In the wake of the election of President Trump, the US is seeing an unprecedented upsurge. Primarily, this is due to market players’ interpretation of Trump’s rhetoric, promising an ‘America First’ policy. The policy is meant to focus on boosting growth along with the prospect of a deregulatory agenda. As equity strategist with Bank of America Merrill Lynch, Savita Subramanian, stated:
“Improving investor sentiment, accelerating global growth and hopes for stimulus […] is driving the market to new highs”.
Indeed, the S&P 500, a benchmark stock index which tracks 500 stocks – seen as a leading indicator of US Equities – has hit multiple record highs recently, last week hitting 2400 as investor confidence in US growth surged.
The bond market, however, has remained stagnant, fixed income investors maintain pessimism in the face of the equity upsurge, reflecting some structural challenges facing the US, including the current global savings glut. However, assuming growth will occur, what does this mean for investors?
Certainly, inflation is key when assessing investment strategy under growth. Inflation can occur through a ‘demand pull’. If demand for goods and services rises or experiences a shock through a rise in consumer confidence (which may be happening within the US with rising hopes for fiscal stimulus) for example, then producers charge higher prices in order to maximise profit in the current competitive climate.
It can also occur through a ‘cost push’, in which the cost of important raw materials, such as oil, increases, therefore increasing production costs and has a knock-on effect on the prices consumers face.
The so-called positive inflation caused by the ‘demand pull’ is associated with growth, and expectations of such inflation are increasing within the US, something that may hurt fixed income investors. Inflation is a bonds’ worst enemy, eroding the purchasing power of future cash flows.
This is easily visualised using a simple 1-year bond which pays a fixed interest rate at maturity and does not pay coupons. If such a bond were bought for £100, at 5% interest rate, then at maturity, an investor would receive £105. However, if inflation occurs, then the profit received from the bond is effectively reduced as the purchasing power is eroded by the increase in prices: it will not buy as much.
If inflation is 2%, the actual return would be 3% (using the Fischer equation, in which real interest rate = nominal interest rate – inflation). Therefore, as inflation in the US is likely to occur in the coming years, investors may move away from fixed income towards equities.
Another solution for investors are Treasury Inflation Protected Securities. Promising lower yields, their prices hike when inflation expectations experience an upsurge.
The Federal Reserve and its response to the threat of inflation are also pivotal. If the Fed increases the base rate, then interest rates faced by firms and consumers follow suit, dampening aggregate demand through a decrease in investment and consumption, as asset prices decrease and agents feel less wealthy.
This, in turn, stagnates the inflation caused by the initial demand shock. Indeed, such an interest rate hike seems to be on the horizon, with markets seeing a near 100% chance of an interest rate increase. With all eyes on the March 14/15 meeting, an increase in interest rates can affect investors’ decisions through multiple channels.
Bond prices move inversely to interest rates. This is because a bond paying a fixed interest rate previously issued is less desirable than newly issued bonds with a higher interest rate, thus decreasing demand for the bond and necessitating a decrease in price to compensate for the decrease in demand. As seen, the monetary policy sensitive US two-year yield, which moves in an opposite direction to prices, hit a seven-year intraday high last Friday.
Though uncertainty is prevalent within the US regarding future growth and therefore investment decision making, if growth occurs one should expect to see investors shifting from high yield to equities, or even to TIPS (inflation-linked bonds).
Though the market could go either way, with Trump’s ambiguity regarding stimulus along with the increased chances of an interest rate hike possibly dampening hopes of growth, many market players remain optimistic. An interest rate rise suggests the Federal Reserve is confident in the future economic outlook of the US, and investors may follow suit.