In the late hours of November 8th, 2016 the results of the US Presidential election were solidifying (candidate Donald Trump was the presumptive winner) – US equities sold off ~ 5% across all domestic market indexes. Panicky investors appeared hyper-focused on certain aspects of the newly elected Presidents’ campaign rhetoric which centered on protectionist trade policies, an unconventional communication style (Twitter) and campaign approach that ultimately led to an upset victory. This fear, however, was short-lived as markets opened on November 9th and the focus quickly shifted to the advantages of a business-friendly President that would be further bolstered by a Republican majority Congress that could actually pass legislation to usher in a pro-growth reformist agenda helping to jump start a supply-side led rebound in what had been up to that point a mediocre recovery.
The price action in the market on the evening before and first day after the elections is a perfect microcosm of the larger focus of this blog. Looking back over the past 29 months, the market has struggled to decide which Administration they thought they were getting: the one they feared on election night or the one they embraced the next morning. We will look back over Trump’s presidency in order to understand the evolution of Trump’s policies and strategies, the market’s shifting reaction function to the political agenda and how this evolution could illuminate the future for investors.
Deregulate and Stimulate
The early days of the new administration confirmed investors’ optimism: corporate and personal tax reform was passed, cabinet appointees were chosen who were focused on reducing and eliminating burdensome regulations, and perhaps most importantly there was a renewed optimism amongst the business community that sent sentiment data to new highs due to a belief that the new “CEO of the U.S.” understood how to run a business. Investors embraced the new administration’s pro-growth initiatives through higher equity prices, which the President embraced and further used as a measuring stick of his administration’s success. Along the way there were trials and tribulations, yet investors and businesses never lost sight of the Presidents’ mutual interest in rising asset prices (the ultimate measuring stick of success).
While the President continued to pursue his campaign promises, investors adapted to a more combative communication strategy through a new media platform (Twitter). As the economy accelerated on the back of fiscal stimulus and renewed business confidence, the Administration turned their attention to trade deficits. On the surface, the aggressive communication and unconventional engagement with our trade partners had the likeness to the campaign’s protectionist rhetoric the market originally feared on election night but it was tolerated based on a belief that the Presidents’ negotiating tactics were only “tactics” and the realization that some of these trade deals were truly outdated, unfair and indeed required a revisit. The combination of seasoned trade negotiators (Lighthizer), the Presidents measuring stick (equity market performance) and the perceived “Presidential Put” following a subsequent market correction had investors comfortable that trade skirmishes would not escalate into trade wars. USMCA (or NAFTA 2.0) negotiations came and went with some volatility but an eventual resolution. When European auto-tariffs were floated and markets reacted poorly and businesses pushed back, the decision got put off, placating investors. Even when the administration actually began to implement tariffs on Chinese imports in early 2018, the markets had become accustomed to the Administrations’ reaction function. Even if investors were unable to anticipate the President’s next move, there was at least a pattern to the behavior, a perceived negotiation strategy and a clear delineation between policy initiatives and the ultimate response in the form of a “Presidential Put.”
Wag the Dog Moment
This perceived framework started to shift after the mid-term elections in November 2018 when the Republicans lost control of the House and scope for domestic policy initiatives declined under a split Congress. At that point, attention turned to foreign policy, of which the White House could more easily work unilaterally. At first, the Administration settled for quicker wins to avoid disrupting the market. As 2019 progressed, the Administration’s view appeared to shift, and its preferences to keep the focus on China and other trade partners intensified. Quick wins turned into drawn out battles (perhaps to counterbalance the partisanship and uncertainty surrounding the Mueller investigation). Despite the tougher negotiations, the White House still appeared to remain somewhat sensitive to the “measuring stick.” Small, targeted tariffs proposed on European goods in April 2019 were clearly a negotiating tactic to keep Europe on notice but there was minimal expectation for trade policy negotiations to escalate too far with our allies. While the tone had become more confrontational, the market still expected the measuring stick to prevail. Those expectations were dashed in May when trade negations with China fell apart. The debate goes on as to whom is to blame for the lofty expectations and the disappointing outcome of the most recent China development. But it was clear the Administration was becoming less willing to concede despite the negative repercussions to asset prices. The street fighting tactics that made for a great campaign trail were beginning to bear their teeth. The Administration also recently expanded the list of countries it plans on taking on, by re-categorizing India from an economic development perspective, and thus weakening trade exemptions and setting up an additional fight down the road.
The inflection point for the unconventional
On May 30th, the President tweeted the potential for additional tariffs on Mexico linked to lack of progress on immigration. Not only was this a major break from the previous strategy of a delineation between policy initiatives (i.e. trade and immigration), but by all accounts it came as a surprise to the broader Administration suggesting it was off-the-cuff and not part of a strategic plan. The timing also seemed odd given USMCA was poised to be signed and the ongoing stresses associated with China tariffs. The move had elements which concerned investors over two years ago: confrontation, protectionism and unconventional policy with the risk of causing disruption with our long held allies. It is still early days, but the fulcrum appears to be moving quickly back towards the Administration that market’s feared on election night.
