Will Political Uncertainty Affect Bonds And Equities?
Cumberland Advisors | May 15, 2017 10:14AM ET
President Trump’s firing of FBI Director James Comey sent a shot across Washington’s bow last week. Republicans and Democrats alike questioned the timing of the action and professed unease with the firing. Where the fallout from this episode ends up is open to speculation. Whether Congress creates an independent committee and/or appoints a special prosecutor to investigate the firing action remains to be seen. What is clear is that the White House was caught off guard by the reaction to the firing.
Here at Cumberland we are concerned with financial markets. And our concern is whether Congressional preoccupation with the firing and its aftermath will affect the reforms that have already been proposed and partially passed. Will there now be a Republican delay with regard to health care? Will there be a delay on tax reform? In other words, does UNCERTAINTY about forward movement in the administration’s program start to affect the financial markets and the market’s view of the potential for reforms that have been a significant force in both the equity and bond markets since the election?
The firing of Director Comey reminds many of us of the events of the Watergate crisis that enveloped the country from 1972–1975 and brought down the presidency of Richard Nixon. The fact the firing happened at night had a decided Nixonian quality to it. We decided to look back to that period and review market performance then.
The chart below is the Dow Jones Industrial Average from 1972 to March 1975.
A quick history note. The break-in at the Democratic National Committee offices in the Watergate Hotel occurred in June of 1972. President Nixon was re-elected in November 1972, in spite of media reports of a cover-up of illegal operations. By 1973 the scandal had escalated. The Senate established a committee to investigate, and the Justice Department appointed a special prosecutor. In fall of 1973 the special prosecutor was fired on a Saturday night (known as “the Saturday Night Massacre”). In 1974 a number of administration officials were charged with crimes relating to Watergate and the cover-up, and President Nixon resigned in August 1974, succeeded by Vice-President Gerald Ford.
The Dow, for the most part, languished along a downward path from the 1972 election to Nixon’s resignation, with some respite in 1973. To be sure, many other factors contributed to the market’s decline. The Yom Kippur War between Israel and Egypt/Syria in the fall of 1973 hastened the 1970s oil crisis when OPEC declared an embargo that raised the posted price of oil from $3.00 a barrel to approximately $12 by spring of 1974. This was most Americans’ first experience with long gas lines and high prices for fuel and served as a backdrop for the continued erosion of the stock market. The Dow experienced a relief rally after Gerald Ford assumed the presidency in August 1974, but that rally just brought the Dow back near its November 1972 re-election high.
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The bond market was not spared problems, either. The graph below shows the yield of the US government 10-year bond (white line with shading beneath; right axis) and CORE inflation (light orange line; left axis) during the same period.
It is very clear from this graph that inflation EXPECTATIONS were rising rapidly during most of the Watergate period, with bond yields substantially above core inflation. The Federal Reserve did not help in the process as their response to increasing oil prices and the war in the Middle East was to RAISE the short term Fed Funds rate from 5.50 to over 10 percent. The rise in the 10-year Treasury yield from roughly 6% to 8% would equate to a rise in today’s yield from 2.4% to approximately 3.2%. This rise in yield was undoubtedly the result of expectations of future inflation due to the oil shock. We now have a Federal Reserve which is much more conscious of the ramifications of their actions and who will be raising short term rates, but at a slow pace. See my colleague David Kotok’s piece on the Federal Reserve and management of its balance sheet.
Below is a graph comparing CORE inflation (excludes food and energy – light orange line) and headline inflation (includes food and energy during the 1972-1975 period. – white line with shading beneath).
Certainly the backdrop of war in the Mideast, the rapid increase in oil prices, and accompanying inflation were strong factors that depressed markets. But markets in those days were significantly concerned by an administration unable to address its policy agenda, bogged down as it was with problems that had taken on a life of their own, and a Congress preoccupied with the issue. The question is, will the Comey firing and its aftermath similarly distract the Trump administration and Congress and impact the entire Washington political machine so greatly that important legislation stalls? We will be following developments closely.
As we survey today’s markets, we find the Dow Jones up approximately 6.7% year to date and the broader market averages up even more. The 10-year US bond, which began the year at 2.43%, is slightly lower at 2.32%. Trailing CORE inflation, which opened the year at 2.2%, is now at 1.90%. We believe that long-term tax-free municipal bonds that offer near-4% yields (a 6.62% taxable equivalent at today’s top rate and 6.15% even at the new proposed top rate of 35%) still offer superior value. Comparing them to a 30-year Treasury bond of 3% (133% yield ratio) and 1.9% core inflation, their value is evident. And given what’s going on in Washington, we may be at these tax rates and under current law for a while.
by Cumberland Advisors
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