Navigating a Fed tightening cycle, a divergence between economic and profit performance, and significant patience with respect to a rollout of fiscal stimulus, forgetting international relations for the moment, will be critical drivers to equity performance in the new year. We expect the dollar to remain firm based on the relentless widening in interest rate differential and policy divergence with the rest of the world.
President Trump’s ‘black’ inaugural speech highlighted that he has not tempered his “America First” policy prescription, and policy uncertainty has increased again. His agenda is still a moving target, but three key risks have emerged for financial markets.
- First, a border tax could see a 10% rise in the US dollar. It would also be bearish for global bonds and emerging market stocks.
- Second, Trump also has his sights set on China. And China has recently been publicly bearing its teeth, especially as regards the South China Sea. Investors seem to be under-appreciating the risk of a trade war, not to mention a possible real war.
- Third, the plan to slash Federal government spending could completely offset the fiscal stimulus stemming from the proposed tax cuts and infrastructure spending.
The good news is that the major countries, including China appear to have entered a synchronized growth acceleration. There is more to the equity market rally to come. The global profit recession is over and the rebound has been even more impressive, than could have been expected. So long as the US protectionist policies do not derail the growth acceleration, corporate Earnings Per Share, world-wide will continue robust.
The Fed will raise rates three times this year. The Bank of Japan will continue to target 10 year JGB yield of 0%, but the ECB will begin hinting at another tapering in the fall. US policy is very fluid, but for now the new administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine US growth, then stocks will continue beat bonds by a wide margin.
However, one additional, cautionary, thought:
The Bulletin of Atomic Scientists moved the hands of its Doomsday Clock forward by 30 seconds to two and a half minutes to midnight, in response to Trump’s ‘unsettling and ill-considered’ comments about the use of nuclear weapons, growing concerns over North Korea and worries about relations with Russia. This is the closest the clock has been to midnight since 1953.
The US Dollar is 40% above its lows in 2011, its sharpest rise ever against a basket of rich-country peers. This latest surge is in prospect of a shift in economic policy mix in America. Trump will cut taxes, and spend more public funds on fixing our crumbling infrastructure. Such a big fiscal boost will lead the Fed to raise rates at a far faster rate to check inflation. Zippier growth in the US should be welcomed world-wide for its knock-on effect, but, recalling the Reagan era widening budget deficits and high interest rates, reminds us that, that episode caused trouble abroad. Today, the dollar has become more pivotal. That makes a stronger dollar more dangerous for the world and for America.
America’s clout as another country’s major trading partner is smaller, dropping from 44% in 1944 to about 32% twenty years later. But the dollar’s supremacy as a means of exchange remains unchallenged. An estimate of a de facto countries whose currencies move in line with the dollar, encompasses 60% of world’s population and 60% of its GDP. This kind of dollar denominated debt amounted to about $10 trn, a third of it in emerging markets.
When the dollar rises, so does the cost of servicing this debt. Cheap offshore borrowing during the good times, caused an increased supply of local credit. Capital inflows pushed up local asset prices, encouraging further borrowing (recall the US housing boom that crashed landed in 2008) Not every dollar got invested, some ended up in bank accounts for other uses.
A strengthening dollar sends this cycle in reverse. As the dollar rises, borrowers husband cash to service the increasing cost of their own debts. As capital flows out, assets prices fall. The upshot is that credit conditions are bound ever more tightly to the fortunes of the dollar. Watch out Brazil, Chile, and Turkey.
For America the trade balance will worsen as the strong dollar sucks in imports and its exports demand softens. A bigger deficit raises the chance that Trump acts on his threat to impose steep tariffs on imports from China and from Mexico. If Trump succumbs to his protectionist instincts, the consequences will be disastrous. The global economy is weak and the dollar’s strength will enfeeble it further.
If interest rates were to move higher, as they just did recently and are likely to do so over the next year, not only would this interfere with Trump’s policy agenda, but those increases would be passed on to consumers and businesses who borrow money at rates based on government bonds. Rising rates could cramp the whole economy and make a lot of people upset.
