and it likely will result in a steepening in the yield curve over time. We’ll be watching closely for signals of how added spending will be financed.

Rates won’t always rally when risk assets are hurt.

There are some common misconceptions that investors should guard against. Specifically, with bonds and equities more correlated today than in the past, investors must not assume that rates always rally when risk assets suffer. Moreover, while some believed that the U.S. dollar (USD) would ultimately decline on a Trump victory, we think this view is mistaken. The dollar is more likely to range-trade for a time, or even strengthen, depending on the direction legislation and policy take in 2017.

We are cautious about how the election result will impact emerging markets debt (EMD).

Trade policy uncertainty and a potentially higher USD could potentially weigh on the asset class. Still, as we’ve argued in recent months, the need for income isn’t going away, and the carry potential, particularly in the front to middle segments of select emerging market country rates curves, should remain attractive. What to watch: capital flows. A good amount of money has shifted in EMD, but it will be important to see if investors have the patience and wherewithal to stick out any near-term headline risks. In the meantime, we are cautiously optimistic on the carry prospects for shorter to intermediate EMD (as long as the USD remains contained and we do not descend into a trade war).

We think the election result should be, broadly speaking, positive for U.S. corporate credit sectors.

They may now operate in a more business-friendly environment. We could potentially see relaxed regulatory burdens, lowered corporate tax rates (and/or one-time overseas capital repatriation), and several industry-specific tailwinds that aid credit markets. In particular, we are still positive on long-end investment-grade corporates. Further, some high-cash-flow securitized asset markets continue to appear attractive.

We see a potential headwind for municipal bonds.

If personal income tax rates were to decline, and additional infrastructure spend were partly financed in municipal markets, this could be marginally negative for muni performance.

We continue to like rates markets ranging from the front end of the yield curve to its belly.

We think Treasury Inflation Protected Securities (TIPS) have an important place in portfolios today. And given that the U.S. is likely to continue to progress down a path of interest rate normalization, diversifying rates exposures globally also makes a great deal of sense.

Finally, over the short term, we believe a December Federal Reserve (Fed) hike is still likely. A lot can happen between now and then, but if markets remain stable, and labor markets don’t dramatically falter, the central bank will probably go ahead with a quarter-point hike.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog.

 

Investing involves risks including possible loss of principal. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Welcome to the New World of Reflation

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Tuesday’s election upended not just the political consensus but also the market one. In the aftermath, one investment theme has dominated: reflation. Specifically, this suggests that after several years of fiscal austerity and several decades of declining inflation, these trends are on the cusp of reversing. If so, what does this mean for markets?

Since the election, investors appear increasingly convinced that a Trump administration will lead to higher inflation, and potentially higher growth as well. By Thursday (10 November 2016) U.S. 10-year inflation expectations—based on breakevens in the TIPS market—had soared to 1.90%, the highest level since the summer of 2015.

Besides the impact of aggressive fiscal stimulus that President-elect Trump has proposed, inflation expectations are rising on the back of fundamental developments that preceded the election. After declining for 18 months, oil prices have been stable since the spring. More importantly, core inflation has been steadily creeping higher on the back of a sharp acceleration in medical costs and higher housing inflation. This is important as these components of inflation tend to be “stickier” and larger than energy prices.

In addition, wages are starting to rise: U.S. average hourly earnings have accelerated to 2.8% YoY from a prior level of 2.7% in September. And among the lesser-noticed results from Tuesday’s election, four states voted to raise the minimum wage.

Against the dry tinder of firming prices, we now have a potential match: a rare combination of fiscal stimulus and tax cuts. A historic election has redrawn long cherished political positions, and investors are facing an unusual combination of deficit-financed stimulus, delivered through the mechanisms of higher government spending and lower corporate and marginal tax rates. This potential relaxation of fiscal constraints is significant, particularly when you consider that the economy, specifically the labor market, has less slack than at any point in the post-crisis period.

What does this mean for portfolios?

In a reflationary environment, bonds are likely to be a less effective hedge against equity risk. Instead, investors are likely to hold more cash as a mechanism to dampen equity volatility. On a more granular level, investors may want to focus on those segments of the market, notably cyclical companies that stand to benefit from an acceleration in nominal growth. These include financials, which should benefit from a steepening yield curve, but also segments of the consumer space and “old economy” companies in sectors such as industrials and energy.

Finally, higher nominal growth should translate into higher nominal interest rates, to the detriment of the so-called bond market proxies (equities that provide high dividends). This was already evident the day after the election. While the S&P 500 was up over 1% on the day, U.S. utility stocks lost over 3% while consumer staples fell more than 1%. Although both sectors are off substantially from their summer highs, they are still far from cheap. Large cap consumer staples stocks trade for over 5x book value, roughly twice the multiple of the broader market and the highest valuation of any sector. This makes them especially vulnerable in a rising rate environment.

Welcome to the new world.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

The Morning After: What Now For Markets?

white-house

In a shocking development reminiscent of Brexit, Donald Trump, the Republican nominee, was elected the forty-fifth president of the United States on Tuesday, 8 November. In addition, Republicans maintained control over both houses of Congress.

Trump’s unexpected victory brings with it a great deal of policy uncertainty, given his lack of specificity during the presidential campaign. Judging by the tone of his campaign, one can surmise that foreign trade will likely be a major focus of the new administration. It is quite unlikely that the Trans-Pacific Partnership will be ratified against the present backdrop, while the North American Free Trade Agreement (NAFTA) could be renegotiated or even abandoned. Uncertainty over immigration policy is likely in the near term, which could potentially impact labor markets.

