One year of Trump

Trump Tower

January 20th marked Donald Trump’s one-year anniversary as US President.  So far, his tenure has proved controversial and divisive, both domestically and abroad. His attempts to take credit for the performance of the US economy and equity market should be taken with a pinch of salt, particularly given the considerable momentum carried over from his predecessor’s term and the strength of other asset markets around the world. However, he has certainly had an effect on financial markets. Risk assets rallied strongly immediately following his election, partly because investors thought it would lead to the implementation of pro-growth and business-friendly reforms. Since, speculation surrounding his policies has continued to drive rotations in performance leadership among the various industry sectors within the US equity market.

Controversy

Trump has remained in the headlines since his inauguration in early 2017.

While global asset markets have generally been strong since Trump’s election, his presidency has been characterised by divisive positions on numerous issues. He has signed executive orders barring citizens from six Muslim-majority countries from entering the US and is actively pursuing other reforms designed to limit immigration. He has withdrawn the US from the Paris climate agreement and threatened to withdraw support for some of the US’s NATO allies, unless they increase their defence spending.

In the Middle East, he broke with decades of international policy by naming Jerusalem as capital of Israel, a move that was heavily rebuked by the United Nation’s general assembly. He has also used inflammatory rhetoric towards North Korea and been accused of disparaging language about certain African countries. Domestically, he has been involved in a number of political scandals, including the sacking of FBI director James Comey and investigations into his election campaign’s links to Russia. His plan to build and have Mexico pay for a border wall, either directly or indirectly, also remains a controversial background story.

While many of his actions have attracted wide criticism, investors should focus on those with the potential to alter the investment backdrop.

Some commentators argue that Trump’s unpredictability has undermined his credibility. Others have gone further, stating that his incongruous style is having an adverse impact on the US’s longer-term international standing. While both of these statements are debatable, there is clear evidence that Trump’s domestic popularity has waned, with his approval rating having fallen to the lowest level of any US president in their first year in office (Figure 1). Fortunately, a president’s political popularity is not always commensurate with the level of investor sentiment, as has been evident over the past year. However, some of his policies are consequential for asset markets and in this article we discuss how some of these could affect the global economy and investment backdrop in the coming year.

Trump’s approval rating
Figure 1: Trump has seen his approval rating decline since his inauguration as he has failed to fulfil many of his campaign promises, while also being criticised for a number of controversial actions. Source: Thomson Reuters Datastream
Taxation

Tax reforms have been highly anticipated and the market’s reaction shows they will provide a boon to investors.

Trump’s administration finally managed to fulfil his promise to reform the US tax code in December. Named the “Tax Cuts and Jobs Act of 2017”, the legislation provided the first major change to the US tax system in decades. It also provided Trump with his first major legislative victory. The reforms have been a key driver of risk assets’ strong performance in early 2018, with the speed of its implementation evidently surprising some investors; this is understandable given the Republican Party’s failure to repeal and replace Obamacare earlier in 2017.

As expected, the reforms are in line with Trump’s pro-business philosophy…

Broadly speaking, the Act’s key elements include permanent tax cuts for corporations (the corporate tax rate reduced from 35% to 21%) and temporary cuts for individuals. There are also various other intricacies, including a provision offering companies with a one-off opportunity to repatriate capital held overseas at a reduced tax rate. Trump has argued that the Act will make the US a more attractive place for businesses to locate, thereby repatriating jobs and further facilitating his ‘America First’ mantra. However, the new US corporate tax rate remains higher than many countries around the world, for example Ireland (12.5%), where large US companies such as Apple and Google operate significant parts of their businesses.

…and they should benefit the economy in the coming years.

While tax cuts are generally positively received, critics have suggested that these reforms disproportionately benefit corporations and the wealthy. Indeed, some commentators have suggested that the reforms will allow Trump to receive a larger proportional tax cut than the average middle class family. Like Obamacare, it was passed with partisan backing alone and polls show that many Americans perceive it as mainly benefitting others. Despite this, it will still benefit individuals and small businesses, raising incomes and supporting consumption growth. It could also catalyse an increase in corporate investment, thereby boosting demand and increasing productivity over the medium term. Overall, it should have a positive effect on broad economic growth in the coming years, with implications for both the inflation outlook and the Federal Reserve’s (Fed) monetary policy projections.

However, the benefits will not be without cost, particularly over the longer term.

The boost to growth should offset some of the cost, but it is estimated that the Act will add around $1.5 trillion to the nominal US government debt over the next ten years. Treasury issuance will have to increase to fund the tax cuts, notwithstanding savings in other areas, and this will have ramifications for both bond yields and, therefore, equity-market valuations. Furthermore, the timing of this fiscal stimuli is questionable, given that the US economy is already nearing full employment.

