The Positive

Since late 2016 the US Federal Reserve has increased interest rates (Fed Funds Rate) from 0.25% to 2% currently. Furthermore, it is expected that a further 3 rate hikes are on the horizon, one per quarter for the next 3 quarters. These increases are fuelled by encouraging Gross Domestic Product (GDP) figures in the US and in general worldwide, as the majority of the world economies have been expanding on the back of a long period of low interest rates and other stimulus measures. In turn, the increase in growth has brought about an increase in the general price level (inflation rate) which is one of the main focus points of central banks as they aim to keep this figure in check. Expectations of increases in consumer spending and wage growth are also very encouraging which would continue to fuel the case for expansion in the US.

The Negative

On the downside however, we are all aware of the famous trade wars whereby since his election to office, President Trump has been on a mission to get better deals for the US with all its trading partners and has not been afraid to make his intentions clear…at least through his twitter tweets. A trade war is seen as a lose-lose situation since it would normally end up with both parties suffering from tariffs and other trade-limiting measures and fees. If we look at the current situation we have the NAFTA (North American Free Trade Agreement) which is an agreement between the US, Canada and Mexico – negotiations have been ongoing for years and there are even rumours that the US could get into negotiations with Mexico and exclude Canada. Between the EU and the US there are mounting tensions with respect to Aluminium and Steel tariffs and the ongoing saga with Auto tariffs. Auto exports are important for both economic blocks, so it would have a direct effect on both sides of the Atlantic. Then of course we have the ongoing China-US trade debacle. Considering that so many US companies are connected to China (For example Apple’s IPhone is assembled in China) these tariffs have multiple implications for both sides.

Possibility of a Turn-Around?

Another major issue with the US is that the spreads between the 2-Year government bond and the 10-Year government bond has narrowed considerably. Put simply, the difference in the yield of holding the 2-Year US Government bond and the 10-Year US Government bond is very low. Taking current readings, we see 2.641% vs 2.936% for the 2 and 10 year, respectively. That is a spread of just 0.295 percentage points. This has two major implications. One is that the market is not expecting much more interest rate increases following the expected 3 rate hikes over the next year or so. The second is that there is a chance of experiencing an inverted yield curve[1]. The Chart below shows the 10-Year vs 2-Year spread and the GDP figures over a 40-year period from 1978 till 2018.

Source: Macrobond, ING

From the Chart it is easy to see that each time that spread turned negative, meaning that the yield on the 2-Year bond was higher than the yield on the 10-year bond, GDP took a hit. Thus, should we in fact experience an inverted yield curve one would expect a fall in the US economic figures and a potential recession.

Trading Ideas

Given all the above, what are potential ways of trading the markets? One interesting fact is that increases in interest rates are expected to be limited to a further 0.5-1% in the coming year. This means that although interest rates are expected to go up further which is a bad thing for US Bonds, they are only expected to increase by a small amount and then stop increasing – which is a good thing for US Bonds. Thus, it could be an opportune time to look into US bonds at the moment. For example, one can find US Investment Grade bonds such as bonds issued by AA-Rated Apple which have a 4-year maturity yielding over 3%. If we look at high yield bonds (those rated BB or lower and thus representing the higher risk of the spectrum), taking the PIMCO US High Yield Bond Fund as a reference, the current yield is at just over 6%.

On the equities side, taking the iShares Core S&P 500 ETF as a point of reference the return has been 120% over the last 10 years representing an annual average return of 12% per annum. There have been some small corrections over the 10-year period, however the overall direction has been steadily trending upwards. If things keep going well for US companies, we would expect the S&P 500 to keep trending upwards. However, there could be some corrections on the horizon, especially from the many companies that could easily be affected by the trade wars. Thus, an interesting play would be to buy into such a broad index with part of the money available for investment. This would leave some spare funds available to re-invest should a downward correction actually come along.

What is normally suggested for most investors who do not have the time or expertise to research individual companies is to buy through a collective investment scheme such as traditional mutual funds and Exchange Trade Funds (ETFs). This would leverage the expertise of fund managers if one is looking for an actively managed fund that seeks to find the best opportunities within the investment objective it is tied to. An ETF would typically be more of a passive investment which would replicate something else. In reality this may be more worthwhile than other actively managed funds, especially on the equities side.

The Bottom Line

The post has argued why I am currently still interest in the US market while at the same time pointing out the main drawbacks. I am still bullish however that the markets in the US could generate good medium to long term returns. It may be a bumpy ride in the short term, however the positive outweighs the negative in my eyes and I am still happy to have an exposure to these markets.

Should my opinion be correct and the US markets do continue to do well, this could lead to problems in the emerging market bond sphere. This is due to two main reasons, the first is that positive US markets could easily lead to a stronger US Dollar. A stronger US Dollar would mean higher costs for emerging market economies since they tend to issue a number of bonds denominated in US Dollars which would become more expensive to service and maintain should the US Dollar go up in value. The second is that the extra yield for holding the riskier emerging market bonds will continue to fall, giving less return for the risk taken.

[1] The yield curve is a curve that shows the yields on several bonds of different maturities.

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