Can Inflation be Trumped?

Last week we had two clear signals around the economics of the United States. First, we had President Trump and the Republican Party winning the Presidency, taking a majority in the Senate and what looks like a majority in the House of Representatives. Second, we had Jerome Powell, Chairman of the Federal Reserve announce another interest rate reduction.

Economic policy can be divided into two camps, fiscal and monetary. Fiscal policy, set by the government, is focused on where a government will spend and how this will be financed (government expenditures and revenues). Monetary policy, set by the central bank (Federal Reserve in the case of the U.S.) determines the money supply and the price of money (interest rates).

Inflation is an incredibly important force in economics, with very important market consequences. Inflation erodes consumer’s purchasing power, indicates whether economic growth is too hot and for central bankers it’s the important determinant in interest rate policy. Interest rate policy determines the cost of money in an economy which has implications across the valuation of all asset classes. Therefore, understanding inflation drivers and dynamics, helps understand markets.

Inflation Inducing Policy

The markets entered the U.S. Presidential Election looking for a clear answer. As we all awoke on Wednesday morning, it was clear we had that. President Trump had not only secured the White House, but the Republican Party had also secured both the House of Representatives and the Senate. President Trump now has a clear path to enact change and enforce policies aligned with his goals.

There remains a great deal of uncertainty around how President Trump will act, what his alliance with Elon Musk will bring and how the markets will react. Trump’s key campaign points included reduced immigration, combatting inflation and protecting U.S trade. Are these achievable at the same time? In fact, both the expected trade controls, including substantial tariffs on imports, alongside reduced immigration, are inflationary forces.

Several of the policies that Trump would like to enact have embedded inflationary forces but the main two are immigration and tariffs:

• Immigration – immigrants usually have less transferrable skills and therefore are on the lower end of the wage spectrum. Limiting immigration reduces the available low-income workforce, which has inflationary impacts
• Tariffs – President Trump has made it very clear that he intends to add tariffs to global trade partners of the U.S. This protectionist move has an initial inflationary impact as consumers are faced with either buying less competitive domestic products or buying imports with the tariffs included

Fiscal Responsibility and Treasury Bonds

The most vicious market action on the back of the election news was felt within the U.S. Treasury bond market. The U.S. yield curve is the most important factor to understand in terms of the time value of money, therefore the valuation of most assets. When the 30-year U.S. Treasury prices move down 2% in a day, it sends a dramatic signal to the market. The market is saying that the price of money over the next 30 years just became 0.2% more expensive per year.

Why did the bond market send a clear signal with higher yields when the likely path for the short term are rate cuts by the Federal Reserve? Simply put, the bond market is saying that they don’t expect to see much fiscal prudence and therefore increased indebtedness of the nation. The chart below shows the interest expense the Federal government is facing. Not only has the total indebtedness of the country been increasing, but as interest rates remain high, the interest expense has compounded the issue.

Increased fiscal deficits (driven by tax cuts) will require additional government debt issuance. With demand for Treasury bonds (both domestically and internationally) reduced, any increase or perceived increase is likely to lead to higher yields and lower prices. Secondly, the market priced in higher inflation expectations post the Trump victory, indicating that the bond market expects Trump to be an inflationary force.

If the Federal Reserve is reducing interest rates at the short end of the curve, while yields on longer dated bonds are increasing, then we should exhibit a steepening yield curve. In effect bond owners are demanding a larger term premium to lend funds to the U.S. Treasury.

Powell’s Fight

Chairman Powell of the Federal Reserve, the nation’s bank, is responsible for setting policy interest rates. Under Trump’s first term, there was clear tension between the two and that is likely to exist come January. Powell has two years left on his term as the Chairman and it would be very unlikely that President Trump would offer him another term. That leaves Powell in a difficult position. Does he stay in the seat and face immense pressure from the executive branch to cut rates and cut them quickly or does he declare victory on inflation and step away from the role early?
In his press conference this week, Powell made it relatively clear that politics will not interfere with Fed policy. However, if President Trump creates too much inflation, will Powell have the fortitude to raise interest rates?

The Greenback and Competitiveness

President Trump has made it clear that he would prefer a weaker U.S. Dollar, therefore increasing the competitive position of U.S. exports. The large interest rate differential between the U.S. and other developed and developing nations has led to the strong performance of the U.S. Dollar relative to trading partners. Any reduction in the competitiveness of the U.S. Dollar will add to inflation through more expensive imports.

Since the financial crisis, the U.S. Dollar has increased approximately 40% versus its trading peers. The DXY Index, shown in the chart from CNBC below, is a measure of the U.S. Dollar on a trade weighted basis against trading peers. If the U.S. Dollar has increased 40% versus trading peers, then over the last 15 years imports have become 40% cheaper while exports have become 40% more expensive. President Trump is focused on reversing this trend and making the U.S. more competitive on a trade basis.

The most certain way to make U.S. Dollars less attractive, is to reduce the relative different in interest rates. However, for this to be achieved there must be clarity that inflation is under control. Either way, we are likely to see rate cuts at the next few Federal Reserve meetings. Given that inflation in the U.S. has been getting under control, Powell has the cover to cut rates in the short term (as he did this week).

How to position from here?

As active managers, we prefer periods of high dispersion, with winners and losers across sectors, geographies and styles. A second Trump lead administration and their policies are likely to create such dispersion and therefore a wider opportunity set for active management.

Here are where we see some opportunities and risks:

• Although interest rates may decline in the short term, we expect inflationary pressures will resurface, forcing the Fed to either maintain higher interest rates or hike again. We believe that this makes fixed income opportunities that are floating rate in nature more attractive than fixed coupon
• Under an inflationary backdrop, we prefer to own real assets such as commodities, real estate, infrastructure and gold. Each of these participates differently in an inflationary backdrop, but we like the purchasing power protection these assets bring to client portfolios
• Reduced regulation across various industries will bring relative winners and losers. The promise of lower regulation was embraced by the markets with financials, a sector that has suffered from stringent regulation since the 2008 financial crisis. Other areas such as healthcare also look attractive with a less regulated backdrop
• Within equities, we expect to see more breadth across the winners and losers. We have been in a narrow equity market rally for 2 years, but these policies are likely to have broader applications, while generally supportive of equity markets
• Emerging markets face both challenges and opportunities from these changes. If the U.S. Dollar remains strong (as it would with relatively high interest rates in the U.S.) then these countries will be challenged on their fiscal budgets. Many of these countries borrow in U.S. Dollars and therefore a strong dollar increases their cost of funding. Many emerging markets will also be relative losers from tariffs, making their exports less attractive to the U.S. However, these dynamics seem to be baked into prices, making some attractive asymmetric opportunities from any relative strength

We expect that the new President and his policies will be inflationary. The next 2 years will be fascinating to watch the battle between fiscal and monetary policy. Will the two forces be fighting each other? We think we will face a stronger backdrop for top-down asset allocation, increased rewards from bottom-up active management and greater benefits from the diversification of return drivers.

My very best,

About Grayhawk

As a Chief Investment Office, Grayhawk Investment Strategies Inc. (“Grayhawk Wealth”) (“Grayhawk”) works with successful Canadian families to provide personalized investment management services, curated to help position them to achieve their wealth goals and accelerate their impact.

Grayhawk Wealth has offices in Toronto, Calgary and Montreal and is registered as a Portfolio Manager and Exempt Market Dealer in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Québec and Saskatchewan and as an Investment Fund Manager in Alberta, Ontario and Québec.

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