Board of Scholars

Since the Election

By January 12, 2017 No Comments

It’s been said, “Elections have consequences.” The economic consequences of our most recent election are quickly becoming clear.

Following the vote in favor of now President-Elect Donald Trump investors responded with a sell-off in bonds and a rally in stocks. These financial market moves have a number of consequences.

First, investors with an undiversified portfolio felt the pain of this risky strategy. Since the financial crisis of 2008 many investors have loaded-up on bonds, moving away from traditional asset allocation strategies that keep the mix of stock and bonds relatively stable.

Since the election capital has moved from bonds to stocks. Stock mutual funds saw their largest inflow in two years and bond funds lost the most in over 3 years.[i]

The second consequence of the election is the economic outlook bond prices now predict. The US Treasury yield curve is both rising and steepening, raising expectations for both economic growth and inflation.

The yield curve is a graphical representation of the relationship between interest rates on government debt with different maturity dates. The yield (interest rate) on debt moves inversely with prices – when investors sell bonds, yields rise.

When the yield curve line moves upward for all maturities it indicates investors are selling out of bonds and moving capital to riskier assets. This suggests investors expect economic growth to improve, resulting in higher profitability for stocks and other risky assets.

The shape of the yield curve – upward sloping (long-term rates are higher than short-term rates) or downward sloping (long-term rates are lower than short-term rates) – depends on other factors. These factors can be classified into two general categories – expectations or liquidity concerns.

Expectations for future interest rates influence bond prices today. If the yield curve is currently flat – short-term rates and long-term rates are very similar – or downward sloping it is likely investors’ believe rates will be lower in the future. In this case, investors are buying more long-term bonds to capture the high current rates pushing their yield down (the yield on a bond and its price are inversely related). 

Conversely, if the yield curve is upward sloping, as we see now, investors expect future rates to rise. To capitalize on the expectation for higher interest rates investors sell long-term bonds and buy short-term bonds, respectively raising and lowering the yields on each.

A second factor that can explain the shape of the yield curve is investors’ perception of the risks of holding securities for longer periods of time. A preference for shorter term securities is called the liquidity premium and raises the relative yield on long-term securities. When the preference for short-term bonds becomes greater, investors sell current long-term securities and buy short-term securities, respectively raising and lowering the yields on each.

Since the election the yield curve has steepened slightly, but the slope is still smaller than it was at this time last year. The move upward for the whole yield curve and a still small slope suggests the second factor, liquidity concerns, may be declining. Therefore, the yield curve currently supports a better outlook for growth and profitability.

As always, we have to be cautious with financial indicators. The yield curve is not a perfect predictor of future economic conditions, and the Federal Reserve may be artificially holding this indicator down by continuing its bond buying programs. Nonetheless, the economic outlook has improved since the election.

 

What could go wrong?

Business investment, a necessary component of long-term economic growth is still weak and may not improve. Policymakers will need to use the election results as motivation for improving business conditions. Two key policy changes would help – tax reform and fiscal constraint.

Businesses want tax reform and less regulation. The current reliance on high corporate and personal income taxes distorts incentives and creates unnecessary administrative burdens. Small business owners facing higher individual income tax rates and more government oversight are discouraged from investing in their firms. Multinational corporations are keeping more of their earnings overseas to avoid the higher tax rates and additional regulations here.

Second, stimulus spending is unnecessary and counterproductive. Some economists claim the slow economic growth of late requires greater government spending. But the data on gross domestic consumption (GDP) does not support this contention. The biggest component of GDP, personal consumption expenditures, continues to grow and unemployment is at normal levels. Apparently, consumers don’t need the help.

More fiscal spending is just another tax. Economic theory and historical experience show that when people foresee that taxes will have to be raised to offset the future payments of principal and interest on new government debt, then today’s borrowing to finance new spending is equivalent to a tax. That is, there is no real difference between the government taxing its citizens or borrowing to finance its spending.

Financial market action since the election suggests the consequences of this election may be positive, but this could end up being just a short-term bump. The consequences of previous policy failures have yet to be corrected.

The views expressed here are those solely of the author and do not represent Northwest Nazarene University or Rathbone Warwick Investment Management.

Peter R. Crabb, Ph.D.

Peter R. Crabb, Ph.D.

Professor of Finance and Economics

Department of Business and Economics

School of Business, Northwest Nazarene University

[email protected]

 

Dr. Crabb holds a Ph.D. in Economics from the University of Oregon and an MBA in Finance from the University of Colorado. His research in economics and finance is published in the Journal of Business, the Journal of Microfinance, and the International Review of Economics and Finance, among others. Dr. Crabb lives with his wife, Ann, and their four children in Canyon County, Idaho.

Dr. Crabb’s regular Financial Economics column is published by the Idaho Statesman. Previous work experience includes international trade, banking, and investments.

 

[i] http://www.cnbc.com/2016/11/18/the-trump-trade-week-1-a-violent-rotation-with-a-bond-bloodbath.html