Go figure. President Trump!
President elect Trump promises to reduce regulations, increase infrastructure spending, and cut taxes, which lead many to conclude that growth in inflation and interest rates will result. He has sworn to ‘Put America First. Demanding respect from a freeloading world that takes leaders from Washington for fools’. He will ‘no longer surrender this country or its people to the false song of globalism’. Mr. Trump is angry. So, apparently, are those who elected him.
Welcome to the new nationalism. This is the first time in a century, great and rising powers are in the thrall to various siren songs of chauvinism; Along with Mr. Trump are Russia, China, Turkey and France embracing pessimistic views of foreign affairs.
Nationalism is a slippery concept, at its best it unites a country around common values. This ‘civic nationalism’ is conciliatory, leads to Peace Corps and universal values such as freedom and equality; in contrast to the second, ‘ethnic nationalism’ which is zero sum, aggressive and nostalgic. It draws on race or history to set nations apart. It leads to war.
We risk shifting from the universal, civic nationalism towards the blood and soil, ethnic sort. Mr. Trump’s populism is a blow to civic nationalism. The US has historically backed rules-based order. Trump threatens to weaken that commitment even as ethnic nationalism is strengthening elsewhere. Putin has shunned cosmopolitan liberal values for a distinctly Russian mix of Slavic tradition and Orthodox Christianity. In Turkey Erdogan has turned away from the EU, and from peace talks with the Kurds who make up over 30% of Turkey’s populace. He favors strident, Islamic nationalism that is quick to detect any slight. India’s Modi remains outward looking but has radical ethnic nationalist Hindu groups preaching chauvinism and intolerance. France has consistently pursued statist and protectionist drawbridge-up policies. France goes to the polls in the shadow of Marine le Pen, leader of the National Front, soon.
Meanwhile, Chinese nationalism has become angry and vengeful. Since 1990, Chinese children have been receiving a daily dose of ‘patriotic education’ centered around the Han people: everyone else is a second-class citizen.
The Eu, the world’s greatest experiment in ‘post-nationalism’ has foundered. The Eu was expected to transcend national rivalries. In large parts of the Eu this never happened. The last time America turned inward, was after WWI. The consequences were calamitous.
Mr Trump’s new nationalism tends to produce intolerance, and to feed doubts about the virtue and loyalties of minorities. Regional and global problems will become harder to solve. Even if Trump enacts even a fraction of his mercantilist rhetoric, he risks neutering the WTO. For smaller countries that are today protected by global rules- it will be a harsher and more unstable world.
Trump needs to realize that his policies will unfold in the context of other countries’ jealous nationalism. Disengaging will not cut America off from the world so much as leave it vulnerable to the turmoil and strife that the nationalism engenders. Trump needs help to reach reality.
Wake up American voters! ”I love the uneducated” Trump said recently. His policies are tweets long. He is incapable of producing ideas of depth and substance.’ Build a wall’, ‘reduce Moslem immigration’, ‘make NATO allies pay for their protection’. His ideas are easy to read, impossible to fathom and short on detail. How to achieve his economic boom is a mystery. His extra detail makes nothing clearer.
His economy is irreconcilable with facts. He says jobs are scarce, poverty is rising and incomes are stagnant. In reality, America’s economy is the strongest in the rich world. Unemployment is only 4.9%; the poverty rate has been falling since 2012 and median incomes have risen by 5% in real terms in the last two years.
His proposed treatments are no better than his diagnosis. He wants to scrape the wrong regulations. He promises to cut top rate income tax from 36.9% to 33%. He would cut corporate tax by half though he has given no plan for paying for all this bounty, other than to borrow. He only exacerbates his difficulty in coming up with the astronomical sums needed to pay for his ideas.
The worst part is his trade policies. His protectionism would wreck the economy (estimates are as high as by $5.3 trillion!); reduce wages and achieve little else. Manufacturing’s share of employment has fallen because of technology, not trade. His proposals would actually turn back productivity gains. His ideas would cause wages to fall. The few jobs that would return would cater only to domestic demand. High cost American goods would not be able to be sold to the world as they do now.
