During the final quarter of 2016, U.S. financial services stocks reacted the most favorably to news that Donald Trump would become president. The Morningstar Financial Services Sector Index has risen 20% quarter to date. While financial services was one of our most undervalued sectors at the time of our last quarterly update. The market has incorporated expectations for stimulus, higher inflation (from stimulating an economy already close to full employment), and higher interest rates (from higher budget deficits and inflation).
The interest rate environment is likely to remain a key focus for financial stock investors in 2017. In the weeks following the U.S. presidential election, the yield on U.S. 10-year Treasuries rose by approximately 50 basis points as investors reassessed their outlook for the country's economic prospects. The Federal Reserve also raised its target for the Federal funds rate for the second time since the financial crisis (by 25 basis points to 0.50%-0.75%), and the members of the Federal Open Market Committee took a slightly more hawkish stance toward future actions.
However, a deeper look at current conditions produces a little more cause for caution. Investors' attentions are often focused on Fed actions, missing the larger picture. The Fed sets short-term rate targets in the near term, but its actions are effectively responses to changes in an unobservable real interest rate. If the Fed's policies are too loose relative to the true equilibrium rate, inflation results. If the Fed is too conservative, unemployment rises. Only in the short run can the Fed change the rate environment--bigger macroeconomic factors are at play in the long run.
It's also important to note that rates themselves are made up of building blocks. The first block is the real interest rate--the true economic return after inflation. On top of that, inflation expectations are added. Finally, a term premium--the extra return needed to hold long duration securities--typically results in an upward-sloping yield curve. Of these building blocks, we believe the market is currently focused on inflation. Five-year forward inflation expectations have jumped by nearly 20 basis points since the election. With this volatility came a 30-basis-point increase in the New York Fed's term premium estimates.
We think the change in inflation expectations may be a result of three factors. First is the likelihood of increased infrastructure spending--a plan favored by both parties. Second is an increasingly protectionist attitude toward trade. The U.S. has been importing deflation from low-cost countries, a trend likely to reverse over time. Third may be the prospects for tax cuts and the potential impact of a higher resulting debt burden.
Increased spending on roads and bridges should both stimulate growth and create high-paying jobs for an important segment of the population--a relative lack of construction jobs has been somewhat problematic since the housing bust. Thus, some upward wage pressure could result. As products are increasingly required or encouraged to be produced domestically, consumer prices could rise considerably. A "Made in the U.S.A." label is typically accompanied by higher labor costs. Higher levels of debt resulting from a looser fiscal policy--taxes are likely to be cut under the new administration, while spending cuts could be slower to materialize--are also inflationary.
The Federal Reserve seems to agree that the real equilibrium interest rate is still quite low by historical standards. We think the underlying factors producing low interest rates--advances in technology, demographic trends, and the state of the global leverage cycle--will result in a gradual normalization rather than a quick return to historical norms.
We hypothesize that these factors will determine the future course of interest rates:
First, the "new economy" characterized by globalization and technological advancement (automation) will have long-lasting effects on the balance of savings and investment and will continue to exert an effect on the demand for capital and labor for years to come. Thus, a lower rate is needed to ensure full employment and robust capital investment and inflation pressures will be reduced.
Second, demographic changes--primarily an aging and longer-lived global population--will eventually reduce the savings glut produced by rapid growth of the working-age population in recent decades and result in higher healthcare spending by older generations, offset by potentially lower consumption in other areas. The rise of the millennial generation in the U.S. will also contribute to economic growth. As millennials--the largest generation in U.S. history--begin to enter their 30s, we expect household formation and home purchase activity to accelerate dramatically. A healthy labor market should only add fuel to the fire.
Finally, the state of the credit cycle will weigh on consumer and corporate behavior, as well. The U.S. population is beginning to borrow again--though credit growth is likely to be subdued relative to the expansion that occurred from World War II to 2008. Furthermore, other major economies--Western Europe and China, for instance--are unlikely to experience a near-term rebound in credit demand. On balance, these trends should result in slow upward movements in rates, but we expect a multi-year normalization process.
