Well we got that one wrong!
In recent blog posts and in our weekly client conference calls, we predicted that Clinton would be victorious over Trump, in large part due to his high unfavourable ratings with women and minorities. Like so many other pundits and pollsters, we failed to appreciate the extreme indignation among so many Americans that lead to this historic outcome. But to be fair, we by no means saw it as a lock for Hillary (in a conference call shortly before the election I put the odds of a Trump win at 40%), and as I believe history will show, the vague FBI letter that they were reopening their investigation into Hillary’s email server just days before the election may have been what did her in (or maybe Benghazi, the Clinton Foundation, term “deplorables” etc.).
So, now that we have Trump moving into the Whitehouse, with his interior designer likely drawing up plans to deck out 1600 Pennsylvania Ave in gold and tacky baroque sculptures and paintings, what does this mean for the economy and financial markets?
In a word….inflation.
Trump’s policies of pro-growth tax cuts, massive infrastructure spending, tariffs on imported goods from China and Mexico, and larger expected deficits, all point to higher inflation and in turn, higher interest rates.
This is exactly what the market is now pricing in with the US 10-year Treasury yield surging roughly 50 basis points (bps) following the US election. And it’s not only US yields that have risen with the Canada 10-year government yield gaining 30 bps to 1.56%. Globally, the back up in government bond yields has wiped out over US$1 trillion in bond values since Trump’s victory. This is potentially a big deal, and could represent a sea change for the economy and financial markets.
US 10-Year Treasury Yield Jumps 50 bps Post Election
Since the financial crisis we’ve been stuck in this low-growth, low inflation environment. For example, US GDP growth has averaged 2.1% since the financial crisis versus the long-term average of 3.3%, and US inflation at 1.5% versus the long-term average of 3.8%. Trump and his policies could be a game changer, particularly for inflation, which explains the back up in bond yields and inflation expectations. This can be seen in the chart below which is an index that measures future inflation expectations, and it surged higher following Trump’s victory.
Inflation Expectations Surge on Trump Win
With inflation likely to rise under a Trump presidency, how should investors be positioned in this changing environment?
First, we see equities as the best asset class for an inflationary environment as they provide a natural hedge against inflation. As inflation picks up companies raise prices for their products/services to help protect their margins and profitability. Higher prices result in stronger corporate profits and rising dividends, hence the natural hedge against inflation. Below is a chart that illustrates this relationship with the S&P 500 overlaid with Y/Y changes in US inflation.
While not perfect, it does illustrate the positive correlation between inflation and the S&P 500 generally. So, stick with your equities which we believe will continue to rise into 2017. From a sector perspective investors should focus more on cyclical sectors like industrials, information technology and energy, rather than interest sensitive sectors like utilities, which typically underperform in a rising inflation/interest rate environment.
Equities Act As A Hedge Against Inflation
The next best investment for an inflationary environment, and a must have in portfolios right now are real return bonds (RRBs). RRBs are government issued bonds that are linked to inflation. As inflation rises both the interest and principal amount increase, helping to preserve your purchasing power. Since inflation bottomed in late 2015, Canadian RRBs have outperformed straight government bonds, with the iShares Real Return Bond ETF (XRB-T) up 3.6% YTD versus the iShares Canadian Government Bond ETF (XGB-T) down 0.9%. We believe inflation will continue to rise and may ultimately see a boost from Trump’s policies with RRBs likely to do well in this environment.
Higher inflation should lead to further Fed rate hikes, and we continue to call for a Fed hike in December, and possibly a few more in 2017. As such, we believe investors should hold shorter dated maturities which are less sensitive to a rise in interest rates, and have their fixed income holdings tilted more in favour of corporate bonds, both investment grade and some high yield, versus government bonds. Corporate bonds typically outperform in a rising interest rate environment as credit spreads (the difference between corporate and government bond yields) tighten on the back of an improving economy.
Finally we continue to be bullish on the Canadian preferred share market which we see recovering further in 2017, as the Fed and then the Bank of Canada start to hike rates later in 2017 and 2018. Specifically, we like the fixed resets within the Canadian preferred share market which reset their dividends every 5 years versus perpetuals which have a set dividend. We continue to hold the iShares Canadian Preferred Share ETF (CPD-T) for clients with its 72% weighting to fixed resets.
So there you have it. We believe inflation has bottomed and we see it rising further if Trump is able to get some of his economic policies passed through Congress. Are you positioned correctly for this potential outcome? And are you ready for “Trump Whitehouse”?