The behavior of markets so far this year may seem to be at odds with the notion that political uncertainty is both rising and increasingly relevant. Record-low equity volatility, rates that are moving sideways, and the narrow range in which investment-grade credit spreads have been trading are factors that would normally suggest a benign outlook. But looks can be deceiving. Too much uncertainty can also create paralysis among investors. Markets may be balanced precariously, even if they are trading as if all were well. One need look no further than the U.S. interest rate environment to see the policy knife-edge at play.
When considering how an administration’s proposals will affect markets, the question is as much about how companies and consumers will respond to the possible changes as it is about the exact policy details. Since President Trump took office, confidence indicators have moved sharply higher, into territory that would typically suggest increased spending by businesses and consumers. Yet after years of disappointingly weak business investment and rising consumer savings, most investors and economists are taking a wait-and-see approach.
For corporate bond valuations, the binary nature of tax reform is playing havoc with return forecasts that rely on assumptions about supply versus demand. The U.S. investment-grade corporate bond market expanded by 8 percent, or $650 billion, in 2016. If the growth of the market were to slow to between 1 percent and 2 percent, as could easily happen, the spread with which corporate bonds trade relative to Treasuries would likely narrow considerably, all else equal. Demand for corporate bonds would simply overwhelm supply. On the other hand, if efforts to reform the corporate tax code were unsuccessful or temporary (as were the Bush tax cuts), corporate leverage likely would remain elevated, the advanced age of the business cycle would continue to be a concern, and valuations would tend to appear more stretched over time.
If a significant number of corporate plan sponsors adopt this strategy, and if they’re focused on reducing funded-status volatility, they may cause a spike in the future demand for high-quality fixed income assets. In fact, a number of plans have already utilized this strategy in advance of tax reform, including Delta Airlines, Verizon, and FedEx, to name a few. We anticipate that once there is further clarity on the tax reform package, this demand may continue to grow.
It’s also worth noting that in the low-interest-rate environment of the past several years, the credit spread curve has been steep, which means that an investor gains a considerably higher incremental yield on a longer-maturity bond than on a shorter-maturity bond. In a rising-rate environment, investors may see this credit spread flatten. We have begun to witness this phenomenon in the banking sector. In addition, in the longer term, if interest deductibility is removed from the U.S. tax code and if future corporate bond issuance declines relative to the current pace, the lower supply of corporate bonds would likely result in lower long-term average corporate spreads. Both of these prospective changes in the market might make today’s corporate bond spreads considerably more attractive than a future state with much lower spreads.