Higher inflation, rising rates, and a shifting political landscape

The New Year is off to a far better start than in 2016 when markets were in disarray and the economic outlook was dim. Back then, commodities were in a downward spiral, China’s economic growth prospects were in question, and U.S. profits were falling. Global equities measured by the MSCI All-Country World Index fell more than 4% alongside the S&P 500 Index in the first week of 2016. 2017, in contrast, began more positively. Global equities were up nearly 2% in tandem with the S&P, and economic data was very supportive. Still, many of the concerns, which plagued early 2016, have yet to fade into a distant memory. While energy prices have recovered to a degree, discourse remains over the trajectory of Chinese growth, pundits still debate the state of the U.S. economy, and many clients inquire about the effects of rising political populism, particularly as it relates to Europe.

With growth improved in the U.S. since mid-year, an uptick in inflation, less slack in the labor market, a new political regime and a Federal Reserve (Fed) which expects to raise rates three times in 2017, this year may mark the point when long-held expectations of Fed tightening finally transpire. The Fed currently expects to hike rates three times in 2017, but the exact amount of policy tightening will likely depend on the “considerably uncertain” fiscal policy, as Federal Reserve Chair, Janet Yellen, clearly indicated in her latest press conference.

President-Elect Donald Trump’s victory in November, along with a Republican sweep of Congress, open a pathway for reforming the tax code, rolling back regulations, and increasing spending on infrastructure and defense. These factors may induce a cyclical shift in opposition to secular drivers of persistently low growth in the U.S. like demographics, low productivity, disruptive technology, and inequality – to name a few.

However, the environment also seems ripe for continued political disruption, particularly in Europe, where populism continues to unfold. The United Kingdom (UK) will have some hard-to-calculate risks associated with the Brexit vote. Italy will have a caretaker government until its next election, possibly in 2018. And important elections lie ahead in the Netherlands, France, and Germany. In the U.S., the potential risks stem not only from a shift in policy but also from a shift in the way government policy is pursued.

The equity market implications are less clear. On the one hand, Investors in the U.S. recognize that economic output is growing at a reasonable rate and may accelerate. On the other, valuations are more attractive outside the U.S. but face greater risks, like Japan, Europe, and the Emerging Markets.

The U.S. continues to enjoy what has become a very prolonged expansion, and over these past seven-plus years, the labor market has healed to a point at which most economists agree is near full employment. If the labor market continues to heal, and the supply of available labor gradually becomes scarcer, wages will likely rise at an increasing rate as employers compete for qualified candidates. As incomes rise, so too, should consumer spending and confidence, which has already reached 12-year highs. At the same time, upward trends in wages and spending will likely push prices higher. Most inflation estimates suggest expectations are rising. The U.S. five-year breakeven inflation is trending upward from early 2016 lows and now reads above its long-term average (since 2002). A strengthening dollar and any increases in productivity will likely dampen inflation pressures.

Our fixed income investors tend to be very sensitive to changes in inflation. When inflation increases, the value of a bond falls as its future coupon payments and principal repayment decrease in real purchasing power terms. As inflation becomes more evident, we expect the yield will continue to rise as it has been doing for several months – a difficult time for a portfolio as a bond’s yield moves inversely to its price.

To reduce the risk of rising rates, we emphasize fixed-income instruments with shorter durations. These bonds with shorter maturities, lower credit ratings, and floating coupons offer beneficial attributes in rising rate environments. The alternative, sovereign and higher rated securities likely face strong headwinds as inflation trends upward.

Admittedly, credit spreads on U.S. corporate and high yield bonds have narrowed after performing well in 2016. This has led some investors to question the asset classes’ future prospects. But certain indicators signal that the trend can hold. As of December: loan delinquency rates are declining; American manufacturing – measured by the Institute for Supply Management (ISM) – expanded for its fourth straight month at its fastest pace in two years; ISM new orders – a forward-looking measure – surged; many commodity prices have recovered; and, global growth has firmed up and broadened.

2017 began on an optimistic note amid strong economic data and the possibility of pro-growth political policy. Unfortunately, this does not mean that the path ahead will be easy or clear-cut. Finding certainty amongst so much uncertainty is a formidable task, but investors should likely expect a more volatile single digit return environment for equities to take precedent in 2017, alongside three other themes: higher inflation, rising rates, and a shifting political landscape.