Income under uncertainty but bonds remain attractive

Trade war looming?

In 2016, when Trump was first elected as US President, China accounted for 22% of total US imports. That share is now 13.5%. Meanwhile, the US accounted for 18% of total Chinese exports - it is now less than 15%. Trump has threated to impose 60% tariffs on the remainder of Chinese exports to the US. Even though China is less reliant on the US, this would still be a massive blow. I was in Beijing at the time of the US election. My impression was that China is likely to respond to any new tariffs from the US by announcing further steps to deal with its property problem and boost domestic demand. The timing of policy announcements from Washington and Beijing is unclear. One might depend on the other. What is clear is that the outlook for global trade and investor sentiment depends a lot on how this US-China relationship plays out under the new Trump administration. There will be implications for trade volumes, corporate sales and market valuations.

Shifting patterns 

Global trade has evolved in response to a more protectionist world. Both Mexico and the Eurozone have larger market shares in the US than China compared to 2016. Mexico, being the single biggest exporter to the US, is at risk from Trumpian protectionism, as Canada might also be. For its part, China has diversified its exports. The rest of Asia is more important to it than the US and the European Union (EU). Exports to Asia have increased from around 5% of total Chinese exports in 2000 to about 18% today. This is explained by geographical reasons but also by China’s place in many global supply chains, especially in technology and consumer durables.

There is also a view that China has tried to avoid US tariffs by diverting exports and production to Asia. If that is true, we can expect US protectionism to have broader targets. China has also been accused of “dumping” – diverting goods that may have once been bound for the US market to other countries, at discounted prices, therefore hurting local businesses. The decision by the EU to raise tariffs on the import of Chinese electric vehicles is another example of the unfortunate direction that global trade is heading in.

Poor policy choices

There is often a logic to the imposition of tariffs, if imported goods are benefiting from subsidies in their country of origin, for example, or if there is clear evidence of dumping. However, using tariffs to reduce trade deficits is not particularly logical. The US runs an external current account deficit of over 3% of GDP. Economic theory tells us that a balance of payments deficit reflects the imbalance between domestic savings and domestic consumption and investment spending. If the US wants a lower current account deficit, it needs to save more and spend less. According to Keynesian economics, that means lower growth.

In extremis, relative prices (exchange rates, which tariffs can impact on real terms) can shift savings and consumption decisions, but that won’t happen in a four-year presidential term. The real solution to lowering America’s trade gap is not what was sold to the electorate. Tariffs will either hit corporate margins (for importing companies) or, more likely, hit consumers through higher prices. Ironically, the dollar is more likely to stay strong, which, all else being equal, would mean a rise in net imports to the US.

This is just one element of Trump’s policy agenda that may have negative consequences, economically and for markets. Cutting taxes and allowing government borrowing to rise is another. A potential ideologically-driven attack on federal government budgets is another. And then there are the proposals around immigration, environmental subsidies, and other social issues. No wonder the most used word in market commentary since 5 November has been “uncertainty”.

Core view is still positive 

Uncertainty is the enemy of complacency. But when it comes to investing, what is important is whether risks will materialise and disrupt cashflows or the valuation of assets. For now, it is hard to assess the extent to which the Trump agenda will be implemented, and at what speed. The central economic view remains healthy. US growth is expected to remain above its trend rate. This somewhat limits the eventual size of any Federal Reserve (Fed) rate cuts. The market implied end-2025 Fed Funds Rate is now at 3.9% which basically suggests just three more 25-basis-point cuts over the next year. If that is consistent with a more expansionary policy stance under Trump, it leaves little scope for significantly lower bond yields. 

Credit is attractive 

Central banks, however, will remain in easing mood. This underpins a continued positive view on fixed income. Inflation may be sticking slightly above central bank target levels, but real policy rates are still high and having achieved a soft(ish) landing, central banks will want to preserve the expansion by easing policy a little more. Moreover, with the US getting some stimulus from corporate tax cuts and deregulation, and Europe seeing more rate cuts, the outlook for corporate credit remains positive. Investment grade credit provides a yield of around 5.25% in the US dollar market, 5.5% in sterling and over 3% in euros. Credit fund managers can find even better yields than these market averages, generating a healthy return outlook, dominated by income. Just in the last three months, the US investment grade market has delivered an income return of close to 4.6% annualised. For US high yield this has been around 6.5%.

But expensive?

In conversations with clients, some concern has been expressed about the valuation of credit markets. Spreads are low, that is for sure (although all-in yields are healthy). Some of the details of this are interesting, however. Conventionally, corporate bond yields are compared against a government bond yield of the same maturity – the “spread versus govies”. On this metric, US credit is extremely expensive with spreads in the bottom one percentile of this distribution of the last 10 years (using weekly observations from the ICE/Bank of America bond database). However, there is another way of looking at spreads, comparing corporate bond yields to the interest rate swap curve. That tells a slightly different story. Spreads are narrow, but not nearly as narrow as suggested by the spread against government bonds. For completeness, European credit spreads are at less extreme values compared to the US on both measures of spread.

Government bonds are cheapening 

The story here is that government bonds have cheapened. Yields on government bonds are above the interest rate swap curve, particularly at the long end of the yield curve. This has been the case in the US and the UK for some time, but recently it has started to become obvious in the euro market. Government bond markets are more impacted by supply and demand factors – during the period of quantitative easing, huge demand from central banks made government bonds expensive and yields were below the interest rate swap curve. Today, the fear is of excess supply as governments struggle to bring borrowing down. For investors with a swaps benchmark – like many insurance companies – a rise in bond yields relative to swaps has created a more difficult performance backdrop.

It’s a complicated and very technical situation but the conclusion is that government bond valuations are being negatively impact by the fiscal outlook. It also means that credit is perhaps not as super expensive as suggested by the simple “spread versus govies”. However, credit is not cheap with current pricing supported by good fundamentals and strong demand. At some point some investors might just think, on a relative value basis, that government bonds are sufficiently discounted to make them attractive again, relative to a forward interest rate curve that could still move lower.

Trump for stocks 

Equity markets are reflecting the Trump trade still. Over the last month the best performing stock markets have been mostly US indices – small and mid-caps, growth indices and the Nasdaq. The prospect of lower corporate taxes and the strength of the technology theme should sustain outperformance by US equities for the foreseeable future. Just look at Nvidia – it beat estimates for third quarter revenue, booking $35bn of sales. The stock price is up 196% year-to-date.

It's back 

Thank goodness proper football is back this weekend. A new era for Manchester United begins. My enthusiasm will at least last until this Sunday, but hopefully beyond, with reports suggesting a different style of play for the team being evidenced during training sessions this week. United has lost four Premier League games this season, hopefully not many more and there is plenty of scope to move up the table. Boa sorte Ruben!

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 21 November 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.