Are investors getting ready to dump the Trump trade?
Certainly, Wall Street's faith that US President-elect Donald Trump's promised fiscal stimulus will spur growth and inflation is showing signs of flagging. The US share market edged lower last week, while the yield on benchmark US 10-year bonds dipped to 2.4 per cent, down from the two-year high of 2.6 per cent level it reached in mid-December. (Yields rise as bond prices fall.)
But, at least for the moment, most analysts are sanguine that the rationale for the so-called Trump trade of selling bonds and buying stocks remains intact. They argue that last week's dip in US share prices is a healthy correction following the hectic post-election rally, and that the yield on US 10-year bonds, which has been moving higher since hitting a record low of 1.36 per cent last July, will continue its ascent.
High-profile US bond investor Jeff Gundlach, who founded the $US100 billion ($133 billion) DoubleLine Capital and who correctly called the July low in US bond yields, believes the US 10-year bond yield could reach 3 per cent this year.
"I expect the history books will say that interest rates bottomed in July 2012, and double-bottomed in July 2016," he told Barron's RoundTable.
According to Gundlach, the best way to predict where interest rates are heading is to look at the movement in nominal GDP levels.
"Last year, real [inflation-adjusted] GDP probably grew 2.1 per cent. If fiscal stimulus lifts the growth rate this year to 2.5 per cent to 3 per cent, and you throw an inflation rate of 2 per cent to 3 per cent atop that, conservatively you're talking about nominal GDP around 5 per cent.
"How can bond yields stay at 2.4 per cent in that environment?"
Gundlach added that at some point, rising bond yields "will create competition for stocks" and diminish the allure of US shares.
"Bonds could rally in the short term, but once the yield on the 10-year Treasury tops 3 per cent, which could happen this year, the valuation argument for equities becomes problematic."
But other analysts warn that investors are misguided in believing that Trump's policies will spur growth and inflation. In the latest quarterly letter from Hoisington Investment, bond fund managers Van Hoisington and Lacy Hunt argue that investors were similarly overly optimistic about the 2009 fiscal stimulus and about the US Federal Reserve's initial bond-buying programs.
"In these cases, the rush to judgment was misplaced, as widespread economic gains did not occur and the US experienced the weakest expansion in seven decades along with lower inflation."
Hoisington and Hunt argue that Trump's tax cuts are unlikely to be as successful as former US president Ronald Reagan's much larger tax cuts because US federal debt now stands at 105.5 per cent of GDP, compared with 31.7 per cent back in 1981.
What's more, tax cuts take time to work. "Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive US aggregate indebtedness higher, further restraining economic growth."
And while Trump's regulatory reforms could increase energy production and boost economic activity, Hoisington and Hunt argue that "proposals to cut the trade deficit by tariffs or import restrictions would have the exact opposite effect."
They also point out that the steep rise in US interest rates over the past few months will also act as a drag on economic activity.
"This situation is the same problem that has constantly dogged highly indebted economies like the US, Japan and the eurozone.
"Numerous short-term growth spurts result in simultaneous increases in interest rates that boost interest costs for the heavily indebted economy that, in turn, serves to short-circuit incipient gains in economic activity."
As a result, Hoisington and Hunt believe that US nominal GDP growth will be 2 per cent this year, and they continue to stand by their long-held prediction that the yield on US 30-year bonds will fall to 2 per cent, from just under 3 per cent at present.