Protectionism threatens high value manufacturing jobs. It disrupts supply chains. Exports would fall. Export-supported jobs pay a wage premium of about 18%. Retaliatory tariffs on American exports would reduce overseas sales. Tariffs would eviscerate the purchasing power of American wages as imported goods would become more expensive. The poorest Americans would suffer the most. Trump has not explained what his ‘deals’ might look like- As big a mystery as his tax returns. His proposals threaten jobs and living standards of millions of Americans, the very same voters who are his strongest contingency, is the very same group that will suffer the most, if he were elected President.
Rarely has a candidate for president been less deserving.
The Dollar and the Fed still rule
With the world turning inward, we should recognize that countries are beholden to the US dollar more so than ever before. A mere hint of a shift in Fed policy sends shivers, up and down, the boulevards of most countries’ financial districts. While the US may no longer be the super economy it once was, having eased from controlling 40% of world GDP, to now controlling about 23% of world GDP, the dollar is still the superpower currency. In the last 600 years, there has been one mega currency in each century. The dollar has been Number One since it succeeded the Pound Sterling about a century ago and there is no rival in sight. In the last fifteen years, foreign currency reserves value rose from $3 trillion dollars to $11 trillion. Nearly two-thirds of those reserves are held in U.S. dollars. 90% of all trade, world-wide, is conducted in dollars. The dollar has never been more influential and the financial hegemony of the U.S. has never been greater.
Domestically, despite comments to the contrary, the American economy is flourishing. Unemployment is only 4.9%, newly created jobs increase by nearly 150,000 monthly, consumer confidence is strong, and new homes sales are higher than 2008. The second quarter growth rate was strong. Most of all the Fed did not bump up rates. Why? Inflation is barely 0.9%. Price rises will pick up as the effect of cheap oil and the strong dollar dissipate. Core inflation is 1.6% and wages are being pushed higher. The Fed, I believe is finding it hard to tell how loose monetary policy actually is. Several factors are holding down the natural rate: weak productivity growth. In 2000s, productivity averaged 2.9%. Since 2008, it has been 0.9%. Another culprit- Attention Sociopath Trump! – is being caused by an ageing workforce and population. We NEED the immigrants Trump is so eager to throw out of and to wall out of our country. Markets, too, seem to expect low rates to continue. However the strength of the consumer means there is a chance of a rate rise this year.
The economy will improve via two things: innovation and productivity, which are interlocked. It seems that all of the products that make our lives better were not around 30 years ago. And secondly, what is really important is gains in productivity. Back 100 years farms were producing 30 bushels of corn per acre. Now they’re producing 160 bushels of corn per acre, and of course, it takes fewer people to do it. Productivity is the name of the game.
Fed grew more confident as near-term risks diminished and held rates steady, but opened the door for a rate rise later in the year, perhaps as late as December. Hiring bounced from 10,000 in May to over 287,000 in June.
American producer prices rose 0.5% month-on-month in June, the biggest gain in a year, and above expectations. Rising costs for energy and services, and the fading effect of the strong dollar, were the main causes. Now energy prices are falling like stones with little prospect of strength. In another sign of the economy’s strength, unemployment benefit claims held steady at a seasonally adjusted 254,000, rather than increasing as expected.
In a more connected world, there is more value in the infrastructure that joins us- roads and routes than borders that divide us. Deconstructing barriers via digital technology and flows of investment are the first steps towards realizing the potential of a connected world.
We have accepted the assumption that the world of our children would be a place of fewer borders and lower barriers to the movement of goods and people. Not long ago, walls were literally brought down, with the promise that global progress and prosperity would henceforth be marked by openness.
Sadly, that is not how things are trending now, and the consequence is troubling for those of us who believe that the most powerful cure for war and economic stagnation is direct exchanges between people around trade and ideas.
