Long before the election upset of 2016, economists in the U.S. were lamenting the decreasing effectiveness of monetary stimulus and clamoring for the fiscal kind. No longer. With an acquiescent Republican Congress, the Trump administration can, realistically, effect some sweeping changes that represent fundamental shifts in the fiscal, monetary, trade, and tax regimes.
Although the actual policies and sequence of events are still unclear, a mere attempt to change the status quo has had the markets respond vigorously to the “Trump trade” in the last two months. Bonds crashed, equities broke all-time high, base metals rallied hard. Is this sustainable? If personnel is policy and personality is destiny, a theme of fiscal stimulus in the form of tax cuts and infrastructure spending, monetary tightening, trade barriers, and geopolitical conflicts is slowly emerging.
Boom Time Ahead?
Start with the tax and regulatory reform. Lighter touch regulations, lower corporate tax rate, and the possible repatriation of large chunks of overseas profits will be a shot of adrenaline to the U.S. equity market in the near term. Couple this with the proposed infrastructure spending later in the year, we should have a mini boom on our hand that buoys hard commodities like oil, gasoline, base metals, and results in net capital influx and a stronger U.S. dollar. Yet this is going to balloon the budget deficit and is not likely to provide the necessary lasting productivity gain to restore long term economic health. It remains to be seen when the market will start to care, but the inflection point is probably not going to be visible until 2018 and beyond.
Insofar as the Fed resuming its tightening cycle, the new administration’s fiscal policies will likely accelerate inflation expectations and prompt the Fed to quicken the pace. U.S. dollar should continue to strengthen as a result of speculative inflow, and the policy divergence with the ECB and BoJ will persist because they are in no position to reverse course. This is likely to be a multi-year headwind for most commodities, the precious metal complex, and bonds. The U.S. will become the accidental engine of growth again in the short term as the euro zone and Japan nurse their sickly economies back to health under the auspices of weak currencies. How long this honeymoon period will last largely depends on the other piece of the puzzle – protectionism.
Trump’s zero-sum view and transactional attitude on various issues like trade balance, trade deals, and tariffs can be telling. Quick wins are valued more than strategic framework and partnerships; capital flow as a counterforce to trade deficit is ignored. Since the president has wide latitude to implement his vision in trade, how aggressively and how pragmatic (or vengeful) this administration responds to events will have a wide ranging effect on world economy. If Trump sticks to his small-bore corporate activism and keeps protectionism in check, the world could muddle through until the next crisis. If deteriorating exports and widening trade gap due to a stronger dollar trigger a retaliatory instinct and a trade war with China is started, growth could come to an abrupt end. In any case, non-oil emerging economies and export oriented commodities such as grains will face a hostile macro environment in the next few years.
An even bigger unknown in 2017 is the geopolitical risk stemming from the new administration’s nationalistic view and ego-driven foreign policy. A new world order with lower nuclear threshold, emboldened Russia and China, and the erosion of U.S.-led rules based institutions will yield unintended consequences. The shift from a cooperative game to a non-cooperative game by President Trump will likely not produce a 1980s-style Plaza Accord to manage currencies or a quieter Middle East. It is against this backdrop that safe haven assets such as precious metals, U.S. equities, and oil may again come in vogue.
If one thinks 2016 was an eventful year, 2017 may prove to be equally disruptive, with a number of X factors lurking in the corner. The Iran nuclear deal may be reversed causing oil to spike. China’s real estate and bad loans could finally get out of hand causing a worldwide panic. China may decide to dump U.S. Treasury to defend the yuan and stem capital outflow, or to retaliate against the U.S. European elections may reinforce the nationalistic trend and begin to unwind the European integration project. Sunnis’ losing tide against the Shias may find an expression in the Saudi leadership. How will Trump respond? The answer may just be lying in a social psychology or a game theory textbook.
To borrow George Soros’s reflexivity concept, prevailing bias often gets ahead of the fundamentals or even influences the course of events. The current recalibration since the U.S. election is a reflection of a regime change. Whether the prevailing bias has run too far ahead of the underlying trend or has barely begun to cross it will be a great question to ponder for the next few months.
May we live in interesting times.
Jan 4, 2017