On the campaign trail, President-Elect Trump vowed to lower taxes and repeal the Medicare tax on investment income. He also promised to repeal the complicated alternative minimum tax, while taxing carried interest as ordinary income. Corporate tax rates would be reduced to 15% from 35%, and repatriated foreign profits would be taxed at a one-time rate of 10%, if Trump’s plan is enacted. Economists, however, question whether this package would spur enough economic growth to offset lost revenue from lower tax rates, which could widen fiscal deficits.

Sectors that may be advantaged under a Trump presidency include:

  • Fossil fuels: Trump repeatedly promoted US energy independence during the campaign, calling for leasing federal land for energy exploration, repealing some regulations on coal and reviving the Keystone XL pipeline project.
  • Pharmaceuticals: Price controls will be less of a concern for the industry than they would have been under a Clinton presidency.
  • Financials: Trump has called for repealing or significantly revising Dodd-Frank. Regulatory burdens could be reduced across the economy, based on his campaign rhetoric.

Trump’s focus on trade during the campaign and the risk that NAFTA might be revisited could pressure the currencies of two of the US’s largest trading partners, Mexico and Canada. Additionally, emerging market currencies will likely be pressured, since any additional US trade barriers would probably further slow the growth of global trade, which could negatively impact both producers of raw materials and of finished goods.

If the US puts trade barriers in place on imports, US exporters may be hurt as a result of trade partners retaliating against US actions. With roughly 40% of earnings from S&P 500 Index companies earned outside the US1, there appear to be significant risks to US-based multinationals. A full-fledged trade war would be damaging to growth and employment, and could have ripple effects beyond US borders. Companies whose business is more domestic in nature may fare better against a backdrop of global trade friction. If financial markets have a persistently negative reaction to a Trump victory in the run-up to the December FOMC meeting, odds of an interest rate hike could shrink.

A front-loaded agenda

Given the political ebbs and flows of recent decades, it is reasonable to expect Republicans to try to pack as much policy change into the first two years of a Trump presidency as possible, much as Democrats did in the first two years of the Obama administration. In 2009–2010, Democrats controlled the White House and both houses of Congress and passed a large economic stimulus package and the Affordable Care Act. Oftentimes, when one party controls both Congress and the White House, voters perceive political overreach and seek to balance the scales during the midterm elections. In 1994, President Bill Clinton’s Democrats lost both the House and the Senate and never regained congressional control during the balance of his two terms. Losing control of one or both houses in the midterms would limit Trump’s ability to achieve his agenda, suggesting that policy change could become more incremental later in his term.

 

1  Sources: FactSet, MSCI Economic Exposure Database, as of 10/31/16.

 

Erik Weisman, Ph.D. is the Chief Economist of MFS Investment Management.

 

The views expressed are those of the Erik Weisman and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

Are International Markets Back?

wood-plane

Very slowly, almost stealthily, international equity markets are clawing back relative to the United States. On a dollar-adjusted basis Japanese stock returns are now on par with the United States, with both the S&P 500 and the Nikkei 225 up around 4.5% year-to-date. And more recently, international markets are actually leading. Since late July the S&P 500 is down over 1%. During the same time period Europe has advanced 1% in dollar terms, a broad emerging market index is up more than 3% and Japan is up nearly 5%. Returns are based on Bloomberg data.

What accounts for the turnaround and, more importantly, can it continue? Three factors stand out:

1. U.S. growth remains uninspiring, despite expectations for a rebound.

The relationship between economic growth and market performance is unreliable and often non-existent. But for a market that is increasingly dependent on earnings growth, a lack of economic growth is a challenge. Although the U.S. economy continues to grow, it is not obvious that it is accelerating. More interestingly, relative to other parts of the world U.S. economic data is disappointing. The Citigroup Economic Surprise Index is once again negative for the U.S. while it is positive for a broader array of major economies.

2. The Federal Reserve will no longer ride to the rescue.

For most of the post-crisis period investors could, and often did, dismiss soft growth on the assumption it would lead to more monetary easing. That is no longer likely. While the Fed has verbally committed to a shallow and short tightening cycle, interest rates are still likely to rise. This is also putting upward pressure on the dollar, which will in turn pressure U.S. earnings.

3. U.S. stocks are expensive; other markets aren’t.

As shown in the chart below, U.S. equities are trading at over 20x trailing price-to-earnings (P/E) and over 26x cyclically adjusted earnings (Shiller P/E). Valuations at these levels have historically been associated with lower forward returns. In contrast, equity markets in Europe, Japan and emerging markets appear somewhere between fairly valued and relatively inexpensive.

spx-p-e-ratio

For long-term investors, the final point is particularly important. Value is often irrelevant in the short term, but over the long term valuations tend to mean-revert. For example, during the past 60 years, annual changes in the P/E of the S&P 500 had a -0.20 correlation with the change the following year.

This is one of the reasons many investors are lowering their long-term return assumptions for U.S. equities. Indeed, the BlackRock Investment Institute forecasts a 4% annual return for large cap U.S. equities over the next five years. This below-average forecast assumes a steady 2% annual compression in multiples. In other words, if correct, investors will be less willing to pay more for each dollar of earnings and stocks will climb at a much slower pace.

Many international markets face their own challenges, but at the very least they are less likely to contend with the steady headwind of multiple compression. This suggests that the recent recovery in international markets can continue.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Diversification strategies do not guarantee a profit or protect against loss in declining markets. International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.