The latest signal of rising barriers is the England’s Brexit from the European Union. Though not necessarily a done deal, it is perilously close to happening.
An enthusiasm for erecting barriers is evident elsewhere, too. Donald Trump wants to build a wall along the border with Mexico, and Hillary Clinton came out against a free-trade deal whose formulation she once supported.
Consumer spending has been the main engine of growth in the U.S. for the past few years and is the case now, but that engine appears to have run slower than it has in the past. Retail sales for February were flat, fell 0.4% in January and March sales grew 1.7%. One big reason for March’s weak overall reading was a drop in auto sales which tumbled 2.1% in March and is still not showing much life. Auto sales continue to be disappointing, advancing only 0.1% last month.
American households have benefited from relatively cheaper gasoline and an improving labor market for more than a year. But wages have been growing only slowly, other measures of the economy have been mixed, and financial markets have been volatile in the last six months of 2016.
The present acrimonious political discourse is polluting our normal American ‘Can Do’ mentality. The sooner we find representatives worthy of our expectations, the better. Any suggestions are welcome. I keep reading that historically, there examples of an even worse environment, I am horrified of looking at the prospect of having to discover if this is true.
The tug of war between the Fed trying to force rates higher and the rest of the world trying to fight off recession continues with no let-up in sight. The US economy grew at 2.4%, faster year end 2015 than thought. The consumer is spending with home-buying especially rosy. But corporate earnings, with the fall in oil prices, have some challenges not just domestically, but also internationally. The global nature of financial markets and the dollar’s critical role within them requires the Fed to go slowly. Its planned additional hikes might well tip America and much of the rest of the world into recession. Even as household wealth grows on strong new job creation, ongoing struggle in Europe and Japan and the slowdown in China have limited how fast US activity can move. Raising interest rates well above the global level may be inviting destabilizing financial flows and an economy choking rise in the dollar. The Fed should tolerate rising inflation, it is preferable to imploding portfolios and risking a recession.
The Bizarre rise of “Trumpism” is frightening. The rest of the world thinks he and his supporters are mad. What, must he and they be smoking?
What might a Trump economy look like?
He makes up policy as he goes along, departing from party orthodoxy. He insults our largest trading partner, China, calling them ‘currency manipulators’. And he wants to force them to eliminate ‘illegal’ export subsidies. He will ‘force’ Mexico to pay for the improbable wall he proposes to build on the border of Mexico, despite the President of that country saying, “No way Jose.”
On taxes he wants sweeping cuts, higher standard deductions, lower dividend and capital gains taxes, and he wants to cut corporate taxes to 15%.
While most economists say such a program would lead to a huge increase in the federal deficit, Trump claims lower taxes will stimulate the economy. Meanwhile, he also calls for a balanced budget that will require huge spending cuts.
He is also going to beef up the military and spend more on Veterans and immigration controls. He claims that he will save $300 billion on Medicare. How he will accomplish this, as usual, he is short on details.
Funding his tax cuts would require unimaginable spending reductions. His program is unimaginable as it is improbable.
How does a demagogic opportunist exploit a divided country? How did Hitler come to power in Germany or Mussolini in Italy? Watching Donald Trump’s fashion show, I am beginning to suspect, or fear I understand. The danger is that the electorate becomes de-sensitized to his absurd outbursts. Trump must be taken on by one electable candidate and the contenders know which is best placed to complete this task. It is time for several of them to fall on their swords.
Though the US economy seems to be a brightish light on the horizon, there seems to be a growing fear that the rich world’s weapons against economic weakness no longer work. Despite central banks’ efforts recoveries are weak, and few on the ground, and inflation is low. For all the cheap money sloshing around, growth in bank credit has been dismal. More can be done but central banks will need help from governments. It’s time for politicians to join the fight alongside central bankers. Public spending could be financed directly by printing money; Wage and prices could be mandated through government incomes policies; while this involves risks, waiting raises the specter of having to rely on extreme action. Multi years Infrastructure projects to fix bridges, roads, and buildings would add predictability to worker expectations. Deregulation would also help. Cut the red tape. Zoning laws are barriers to new projects and tax codes are too complicated. America remains the world’s indispensable economy, dominating the brightest, brainiest and most complex parts of the human endeavor. Its capacity to influence will linger and even strengthen though its economic weight as a percentage of world trade declines. The growing gap between its economic weight and its power will cause instability and conflict if not handled properly. Given its present political atmosphere, expectations are dimming. America’s grip on the global economy helps organize, provide access, enrich bosses and annoys the rest of the world. And here comes China.