Markets as the arbiter
Since these are new developments it might be best to evaluate the Presidents’ term thus far based on a few key metrics (both financial, economic and sentiment). These metrics will help us to judge progress made since the Presidential election (the pro-growth reformist) to the Mid-Term Election (Wag the Dog) to the most recent moves (unconventional disruptor).
As you can see in the table above, the Administration is succeeding by the President’s most important measuring stick, the equity markets, as well as by both business and voters who continue to feel confident in the economy. He is fulfilling his campaign promises except in 2 critical areas: Trade and Manufacturing in which activity has softened. The President’s plan to address this will likely be a combination of further escalation on the trade negotiations and subsidies to ease the pain. Nevertheless, even though some parts of the US economy are already being hurt by Trump’s trade policies, the general opinion of the government’s economic policies according to University of Michigan Consumer Survey continues to rise.
The Disruptive Unknown
The Mexican Tariff threats elevated the uncertainty around the President’s operating style and how he will engage going forward. This disruption factor to foreign policy is an aspect of his Presidency that many investors feared immediately following election night 2.5 years ago. The progression of his evolution and the most recent actions adds an extra level of uncertainty. Although the implications so far have generally been related to foreign policy, we may also need to consider domestic initiatives and this poses a potentially catastrophic risk. For example, the upcoming debt ceiling debate in Q4 which was already anticipated to be contentious will now need to be evaluated under the lens of further uncertainty around Trump’s potential negotiating tactics. It would not be unreasonable to consider the threat of missed debt payments to negotiate better terms with the Democrats or perhaps even worse, threatening default on foreign-held debt obligations to secure better trade deals. As the President said in the run-up to the general election:
“I’ve borrowed knowing that you can pay back with discounts. And I’ve done very well with debt. Now of course I was swashbuckling, and it did well for me, and it was good for me and all of that. And you know debt was always sort of interesting to me. Now we’re in a different situation with a country, but I would borrow knowing that if the economy crashed you could make a deal.”[i]
US Debt default as a negotiating tactic still remains a low probability, but unfortunately it can’t be ruled out completely.
Which Administration are we getting?
Some have argued this is all part of a 3-D chess game that the President has developed over years of negotiating NYC Real Estate. This seasoned dealmaker is testing quite literally everyone by promoting chaos and tough choices in order to achieve his objectives of better trade deals, better immigration policy and lower Fed policy rates. By the President’s own measuring stick, he and his Administration are succeeding and the markets/business so far love or tolerate his tough Tweets. Perhaps the President is really just aiming for lower central bank policy rates which will allow for the recovery and the measuring stick (which the Fed seems to have adopted as well) to continue on.
As the 2020 Presidential election draws near, the evolution of the President’s agenda from Pro-growth to Unconventional Disruptor appears to mirror his intensified pivot from domestic to foreign initiatives in what can be viewed as extension of the street fighting campaign style policies. The market can only handle so much unconventional behavior before the prospective outcomes become too many and too varied to make reasonable judgments. Have the worst of November 8th, 2016 fears been realized? Perhaps not, but the recent shift has all of the elements investors feared and it is quickly becoming not worth the risk.
[i] CNBC Squawk Box Interview, May 5th, 2016 Candidate Donald Trump in response to Andrew Ross Sorkin
Investments should not be undertaken without adequate compensation for the downside risk. As fiduciaries we are lenders of our clients’ money. As such we endeavor to make prudent investments that have upside, but doesn’t unduly expose our client’s to the downside. Investors make decisions with incomplete information about the future. There is always a risk of uncertainty. How can fixed income investors navigate this risk of uncertainty? One of the factors we utilize to ensure we are compensated for risk is a bond’s credit convexity.
If interest rate convexity measures how the duration of a bond changes as the interest rate changes, then credit convexity shows how the spread duration of a bond changes as the credit spread changes.
To illustrate credit convexity a few graphs may be helpful. The first graph below shows how a non-callable security with a six year spread duration would act if credit spreads went up or down 100 basis points. With the starting price at par, the price increases 6% when spreads decrease 100 basis points. When credit spreads increase 100 basis points the price declines by 6% Compare this with a bond with negative credit convexity on the second graph shown below. This bond’s (two year call option and a six year spread duration) price would still decline 6% when spreads widen 100 basis points. But when spreads tighten 100 basis points the price increase will only be 2% instead of 6%. When spreads tighten this bond will be called and the issuer will reissue new bonds at lower spreads. This is an example of negative credit convexity.
Taking our example further, let’s look at how an investor can improve their negative credit convexity. One way to improve the unbalanced return profile is to invest in a seasoned bond with less spread duration. Below you can see that the solid line is less steep than the dotted line. Although the investor gives up some of the upside (can earn one percent instead of two percent if spreads tighten 100 basis points), the downside is half as much if spreads widen 100 basis points.
Another way to improve the unbalanced risk profile is to wait for a market event that leads to an entry point below par. If we now invest in this bond at a 94 dollar price we no longer experience negative convexity until the bond’s price returns to par. Just like in the original example the price would increase or decrease 6% when credit spreads tighten or widen by 100 basis points.
Regardless how confident investors are with their forecasts, bonds carry investment risks such as negative credit convexity. An investor needs to make sure they understand the risks, are getting paid for the risks and consider steps to mitigate those risks.