Bond Fundamentals Moving Forward
While the recent move in bond yields is mostly justified by new information the market has received, the waters are still choppy. We believe bonds should continue to act as an anchor for portfolios.
On one hand, lower taxes, fiscal stimulus and deregulation are all positive factors for riskier assets like stocks (and by extension negative for safer assets like Treasuries). But there are still many uncertainties and other factors that provide reasons to be constructive on fixed income:
1. Uncertain geopolitical backdrop. China is currently growing at a reasonably healthy pace, but that has been aided by a rapid expansion in credit. Nonperforming loans continue to be a concern. In Europe, we see a shrinking political center and the rise of protectionist and anti-immigration parties. After the U.K. voted to exit the European Union, populism is gaining ground in many countries, including Italy, France, Austria and the Netherlands. Such a shift in the EU’s political landscape could increase uncertainty, and possibly call into question the future path of the euro zone as a whole. Fresh ambiguity about security arrangements in Asia and the future of NATO is unlikely to help political stability.
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2. Uncertain U.S. government policy. To paraphrase Aristotle, the market abhors a vacuum. Following the election, many aspects of government policy are in flux, from spending plans to foreign relations. Academic literature shows that higher levels of policy uncertainty have in the past been associated with declines in investment, output and employment.
3. Risk that fiscal stimulus plans miss their target. The nonpartisan Tax Policy Center’s analysis of Trump’s income tax plan finds that, while high-income taxpayers would enjoy most of his proposed tax savings, middle-income families would receive an average tax cut of $1,000. If consumers fail to spend this extra income, economic growth could fall short of expectations. On the infrastructure side, markets are focusing on a pickup in economic growth from fresh funding for highway, water and airport projects. But if the market is expecting quick action, it may be disappointed. A year after the passage of the 2009 stimulus plan, President Obama famously acknowledged that “there’s no such thing as shovel-ready projects.”
4. Risk of a trade war harming growth. If Trump were to follow through on his proposals to increase tariffs on foreign goods, his actions could spiral into a trade war. This would be negative for U.S. GDP growth. It’s worth noting that 44% of S&P 500 companies’ sales come from abroad. China’s state-run Global Times newspaper has already responded to threats of tariffs, suggesting that sales of Boeing aircraft, U.S. autos, iPhones and agricultural products could suffer.
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. Furthermore, over 65% of population growth in future decades is expected to come from immigration, the Census Bureau estimates. Without immigration helping to grow the population, the U.S. could experience a demographic headwind similar to what Japan and many European countries now face.
6. Risk of a shock hitting the economy. External shocks are, by nature, difficult to predict but can have wide-ranging effects. In a recent speech, Fed Chair Yellen highlighted that downturns resulting from shocks to demand could affect the labor force in negative and long-lasting ways. There is also a risk that tightening financial conditions brought about by higher interest rates could lead to a downturn. Bear in mind that we’re 91 months into a post-recession expansion, while the average postwar growth period has lasted 58 months.
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, and this shows no sign of changing. The 100 largest corporate defined benefit plans in the U.S. are only 77% funded. If interest rates rise, pension plans may take advantage of the chance to hedge their liabilities at a lower cost than before. Looking overseas, many institutions buy Treasuries to manage their portfolios — and their yields are attractive compared to other developed-market government bonds.
Most investors know that when bond yields rise, prices decline. To make the magnitude of this risk more tangible, this chart shows how shareholders in our flagship fund The Bond Fund of America® could fare if rates rise. It relies on straightforward bond math that holds other factors (such as credit rating of the issuer, supply and demand, etc.) constant but allows yields to impact bond values and coupons. We calculate how much yields would need to rise over 1-, 2- and 3-year periods for investors to realize a loss to principal, net of coupons.
Although it seems very likely to us that the Fed will raise rates gradually in years to come, expected risk-adjusted returns for investing in bonds remain appealing. Recent volatility in the tax-exempt municipal bond market is beginning to present more opportunities for munis. In the taxable space, healthier realized inflation makes us continue to be supportive of Treasury Inflation-Protected Securities. The Tax – Exempt Bond Fund of America® and American Funds Inflation Linked Bond Fund® are two American Funds that could benefit from the current environment. Currently, the financial media appears to indicate that most market participants appear to think we’ve reached an inflection point in the bull market for bonds — and that Trump’s election is a catalyst for a significant bond market decline (and rise in yields). That leads us to conclude with another Mark Twain quote that resonates: “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
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