Last Friday’s inauguration of our country’s 45th president went smoothly—on the dais. Outside the mall in Washington D.C. and around the country, there were those who were exercising their First Amendment right to protest. The transition of political power will likely be more contentious, given the parties’ differences. The stock and bond markets are undergoing a transition of their own.
While the stock market’s initial reaction to Trump’s election was negative (for hours only, in overnight trading), enthusiasm over an easier regulatory environment and a reduction in corporate taxes quickly lifted equity prices. Stocks also benefitted from a continuation of positive economic surprises throughout November and December. However, since that initial enthusiasm, the markets are transitioning to a “show-me” period.
One of the largest beneficiaries of the market rally was financial stocks. The exchange-traded fund (ETF) that follows regional bank stocks is an example. These banks are smaller than the global behemoths like JP Morgan, Citi and Goldman Sachs and may benefit more from the change in fiscal policies and regulation. The chart below shows the performance of the index ETF from the end of October through last Friday. Through the first week of December, the stocks in this index returned 30%. Since then, they’ve traded down, yet still remain 24% higher.
So why the waning enthusiasm? Two reasons, really. First, interest rates continued to rise after the election as bond investors anticipated a lift in economic activity and inflation due to the new policies. Higher interest rates are good for bank profits. As Congress got back to work in early January, the usual political wrangling caused bond yields to decline by about .2% and so the benefit for banks was smaller. Also, it remains unclear how quickly new policies will be implemented, which has slightly dampened the initial enthusiasm stock investors were feeling. The transition from promise to policy will likely continue to create market volatility.
The Fed’s Transition
The Federal Reserve, our U.S. central banker, responsible for setting short-term interest rates, raised rates in December of last year. This was done at a time when economic data was continuing to improve and inflation was moving toward its target level of 2%. The combination of this move and the election accelerated the sell-off in bond prices, raising yields. The Fed’s transition from easy money and low interest rates to a more “normalized” environment won’t be smooth.
Many bond investors pointed to the Fed’s statement in December that it anticipates raising rates two to three times in 2017, and the market priced those hikes accordingly. However, keep in mind that the Fed proposed more hikes in 2016 and only raised rates once. Its actions are dependent upon the actual performance of the economy and the pace at which inflation rises.
One reason to be careful about translating the recent rise in inflation forward through this year has to do with the effect that energy prices have had on inflation. Last week, the Consumer Price Index (CPI) data was released. The index rose .3% in December and 2.1% for the prior 12 months, just slightly above the Fed’s target (it uses the personal consumptions expenditure index as its preferred measure, which sometimes differs from the CPI measure).
Remember, oil prices averaged $35 per barrel in December of 2015 and then declined to near $25 per barrel during the first quarter last year. With prices near $52 per barrel now, year-over-year energy price inflation will accelerate until we get to the middle of this year.
As you can see in the chart below, the price of oil was near $50 by June of last year. This means that by June of this year, the price increase will be near 0% if oil prices remain stable. The contribution to annual inflation could be substantially less and inflation could begin to decelerate mid-year.
Bond investors will be watching inflation measures for signs of acceleration. The transitory nature of energy price inflation may provide an offset to inflation that could come from heightened economic activity due to new fiscal policies. However, it seems more likely that those policy benefits will come in 2018, suggesting that bond yields may remain more stable than investors currently anticipate.
Time will tell. The new administration promises that the pace of change will come quickly. It seems that markets will have as difficult a time interpreting the new pace of play as the press may. If the administration gets cooperation from Congress to implement changes as swiftly as it would like, the transition to a faster growth economy could be quicker, raising prices for stocks and yields for bonds.