This article was updated on March 14, 2017.
To paraphrase Mark Twain, recent reports of the bond market’s death have been greatly exaggerated. That’s the theme of a new white paper by Capital Group’s head of fixed income Mike Gitlin, portfolio manager Ritchie Tuazon and investment analyst Tom Hollenberg.
While Donald Trump’s election win does change aspects of fiscal and perhaps monetary policy, they believe that the fundamentals for bonds are solid, and that fixed income should remain a core component of a balanced investment portfolio.
They believe that the post-post-crisis landscape of mixed markets with uneven growth and prolonged low rates will persist. Several catalysts have caused bond yields to jump following the election. Despite that move, they believe bonds remain a sound investment.
Why Have Yields Jumped?
In the week following the election, 10-year Treasury yields moved sharply higher, up 70 basis points from their early September lows. This is somewhat comparable to 2013’s “Taper Tantrum,” when yields rose as the market learned that the Federal Reserve was planning to wind down its monetary stimulus program. The market appeared to be reacting to three significant changes a Trump presidency might bring:
1) Uncertainty about the leadership of the Fed.
Janet Yellen’s term as chair is due to end in February 2018. At that time, President Trump could appoint a more hawkish leader who is eager to raise interest rates.
2) Looser fiscal policy.
Trump has championed both lower taxes and higher infrastructure spending. These policies would likely boost growth and increase the federal budget deficit, factors that tend to move yields higher.
3) Higher inflation prospects.
Looser fiscal policy and protectionist measures like tariffs could cause prices to move higher. As inflation expectations rise, bondholders require more yield to compensate for that risk.
How Uncertainties and Other Factors Could Affect Bond Fundamentals
The recent move in bond yields is mostly justified by new information the market has received. However, there are still many uncertainties and other factors that provide reasons to be constructive on fixed income:
1) Uncertain geopolitical backdrop.
Nonperforming loans in China may indicate that the credit expansion aiding its growth could slow. In Europe, populist political movements exemplified by the U.K.’s vote to exit the European Union threaten to shake up the status quo.
2) Uncertain U.S. government policy.
Since the election, many aspects of government policy have been in flux, from spending plans to foreign relations.
3) Risk that fiscal stimulus plans miss their target.
The nonpartisan Tax Policy Center estimates that high-income families will benefit most from Trump’s tax plan, with a smaller break for the middle class. If it results in a relatively light boost to consumer spending, its broader economic impact could be muted. Feeling an impact from an infrastructure package could also take time, if implementation is slow.
4) Risk of a trade war harming growth.
If Trump follows through on his proposals to increase tariffs, his actions could spiral into a trade war. Sales from abroad account for 44% of S&P 500 companies’ sales, so a change in trade policies could hit company earnings.
5) Risk of restrictions on immigration hurting economic growth.
One little-known fact is that the growth in GDP per capita has trailed total GDP growth by 40% since the financial crisis. Significantly curbing immigration could create a demographic headwind for U.S. growth.
6) Risk of a shock hitting the economy.
Since current U.S. growth remains relatively modest, it could be vulnerable to an external shock. Tightening financial conditions due to higher interest rates could also cause a downturn. The current post-recession expansion at more than 90 months is well past the 58-month post-war average.
7) Large number of buyers of U.S. government debt.
U.S. and foreign pension funds and insurers use Treasuries as an important component of their portfolios. If interest rates rise, they may take advantage of the chance to hedge their liabilities at a lower cost than before. Many institutions overseas also buy Treasuries to manage their portfolios – and their yields are attractive compared to other developed-market government bonds.
Don’t Give Up on Bonds
In the white paper, the authors expand on these themes and explain why, if yields rise relatively slowly, higher bond coupons could help prevent significant losses to principal. Although they find it very likely that the Fed will continue gradually raising rates in years to come, they believe expected risk-adjusted returns for bonds remain appealing.
Although many market participants seem to think the bond bull market is over, particularly given Trump’s election, our investment professionals advise caution on this view. Another Mark Twain quote resonates here: “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
Learn more about our core bond funds:
Download the full white paper “Reports of the Bond Market’s Death Have Been Greatly Exaggerated: Post-Post-Crisis Era to Continue.”