|Forbes.com, Winter, 2016. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
The rally in the stock market has gotten a lot of attention in the financial media, but what’s more interesting to me, and arguably more telling for the economy going forward in a Trump administration, is what’s been happening in the bond market.
On Wednesday and Thursday after the election—November 9 and 10—the Barclays Aggregate U.S. Bond Index dropped 1.20% and the Barclays Global Bond Index dropped 1.67% (U.S. bond markets were closed on Friday the 11th for Veterans Day. That trend of falling bond prices has only continued more than 2 weeks removed from the election.
If you had asked many investors how bonds would perform after a Trump win, they probably would have expect bond prices to rise significantly. After all, it certainly appeared that was the direction we were heading on election night when stock futures were dropping like a stone. Bonds have historically risen in times of great uncertainty, and I think people on both sides of the political aisle can agree that there is a lot of uncertainty surrounding President-elect Trump.
We’re currently in the midst of a great deal of political uncertainty, both domestically and abroad, so why have bond prices fallen?
Higher Bond Yields Points to Higher Inflation
The reason, I believe, for this drop in bond prices is tied to the market anticipating inflation. With the bond market expecting future inflation to rise, investors are demanding higher bond yields, which is causing bond prices to fall. This makes sense: If inflation rises, the value of a dollar in the future is going to erode more quickly. In order to better preserve the value of those future dollars, fixed-rate bond yields must increase today so that bond holders’ income is better insulated from that inflation.
This poses an obvious question: Why does the bond market expect future inflation to increase?
The answer is that economic growth is likely going to increase during Mr. Trump’s presidency. Consider some of the policies he’s advocating: He wants to spend $1 trillion on infrastructure. He wants to lower corporate and personal tax rates. He wants to deregulate many sectors of the economy. All of these things are viewed as stimulus with the potential to accelerate economic growth. With the GOP in control of Congress, there’s a high likelihood that many of these proposals will be enacted into law. When there’s higher economic growth, as the bond market is predicting, that has a tendency to lead to higher inflation.
I know many investors and consumers consider inflation a dirty word. After all, we’re all tired of paying more for the same product, whether it’s for a gallon of gasoline or tuition for higher education. Additionally, many Americans had a front row seat to the high inflation of the 70s and early 80s, so it is understandable that there is a negative connotation connected to inflation.
The reality is that a small amount of inflation is beneficial to the current economic system, as annual income increases and movements in prices allow for adjustments that don’t throw the entire economic system off course. And inflation is far superior to the dangers connected to deflation.
The real fear should lie with high inflation and the acidic effects it has on an economy. As inflation outpaces conservative investments, risk-sensitive investors lose purchasing power and reduce their consumption, thus causing twin economic headwinds. When this occurs, economic growth shifts from good growth that enhances society’s standard of living, to growth driven by uncertainty.
Having said that, it’s important to remember we are a long way from entering an environment with high inflation. It’s the fear that a moderate amount of inflation could morph into high inflation that’s making some investors skittish.
Historically, the bond market has been a more accurate predictor of future economic results than the stock market has been. So when the bond market makes a move like this, prudent investors should take notice and analyze whether the movement is just noise or points to a potential fundamental shift.
In this instance, while it is still too early to understand all of ramifications of President-elect Trump’s policies, the data appears to indicate faster economic growth is on the horizon and, ultimately, higher inflation as well.