Trump will burst the bond bubble

After months of bluster, the administration finally appears on the verge of passing a significant piece of legislation that could affect the bond market.

874-D.Trump-634
The bluster is over and tax cuts are on the cards but will it boost stocks?

"The chance to slash the US corporate tax rate to 20% from 35% seems much more pleasant to contemplate than nuclear war," says Randall Forsyth in Barron's. So it's no wonder Wall Street decided to ignore North Korea's latest, more powerful missile and concentrate on the package of tax cuts and reforms produced by the US Senate last Saturday. After months of bluster, the administration finally appears on the verge of passing a significant piece of legislation.

The key elements of the package are the corporate tax cut, a discounted tax rate on foreign profits to encourage firms to bring their overseas cash piles home, and the closure of several loopholes. The bill still needs to be reconciled with the version proposed by the House of Representatives, which should occur by Christmas. The package will add yet more debt to America's fast-growing pile: another $1 trillion or so over ten years.

The tax package could give stocks additional momentum, although given the endless discussion of the topic over the past year, the odds are that most of the boost is priced into America's now extremely expensive equities. UBS Wealth Management is pencilling in a $10 per share boost to S&P 500 profits, so the index's constituents will earn a total of $151 per share in 2018 rather than $141.

Still, earnings have rebounded strongly in any case following a dip in 2015-16, and half the sales of the index's constituents are made abroad, so the global outlook is just as important as the US one. And while Bank of America Merrill Lynch expects a boost to US growth of 0.3% in 2018 owing to the tax bill, the world economy "is growing robustly, and in unison, for the first time since the financial crisis", as Rob Cox notes on Breakingviews.

The effect on bonds, however, could be far more significant. This package comes as the economy "is already at or close to capacity", says Hamish McRae in The Independent. Growth reached an annualised 3.3% in the third quarter, and the labour market is very tight. Adding fuel to the fire now could lead to a nasty jump in inflation. That would be a shock to absurdly overpriced bonds, especially since everyone thinks inflation has disappeared and central bankers almost always fall behind the curve.

We were in exactly this situation in the 1960s, adds John Plender in the Financial Times, with inflation apparently vanquished, the labour market tight, and fiscal and monetary policy extremely loose. Inflation had reached 6% by 1970. Today, long-term interest rates are already creeping up as the growth outlook has improved. But this tax package "will definitively put an end" to the 36-year Treasury bull market.

Recommended

Bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
Beware: inflation is starting to stir in the US
Inflation

Beware: inflation is starting to stir in the US

With US consumer prices up by 1.4% in the last year, concern about inflation is now everywhere.
22 Jan 2021
Why bonds may not be the safe haven they once were
Investment strategy

Why bonds may not be the safe haven they once were

“De-risking” by shifting your portfolio into bonds used to make sense. But not so much any more, says Merryn Somerset Webb. So what should you do inst…
21 Jan 2021
Inflation looks likely to take off this year – but there’s one key risk
Inflation

Inflation looks likely to take off this year – but there’s one key risk

With the world’s governments spending money hand over fist, inflation looks certain to take off at some point. But China could change all that. John S…
19 Jan 2021

Most Popular

Why we won’t see a house-price crash in 2021
House prices

Why we won’t see a house-price crash in 2021

Lockdown sent house prices berserk as cooped up home-workers fled for bigger properties in the country. And while they won’t rise quite as much this y…
18 Jan 2021
The world’s fund managers are getting very bullish – be careful out there
Stockmarkets

The world’s fund managers are getting very bullish – be careful out there

The latest survey of fund managers shows them to be extremely bullish on all the same things. And that, says John Stepek, means the market is in dange…
21 Jan 2021
Prepare for the end of the epic bubble in US stocks
US stockmarkets

Prepare for the end of the epic bubble in US stocks

US stocks are as expensive as they’ve ever been. How can you prepare your portfolio for a bubble bursting?
18 Jan 2021