‘Dude, Where’s My Drone?’ and Other Potential Threats to Trump Rally

Foreign policy challenges could interrupt the equity rally and renew the appeal of bonds as a safe haven in an uncertain world.

Some Strategies for Income-Oriented Investing
Bonds, though perhaps not that appealing on the surface today, do offer a hedge against downside economic risks. In a rising interest rate environment, some segments of the bond market are more attractive than others. Given uncertainty about the pace of interest rate increases and the possibility that rates could reverse during periods of geopolitical stress, a diversified approach is desirable. So below are some observations on different bond classes.

Government bonds: U.S. government bonds offer higher yields and a better value than was the case earlier in 2016, with the two-year Treasury above 1.2% and the 10-year Treasury at approximately 2.5%.  Shorter-duration government bonds are less vulnerable to a rise in rates, so risk-conscious investors may want to emphasize shorter-term bonds until there is more clarity about economic and policy momentum.   Some global bond investors are saying, "Buy bonds, not bunds," as German and most Euro-area government bonds don't appear to offer much value relative to U.S. government bonds.   

Municipal bonds: Municipal bonds, an important but typically sleepy corner of the bond market, are at the center of feverish speculation. Rising interest rates have been a factor in the muni selloff, but speculation about tax reform is also a factor.  A fall in the highest personal tax rate would reduce the attractiveness of municipals relative to taxable bonds, but the market reaction to that possibility seems excessive. The greater risk for municipals, and probably the more significant factor in the recent sell-off, is the potential for tax reform that significantly reduces the tax rate for taxable bond interest and could dramatically change the competitive landscape for municipal bonds.

Investment-grade bonds: Corporate bonds are vulnerable to rising rates, though many large companies locked in long-term borrowing at low interest rates. Corporate spreads are low while balance sheet fundamentals are deteriorating, which usually isn't a good combination for investment-grade bond returns!  However, the search for yield by savers starved for income may prop up the valuations of investment-grade bonds in 2017.

High-yield bonds: High yield is helped by a strong economy, and offers a meaningful return premium relative to government bonds. Volatility in high yield is closer to equities than to investment-grade bonds, and default rates are quietly rising.  Selectivity is very important, particularly given the uncertain environment expected in 2017.

Emerging markets bonds: Selectivity is also very important for advisors considering emerging market debt. Countries with a high proportion of U.S. dollar debt relative to GDP, such as Malaysia and Indonesia, may be vulnerable if the dollar continues to appreciate in 2017. Fundamentals in the emerging markets universe appear disconnected from the bond market, as emerging markets debt spreads haven't widened alongside the increase in developed market interest rates. 

Bond proxies:  Dividend-paying stocks offer the appeal of income and growth, though the reach for yield into utilities and telecommunications stocks may not pay off in 2017.  In a growth-oriented environment, the market may favor dividend-growth oriented companies that can grow revenues and earnings when inflation drives interest rates higher. 

Changes to the market outlook are likely to be driven by a few key economic and geopolitical considerations, including tax and spending initiatives, trade policy, immigration changes, and global geopolitical developments. The euphoria of the recent equity rally may fade as Trump faces the limitations of presidential power, and uncertainty builds about the specifics of his governing priorities and ability to implement policy. Likewise, the bond slump may slow, as yields rise more gradually if economic growth is less robust than hoped and geopolitical events disrupt the path forward.

Disclosures

Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.

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