The shift from monetary to fiscal policies could boost inflation in those markets with higher growth and excess capacity…. and that will have an impact on the financial markets. For Paul Brain, Head of fixed-income at Newton, part of BNY Mellon, long-term public debt will be adversely affected, especially in the US, while credit could hold better if there is growth. As he explained during an interview with Funds Society, the Trump effect has unleashed expectations of growth and inflation, so Fed rate hikes are expected, but will be lower than expected while the ECB will continue with its expansionary policy… even though the IRR of peripheral debt could continue to rise. As for emerging debt, it all depends on whether spending on infrastructure, or trade barriers for developing markets, dominate Trump’s policies.
Are Donald Trump, and the economic outlook that revolves around him, unleashing a return of inflation?
There is a major change taking place globally and Trump’s ideas fit into this new context. We have passed the stage where we only had monetary expansion to support growth, and now governments are focusing on fiscal stimulus measures. In some economies, this change could trigger a rebound in inflation expectations, if interpreted as an additional boost factor. However, the inflationary impact will be lower in those economies that still have slow growth and overcapacity. In addition, many governments may not have the authority to quickly approve sweeping measures unless another crisis occurs.
How will these changes affect inflation in fixed income markets?
Going from relying solely on an expansive monetary policy (which is positive for fixed income) to a combination of monetary policy and fiscal stimulus will adversely affect bonds with longer maturities, as expectations for greater support from central banks are reduced. We have been informing about this change since the summer. However, the initial reaction could lead to further correction if the authorities succeed in launching serious fiscal stimulus programs. The US bond market is the most vulnerable because its central bank has already begun the process of monetary restraint. Credit markets could perform better because of improved growth prospects, and hence, improved corporate profits, but emerging market countries that have issued US dollar-denominated debt will see the cost of that debt rise.
Will investors commit to risky assets or will they opt for safe haven assets in the face of uncertainty?
Risky assets (emerging market debt and currencies) could stabilize if fiscal stimulus measures do have positive effects on economic growth, especially those that were most affected by the collapse of commodity prices. The stock markets appear to be anticipating good news from Trump’s plans and ignoring the negative comments about trade, etc. In our opinion, the demand for safe haven assets will increase as markets shift their focus to other political events, such as the various electoral processes that will take place in Europe next year.
What are the forecasts for the Fed’s performance in this environment?
With rising wages and the prospect of fiscal stimulus measures, the Fed is mandated to raise interest rates in December and present its rate hike forecasts for 2017. We are concerned about the length of the economic cycle for the United States since, beyond the stability of consumption, we began to see investment deceleration. We have left cheap money behind; and the spike in corporate leverage that has occurred during the past two years, along with higher costs (rising wages and appreciation of the dollar), will stifle profits and slow the economy down. So if fiscal stimuli are not enough (because they are downsized while being passed in Congress, are poorly designed or slow to implement), the US economy could slow its growth and then the Fed will stop raising its rates. In short, in the short term the market will price-in a higher official interest rate, but we continue to believe that the maximum that rates will reach will be lower than what the market expects.”
How will this lead the ECB and European debt?
Any factor driving global growth should be positive for an open economy like the European one, but protectionist discourse (both Trump and Brexit-related) and uncertainty over the growing popularity of anti-European parties will constrain growth. Therefore, we believe that the ECB will maintain its monetary policy expansion and that the IRR of European core debt will continue at low levels. On the contrary, the IRR of the peripheral bonds could continue to increase in the short term.
And emerging debt?
If Trump focuses on infrastructure spending, there will be a rally in emerging market bonds, but if there are trade barriers we will see massive sales
Will inflation-linked bonds, floating rate bonds and such instruments gain appeal?
We currently like bonds linked to US inflation and variable rate bonds because we think the potential rebound in inflation and the possibility of the Fed taking a tougher stance is being underestimated. It is possible that at the beginning of next year we rotate to other segments of fixed income if Trump’s policies disappoint.
What is your Outlook on the Dollar?
The dollar is backed by both the US interest rates hike expectations, and rising political uncertainty in Europe. As in the case of bonds, this situation could quickly change once the market’s “infatuation” with Trump is over.