Post-Brexit and post-Trump, investors will be wondering whether they should be putting safety first. And, if so, how? After a year of political shocks, and with elections in France and Germany due next year, taking refuge in a safe haven asset might seem appealing. But what if those havens are not to be found in the usual places?
For many, government bonds are still the default assets bought in times of political crisis. However, they could be rather less safe than some investors assume. If populism remains in the ascendant, it may be that high yield bonds represent a less unsettling place to invest.
Historically, populism has meant higher spending and therefore higher borrowing. President-elect Trump has explicitly promised to rebuild infrastructure to help “make America great again”. This may boost growth in the short term but, in the longer term, it could feed fixed income’s greatest enemy: inflation.
The US stockmarket reacted warmly to Trump’s victory in November. The fact his victory speech was relatively graceful helped. Now the market is looking at the implications of the policies he proposed during the campaign. It is anticipated these will involve generally “reflationary” policies. With a smaller immigrant workforce at a time of increased fiscal stimulus and the initiation of large construction projects, labour shortages may emerge. Wage inflation seems likely.
Meanwhile, more bonds will need to be issued to pay for this infrastructure. But Trump’s hostility to the Federal Reserve seems to have made additional quantitative easing less likely. Making rich people richer hardly seems a populist policy. So with inflation building and the Fed less likely to buy bonds, US treasuries are coming under pressure, with yields having risen quite sharply.
And what of gilts? In the immediate aftermath of the Brexit vote in June, government bonds did well. The Bank of England responded to the vote by cutting interest rates and reviving its QE programme, buying gilts and corporate bonds, forcing their prices higher. Yet sterling continued to weaken and that, in combination with higher oil and commodity prices, could see inflation rise in the UK.
The Bank of England will try to resist raising interest rates for as long as it can. But if inflation becomes entrenched, it may have little choice but to act. Higher interest rates would inevitably hurt gilts.
Another change markets must contend with in the coming months will be the renegotiation of trade deals. One of the biggest reasons that consumer prices have fallen over the last few years has been the integration of global supply chains. The referendum in the UK and presidential election in the US were both clear examples of a backlash against that dynamic.
Some forecasters anticipate these anti-trade policies will provoke a recession. We think that is unlikely, especially in the US, although some emerging economies could come under pressure if protectionist policies are implemented. One unknown factor is how China will react to being branded a “currency manipulator” and to Trump’s unorthodox approach to Sino-American diplomacy. The risk must be that it retaliates by selling some of its (substantial) holdings of US treasuries.
So if government bonds are less safe than they might appear, where else can investors turn for a relatively secure source of income? Some diversification is always prudent – all the more so in times of political and economic uncertainty.
Investment grade bonds are traditionally seen as “safer” than their high yield counterparts and are priced accordingly. Yet the hunt for yield since the financial crisis has been so intense that the additional yield they offer relative to government bonds has been severely eroded. That means they have precious little cushion to protect their holders as underlying yields on government bonds rise.
This combination of circumstances argues in favour of owning high yield bonds. A rise in yields on government bonds should not affect this market, except in extremis. More government spending (on infrastructure) should theoretically boost growth in the wider economy: good news for high yield bonds. Meanwhile, in the interests of diversification, Trumpflation seems likely to favour cyclical stocks in the US, rather than bond proxies.
So we are wary of the traditional safe havens. Higher inflation, higher interest rates and increased government borrowing could make them less safe than their owners hope. In times of political tumult and economic change, safety does not always lie in the most obvious places.
James Foster is co-manager of the Artemis Monthly Distribution fund