Demand and Rates

With Trump’s election, it is now seems to be “consensus” that the Federal Reserve is going to raise rates another three times in 2017.  We question this assumption.  In fact, we may have already seen the highs on the 10-year Treasury in mid-December 2016 as it breached 2.6%.1

Global growth has not changed since Trump was elected.  The Euro Zone remains a complete mess and Brexit is not going to help.  Waiting in the wings are key elections (France in particular) and these elections are likely to be won by those hostile to immigration and global trade and are firmly in the protectionist camp.  Similar to the Trump rhetoric, these politicians are playing on voter’s nostalgic and blurry memories.

Frighteningly, there appears to be some congressional support behind the notion of a “border tax.”  At first, it appeared the targets were specifically China and Mexico, but this is spreading rapidly with Trump’s recent comments in the German newspaper Bild where he targeted and threatened BMW and other German automakers with a 35% import tariff.  Ironically, BMW is one of the (if not the largest) exporters of autos from the United States.  Auto supply chains are incredibly global and complex so this type of rhetoric is not positive.  The real question remains whether this is negotiating bluster or something more tangible.  Do not forget that trade is one area where the President has real and independent authority.  Stated another way, many of these potential trade policy decisions do not require congressional approval.  If tariffs/border taxes are enacted, most will be challenged in various courts and tribunals.  But this takes time and the damage can be instant and long lasting.  So as Trump looks to make his mark early, there is little mystery as to why trade is front and center.  While this type of strong arming plays very well to a Midwest manufacturing/industrial audience, does anyone believe that protectionist policies are good for broad economic growth?  For that matter, are higher interest rates and higher energy prices stimulative or regressive for consumer spending?

Regardless of the outcomes of these issues, we do have considerable certainty on one key variable—demand.  Our portfolios are broad and eclectic.  As such, this gives us a very granular look at pricing and volumes for most major industries.  Every quarter over the past couple of years has felt like “Groundhog Day.”  Revenues down a few percent (often blamed on a strong dollar or the weather, which is our favorite because you can use good weather—people are doing other things versus shopping like going to the beach—or bad weather—they stay inside and don’t go to the mall), while EBITDA is up slightly helped by factors such as cost reductions.  While putting smart, successful business people (i.e., Wilbur Ross, Steven Mnuchin, Rex Tillerson) in charge of key government positions is a great idea, how does this change final demand for goods?  In our view it doesn’t.

The lack of demand will be a hindrance to the Fed’s ability to raise rates; we are not believers in a significantly higher interest rate environment.  The global economy is simply too weak to tolerate higher rates.  The Fed will raise rates in 2017, however, we believe any increase will be moderate and gradual.  The bond market has already anticipated and priced in at least two, 25 basis point increases in the Federal Funds rate and with any action they do take, we don’t expect the medium and long end of the curve to do anything.  To read more on our take on interest rates, the global outlook, and our investment strategy in this environment, see our recent writing “Pricing Risk and Playing Defense.”

1  10-year US Treasury yield for the period 11/8/16 to 2/17/17, source U.S. Department of Treasury.
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