Trump victory raises prospects for reflation
Fiscal policy is likely to take centre stage following Donald Trump’s US election success, which has significant implications for financial assets, writes Michael Grady.
Donald Trump’s victory in the US presidential election has the potential to have a profound effect on the global economy in a number of ways. Although at this stage it is impossible to precisely quantify the impact, we have been confident for some time that global reflation will ultimately banish fears of deflation, with the US leading the way. Trump’s win makes this more likely.
Financial markets had begun to anticipate rising inflation in the run-up to the US election. Trump’s likely fiscal and trade policies are expected to boost it further. For the time being, concerns around the potentially adverse impact on global economic growth of a trade war have been largely relegated to the back seat.
Bond markets have sold off sharply. As at 21 November the yield on the benchmark ten-year US Treasury has risen by around 50 basis points since the election to around 2.32 per cent, its highest level in a year and up from a record low of around 1.35 per cent just four months ago.
That reaction is little surprise. Indeed, given the potential scale of fiscal stimulus Trump will look to push through, the sell-off is not only justified but most likely has further to go. It is probable US Treasury issuance will increase significantly.
If implemented in full, the US deficit would probably rise by between one and two percentage points of GDP per year. According to the Tax Policy Center – a joint project between two non-partisan Washington think tanks – Trump’s fiscal plans are projected to raise federal debt issued to the public to over 100 per cent of GDP over the next decade, compared to around 80 per cent if current policies were maintained.
Moreover, with the US economy already close to full employment, a fiscal boost of this magnitude will likely result in higher inflation and the Federal Reserve raising interest rates faster.
Ultimately Trump’s proposed tax cuts are likely to be watered down by Congress. The Republicans have only a slim majority in the Senate, making it possible for the Democrats to join with just a few rebellious Republican senators to secure amendments. And while the infrastructure bill is likely to face less opposition from the Democrats, it’s far from clear it will be welcomed by Republican lawmakers, the majority of whom remain in favour of small government.
Trump has proposed boosting infrastructure spending through public-private partnerships. Through the combined use of tax credits and repatriation of offshore earnings, he claims he will be able to generate up to $1 trillion in additional infrastructure spending. That will be aimed at transportation, clean water, electricity, communications and security.
However, in order to push through these proposals, Congress will first need to raise the debt ceiling – the statutory threshold dictating how much money the government can borrow at any one time. It currently stands at $20.1 trillion. For Trump to boost spending and cut taxes, this will need to be raised substantially by the middle of 2017. That could prove politically difficult given the Republicans’ repeated challenges to raising it throughout Barrack Obama’s presidency, not to mention the views of traditional Republican voters.
Nevertheless, all told, economic growth could be boosted by as much as one percentage point in 2017 and 2018. With the US labour market already relatively tight – the unemployment rate is just 4.9 per cent – this is likely to fuel wage growth and inflation. We do not expect the Federal Reserve to tighten policy until any fiscal stimulus has been approved, and that may not happen before the middle of next year. Nonetheless, we would expect the pace of rate hikes to quicken in the second half of 2017 and into 2018.
Of course, one of the big questions for investors is whether the increase in uncertainty associated with a Trump presidency could outweigh these reflationary policies. The geopolitical risks are substantial, especially if Trump were to spark some sort of retaliatory trade war with China and others.
At this stage the market is giving him the benefit of the doubt. If he remains pragmatic he will choose a sensible path that avoids a trade war. All the same, the risk of him plotting a more damaging course should not be dismissed, given a large part of Trump’s campaign was focused on protectionism. He has already announced his intention to withdraw the US from the Trans-Pacific Partnership – a free trade deal between 12 countries that was agreed earlier in 2016, but has not yet been ratified. Moreover, he could, for example, selectively impose tariffs on specific industries in certain countries if he can make the case that there are unfair practices going on – as Obama did in the case of Chinese tyres.
But even if Trump doesn’t impose tariffs, just making a lot of noise in the early days of his presidency over trade, immigration and other foreign policy issues could be enough to create significant economic uncertainty, knocking investor sentiment and businesses’ appetite to invest.
As for the implications for the rest of the world, the beneficial effects of any fiscal boost should be widely felt so long as Trump refrains from a protectionist agenda. But protectionism would likely slow global trade further which would hurt Asian nations.
The situation facing ‘emerging market’ countries varies. Those which have relied on cheap manufactured exports to the US, such as China and Mexico would be most directly impacted by protectionism. But the knock-on effect to supply chains could impact other Asian countries such as South Korea, Singapore, Malaysia, Vietnam and Taiwan. On the other hand, commodity exporters, such as South Africa, Russia and Brazil, and those less exposed to the US, such as Turkey, should be better placed.
As for emerging-market assets, the prospect of tighter monetary policy in the US, higher bond yields and a stronger dollar could prove challenging. Many countries have benefited from capital inflows in recent times, as the low volatility environment encouraged a search for yield and led many investors to look for positive carry strategies. A reversal of those flows since the election has already seen emerging market debt, currencies and to a lesser extent equities, all sell off. Going forward, it will be important to differentiate between markets, given the different ways in which we expect various economies to be affected.
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