The migrant crisis sweeping Europe is likely to get worse before it improves. Tempers on all sides are shortening. Head of the Bank of England has dampened expectations of an interest rate rise this year. Meanwhile Euro Zone business activity fell to a one year low, suggesting a slower rate of expansion; the service sector also fell implying first-quarter growth in the bloc would be less than 0.3%. Having said all that, Europeans can seem miserable; its produced writers and philosophers that are downbeat. Paradoxically, Europeans are happiest, today, than they were since the financial crisis of 2008. The only metric consistently correlated with European happiness is relative income. The more it rises, the happier people become. Where they live is also important. Not Northern Europeans are uniformly happier than Southern or Eastern Europeans. Good governance seems to be the main factor.
Brexit is a danger to its economy. It will imperil Britain’s security and its clout. Brexit also would deal a heavy blow to Europe. Uncoupling the fifth largest economy in the world from its biggest market is no joke. Brexit would also deal a pretty heavy blow to Europe’s security. Britain is its fifth largest defense spender. The new EU and the West would be weaker. Let’s hope the British voters think carefully on June 23rd.
Asia countries are competing to modernize their military, now accounting for almost half of the global market for big weapons- nearly twice that of the Middle East and four times that of Europe. The largest importers are India, China, Australia, Pakistan Vietnam and South Korea. Unquestionably, China’s recent assertiveness, seeming simply to be taking what it thinks is its own, underlies this trend. Even if China were not filling in the sea so enthusiastically, its military build-up would not go unnoticed, and reacted to. Nearly 30 % of world trade passes through the South China Sea. China’s behavior there, of late, evidences disdain for international laws, laws which they themselves signed in 2002. Such behavior scares its neighbors and heightens the danger of conflict and justifies why America should continue to assert freedom of navigation and overflight. Net result is to drive China’s neighbors closer to America, and to suppliers of heavy weaponry. China’s excessive industrial capacity harms its economy and riles its trading partners. It should embark on some form of consolidation by closing down older capacity.
Either we validate the financial asset prices and growth faster, or we slip into a global recession with financial disorder. If only central banks would step back and allow economies to determine their own futures. The irony is that the economy has healed, but it is not unfettered. The Fed may be able to get one more rate rise to hold, but no more. We must expect high volatility especially in the currency markets. Business conditions are much more positive than stock markets suggest.
The Fed is now in a very uncomfortable position, which could easily become much more difficult still. This is the risk in hiking rates before economic conditions demanded it. When both interest rates and inflation are very low, there is unlimited room to increase rates in response to an unexpected surge in inflation to a rate will above the target. And under those circumstances it is very hard to react in time and with adequate force to any unexpected weak economic performance.
Europe is looking into the jaws of a recession. Stronger downside risks, including China’s change of growth model, lower commodity prices, and “asynchronous” monetary policy around the world prompted the International Monetary Fund (IMF) to lower its global growth outlook, The IMF pared its global growth forecast to 3.4% in 2016, a decline of 0.2% from the agency’s prior estimate in October. The world faces weaker growth. Fewer jobs are being created around the world and there will be countries that will struggle, particularly those suffering from the double downside risk, which is the trade relationship with China slowing down and lower commodity prices. This will affect some of the emerging market economies and low income countries that are vastly commodity export dependent.
The chaos created by the mass migration from turmoil in Syria to Europe has European economies examining closely their ability to absorb these masses. Many are acting to curb the intake.