U.S. election overshadowing real market risk

As the U.S. election looms, there’s another, larger factor poised to affect the economy, says Ignacio Sosa.

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So much attention has been focused on the race to Washington – for the White House and for Congress – that markets haven’t priced in higher inflation, says Sosa, director of the product solutions group at DoubleLine Capital in Los Angeles. His firm manages the Renaissance Flexible Yield Fund.

“The rapid fall in oil prices that we saw in the last few years, which has really pushed down the Consumer Price Index, is over,” says Sosa, adding consumers will face higher prices as energy prices pick up. “The Consumer Price Index, which has hovered around the zero area, and which is today a little bit under 2%, is likely to rise to 2.5% in the first half of [2017,] which is about the Fed target for inflation.”

U.S. CPI rose at an annualized rate of 1.5% in September on higher energy prices, marking the fastest pace for inflation in five months. If it gains further, inflation is something the next president will have little control over, and will certainly affect the federal budget, says Sosa. As inflation rises, so too will the costs of administering Medicare, Medicaid and Social Security, which already account for 60% of federal funds, he explains.

“We are still in a slow-growth environment,” Sosa adds, and “the fiscal deficit in the United States is going to be set to rise no matter which candidate wins.”

After the election

If Democratic front-runner Hillary Clinton wins, her policies will fall closely in line with U.S. debt projections. She plans to implement US$1.65 billion in new spending on infrastructure and social policies like paid family leave and free university tuition.

She also plans to offset some of her spending with higher taxes for the wealthy. Sosa notes government spending is also an inflationary pressure.

“Under a Republican victory, you would probably have even greater fiscal deficits,” Sosa adds. Republican candidate Donald Trump plans to spend more than Clinton proposes on infrastructure, while increasing military spending and cutting tax rates—in total, his policies would add an estimated US$5.3 trillion to the debt over a decade.

“Depending on what measure you look at, the total debt-to-GDP of the United States is set to rise five to seven percentage points of GDP under Mrs. Clinton, and 10-plus under Mr. Trump,” says Sosa.

As of October 24, U.S. election polls gave Clinton about an 85% chance of winning the election. Based on polling, economic and historical data altogether, her chances remain high at about 83%. The polling averages showed Clinton winning 337.7 electoral college votes, and Trump winning 199.4.

Portfolio matters

Some investors have been complacent about low inflation and interest rates, Sosa warns. So, managers should be inflation- and interest-rate proofing their portfolios.

Here are some options Sosa gives for future-proofing a fixed income portfolio.

Treasury securities

The U.S. Treasury offers Treasury Inflation-Protected Securities (known as TIPS). The principal value of a TIPS rises or falls with the Consumer Price Index. When its term is up, the investor gets the greater of the adjusted principal or the original principal. The interest rate is fixed.

Right now, TIPS are priced on the assumption that inflation will be 1.5% or lower over the next five years, says Sosa. This year, core U.S. inflation has already hit a high of 2.3%, and the latest measure was 2.2%.

“We think these are very mispriced and therefore attractive,” says Sosa, “and they’re certainly more attractive than just a fixed-rate Treasury Bond.”

Asset-backed securities

There’s potential in the mortgage-backed securities that have survived the financial crisis, says Sosa. These securities don’t have government guarantees like Treasury Bills, but “these are mortgages that have survived the Great Recession, 10% unemployment and a 20% fall in housing prices. In our view, these are relatively safe investments.”

Emerging-market debt

For yield, Sosa turns to U.S.-dollar-denominated emerging market debt. He says, “We think this is one of the more attractive areas to invest in, particularly compared to the United States, Canada and Europe.”