America First

Trump is also looking to boost the domestic US economy through other protectionist policies…

The recently implemented tax reforms support Trump’s ‘America First’ mantra, but they provide only a single element of his broader policy agenda. He has also criticised some of the US’s current trade arrangements and been forthcoming in his desire to amend or cancel them. Increased globalisation has widely been credited with increasing overall global output in recent decades, as it allows nations to specialise in areas where they have competitive advantages. However, Trump has argued that it has been detrimental to the US in aggregate. His administration points to the large US trade deficit as evidence that economic activity has moved overseas because consumers and companies prefer to buy cheap imports ahead of more expensive domestically-produced goods.

…with little apparent regard for the global economy. 

With Trump having abruptly withdrawn the US from the Trans-Pacific Partnership trade pact shortly after coming into office, he is expected to seek to implement protectionist trade policies over the remainder of his term. He has refused to nominate a US judge to the World Trade Organisation’s (WTO) dispute court and this has led some commentators to question whether it will be able to continue as a global arbiter on trade. Furthermore, we believe he is preparing to make changes to the North American Free Trade Agreement (NAFTA) between the US, Canada and Mexico. His hope is that protectionist reforms will restore lost manufacturing jobs in the industrial heartlands of the United States, which have a strong Republican presence.

His strategy is likely to have inflationary implications…

While his hypothesis is debatable, critics argue that employment has generally risen during periods where imports have increased, any cancelations or phasedowns of existing trade arrangements are likely to prove negative for overall global growth. With global supply chains optimised to reduce prices and improve margins, any increase in tariffs or ‘on-shoring’ to higher cost countries would also likely generate inflationary pressures, which could impact corporate profit margins. As such, it is particularly important for investors to remain cognisant of their exposure to businesses and countries which could suffer from abrupt changes to international trade rules.

…but we do not believe he intends to pursue it to the point of global recession.

One factor that provides us some comfort is that Trump has tempered his tough rhetoric towards China, a country he has previously labelled a “currency manipulator”. This provides encouragement that a trade war between the two dominant global economies is likely to be avoided. Despite this, there still remains a risk that trade talks will deteriorate.

The economy, inflation and policy

The US economy has strengthened in recent quarters.

Robust consumption growth has been underpinned by further employment gains, high levels of consumer confidence and a resilient housing market. The industrial and manufacturing sectors have also benefitted from recoveries in oil production and mining activity, while purchasing managers’ indices (PMI) are indicating further expansion as we move into 2018. Despite inflation data repeatedly having underperformed expectations in 2017, the Fed continues to assert that the factors holding it back are idiosyncratic and transitory. As such, it has continued to raise interest rates and begun reducing the size of its balance sheet.

Inflationary pressures are building, but longer-term structural factors continue to provide deflationary headwinds.

While inflation is expected to rise to just above the Fed’s target level of 2% (Figure 2), this could take some time. As such, our core market view remains that the current ‘Goldilocks’ low inflation, stable growth economic environment will continue in early 2018. Nevertheless, this is a consensus view that supported risk asset prices in 2017. As such, we see the possibility of inflation accelerating more quickly than expected as one of the key risks facing asset markets in 2018. Such a situation could cause central banks to tighten monetary policy more quickly than expected, catalysing a sell-off in sovereign bond markets. In turn, this could undermine equity market valuations, cause the US dollar to strengthen and potentially destabilise the global financial system. Such events would be particularly detrimental to assets which benefitted from a weak dollar and accommodative financial conditions throughout 2017, such as commodities and emerging market equities.

US inflation expectations
Figure 2: Five-year inflation expectations jumped after Trump’s election as investors anticipated the implementations of pro-growth reforms. However, they retracted as he struggled to implement the changes he had promised in his election campaign. Expectations increased slightly after it began to appear that tax reforms would be passed towards the end of 2017, but they remain relatively subdued and do not yet present a threat to the ‘Goldilocks’ environment. Source: Thomson Reuters Datastream

With inflation subdued for so long a change in expectations could have larger-than-expected consequences.

To provide some context on the current environment, the Fed’s projections already show that it expects to implement a further three interest rate hikes in 2018, while financial markets currently expect only two. However, there are signs that investors’ expectations are beginning to move towards the Fed’s, with inflation expectations rising and the benchmark ten-year treasury yield appearing to have recently broken out of its multi-decade downtrend. While a slight increase in the market’s expectations of the path of US interest rates could provide a short-term headwind to risk sentiment, a greater risk would be if the Fed’s central projections on inflation and rates were to rise markedly. Such a situation could occur if inflation were to begin accelerating quickly.

 


A longer version of this article was first published on the Brookes MacDonald blog 0n 23rd January 2018.