Peering through a glass darkly

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Wednesday, February 8, 2017

Peering through a glass darkly

The impact of President Trump

President Donald Trump’s views on most things appear crystal clear. How they add up for financial policy and the impact on markets and the global economy is less obvious...

Any assessment of prospects for 2017 and beyond will depend on how a number of important contradictions within the new Trump administration play out. Even for UK investors, issues around Brexit are in comparison of parochial concern, which matter most in the next few years for their potential to impact the value of sterling.

In 2017 the environment for the global economy and financial markets feels comfortable, particularly from a UK perspective, despite nagging concerns about the consequences of Brexit. Stock market volatility ended 2016 quite low, the UK and global economy has been performing quite well and the returns earned by UK investors from financial markets in 2016 have been substantially in excess of expectations.

The return from global equity markets has been just over 30%, but part of this may be illusory, as it is measured in devalued pounds. The same measure was just under 10% in US dollars and 15% in euros. The UK return is likely to be negated in part by faster inflation, and the return from investing in smaller domestic UK companies (without much buffer from foreign earnings) was 14%.

The major shocks for pundits and markets in 2016 were the Brexit decision and the election of Donald Trump as president of the USA. Both of these had been seen by most commentators as unlikely to happen. If they had been forecast, most would have expected an adverse reaction from markets.

In the short term, one has to conclude the experts were wrong on both counts.

Mainstream economists saw each as an unnecessary self-inflicted wound. One week before the US presidential election, a group of 20 American Nobel laureates in economics signed an open letter in support of Hillary Clinton saying:

Donald Trump … offers an incoherent economic agenda [which] could jeopardize the foundations of American prosperity and the global economy.

Since Trump’s election, the US equity markets have remained strong and the resilience of the US economy and concerns about inflation have encouraged the Fed to nudge interest rates up, and to signal its expectation of further increases in 2017. Financial markets have taken seriously the prospect of the new administration pursuing a business-friendly agenda. There has been no more loose-talk that might undermine faith in US Treasury securities and one of Trump’s economic policy advisers has written about making the US dollar the world’s most trusted currency.

Markets have bought into the story that a Trump administration will be good for corporate profits and for the potential growth of the US economy by deregulating, by cutting taxes (especially on corporate earnings) and by driving forward investment in infrastructure and education. Parallels are being drawn with the impact of the Reagan-Thatcher liberalisation of the early 1980s. This optimistic scenario may be taking too much for granted, although the cabinet level appointments that Trump has made have the background to pursue his liberalising agenda.

In addition, markets are assuming a benign impact from the new administration’s budget changes, which from campaign rhetoric would be expected to include tax cuts and Federal expenditure increases. This would blow a hole in the Federal debt ceiling. Formally, this limit needs extending by end March, though in practice this could be extended to the summer. It may be that Republicans in Congress are willing to set aside their fundamental concerns about the Federal debt limit, which were such a feature of President Obama’s struggles with Congress.

The justification would be that President Trump’s budget, which is likely to lead to a substantial short term increase in the budget deficit, will be ‘paid for’ from faster trend growth (and so higher forecast tax revenues) as the economy is liberalised and substantial infrastructure investment is implemented. An entirely market-friendly result in the first half of 2017 would be the scrapping of the limit on Federal debt and its replacement with legal limits on entitlement and other elements of current Federal expenditure. But this would be harsh for many who voted for Trump in the hope of better times, even if the stock market might like it.

Unfortunately, such a combination of tax cuts and higher investment spending might be as likely to stimulate a short term boom as to lead to sustained faster trend growth. But even before that, there will be some politicking among Republicans (and within the administration) about what to do with the Federal debt ceiling and their desire to cut tax rates. This is not just fascinating politicking, the outcome will matter for the impact of the Trump administration on global financial markets and the global economy.

Peter Stanyer, independent economic consultant to The Financial Planning Corporation LLP
8 February 2017

Peter is the author of The Economist Guide to Investment Strategy, 3rd edition, Profile Books, 2014.  The views expressed are his own personal views, and do not constitute advice to buy, sell or hold any investment.

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