Developed Markets Quarterly Outlook
World Economy: Is Trumpflation for Real?
The election of Donald Trump to the US presidency has upended the economic and the political outlook for the world. While it stands for a retrenchment from liberalism in both spaces, it remains to be seen where the dividing line between Trump’s promises and his policies will fall. But construction of a positive scenario under his presidency requires that his campaign statements not be taken both literally and seriously at the same time. In addition, it requires two more assumptions: 1) that Trump can carry the Republican Party, whose agenda differs from his in important respects, and 2) that the cabinet and circle of advisors he chooses bring the competence and experience to the office he lacks.
Under these assumptions, the combination of his policies of tax cuts, spending increases and trade protectionism imply a potential short term boost to growth, a likely large and permanent increase in the fiscal deficit and a significant build-up of public debt. Unless the expansion prompts an expansion of the labor force through previously out of work workers returning to the economy, it risks overheating, accelerating inflation.
While each of these policy planks has its own merits and deficiencies, it is their combination that makes them problematic. For example, the fiscal effect of large infrastructure expenditures is amplified by plans to cut taxes. Rising inequality is exacerbated by plans to lower taxes primarily on the wealthy while at the same time rolling back ‘Obamacare’. The risk of overheating is made worse by the mooted imposition of tariffs of up to 45%, which would boost the price of imported goods. Curbs on immigration would contribute to rising wages, raising the cost of production. Protectionism disrupts global supply chains, which would stifle innovation and impede US job growth.
These risks aside, the ongoing recovery in the US economy and the fairly orderly market reaction to the election outcome leave the Fed’s tightening cycle intact for now. As such, a December hike remains likely as do some two additional hikes in 2017. Indeed, Donald Trump’s intended pivot from monetary to fiscal stimulus comes at a time when the former has come under increased criticism, be it for its declining marginal impact (or its failure to deliver at all as some argue) or the adverse corollary effect it has had on middle-class earners.
This is more than a US perspective though. Already prior to the election, the market’s and the political narrative had begun to tilt from never-ending monetary accommodation towards a more activist fiscal stance. While this has been stifled by political resistance in the US so far, and budgetary constraints almost everywhere else, the current winds of change may also finally shift the policy mix. This transition is being reinforced by a belief that inflation is set to rise, partly as a result of adverse base effects and higher energy prices, but also because of rising wages.
Outside the US rising inflation expectations are not a vote of confidence in the strength of the recovery. Instead, leading economies are entering a position in which their output gap remains negative, but inflation accelerates and calls for a tighter monetary stance. On the whole, this would not be an enviable world for equities, but it may not become a concern until after 2017.
Market Strategy: The Double Rotation
The outcome of the election could represent the long-awaited catalyst for the great rotation out of bonds and into equities. Indeed, Donald Trump’s victory turbo-charged the bond market sell-off which was already underway in light of the policy shift described previously. The scale of Trump’s victory convinced investors that he will be able to implement enough of his agenda to provide a meaningful lift to growth and thus corporate profits. This assessment provides the equity leg to the rotation argument.
But if implemented, Trump’s policies also imply a second rotation: that from international to US equities. Growth-boosting policies are strictly aimed at the domestic economy and protectionist measures will hurt emerging markets (EM) in particular, and potentially others as well. But against this backdrop, we are sceptical that the market’s current enthusiasm will be validated in the near term as the Trump administration is set to encounter intermittent resistance by both the public, the Republican Party and Congress. We thus brace for repeated upsets and setbacks in the equity rally. In our allocation, we increase our US overweight only slightly as a result and move EM from neutral to underweight. For the same reason (renegotiation of NAFTA being a specific goal of Trump’s plans), we also downgrade Canada to underweight. Following the post-referendum gyrations, we also re-establish our UK underweight.
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