Trump: Uncertainty as well as hope

International economist Andrew Hunt looks at what US President-elect Donald Trump has promised and how quickly he can make changes to things like Dodd Frank and ObamaCare. In this piece Hunt also looks at what it means for bond markets.

Sunday, December 4th 2016, 6:00AM

by Andrew Hunt

Of course, we have nothing resembling an ‘inside track’ on whom Trump will appoint to his Administration over the next few weeks and precisely what new policies Trump will in fact be able to introduce from a practical perspective – or over what time frame these might occur.

Although in theory the Republicans possess a ‘stranglehold’ on power, in reality the fiscally conservative House of Representatives may act as a firm brake on some of the policies that Trump may wish to enact while the sheer logistics of repealing parts of Obamacare or Dodd Frank may take some time to achieve.

Nevertheless, we would tend on balance to agree with the following consensus views concerning what he may attempt to achieve, namely there should be some form of fiscal easing over the medium term involving tax cuts and presumably some form of ‘public sector – private sector’ partnership on infrastructure spending; a move of some as yet undefined magnitude towards higher nominal interest rates; some form of re-deregulation of the financial sector; and some form of protectionist agenda or at least slowdown within the perceived pace of Globalisation that will likely lead to US residents paying a higher price for (some of) their imports. The latter is likely to prove inflationary for the economy with the result that household real incomes may, initially at least, be eroded by the higher import costs. In this respect, we agree with the bond markets’ assessment of the situation.

Where we perhaps differ from the markets’ view of the situation is however over the outlook for economic growth in the near term. Again, although we are not experts on US public sector procedures, we can easily assume that getting any significant tax cuts passed by the relevant constitutional bodies and enacted into law will not be an instantaneous process.

This is particularly the case now given the political process that was once known as ‘pork-barrelling’ has notionally been clamped down upon. Certainly, it is our impression that over recent years it has generally taken longer, and we are led to believe proven much harder, to get legislation passed through the legislative system and enacted. Indeed, this is often used as a reason to explain the ongoing decline in the number of laws that are being passed in sequential presidential terms. At the very least, it would seem that the US may have become harder to govern and this system inertia may yet blunt at least part of the Trump agenda.

Similarly, from a purely practical perspective, we can also assume that revising / replacing Dodd Frank will take a not inconsiderable time (it was years in the making and will probably be years in the dis-assembling) and, while we fully agree that aspects of Obamacare had damaged the corporate sector, it is not yet clear what solutions are possible, practical and over what time span any changes are achievable.

In fact, it is virtually impossible that any changes to the Affordable Healthcare Act will have taken effect in 2017 and there will as a result be a lingering uncertainty within the private sector over just what will ultimately occur and what effects any new policies will exert. Finally, we can also suggest that creating the necessary financial structures, financing and then over coming practical issues with regard to any increase in public-private sector infrastructure spending projects will also take a not contrary to the message offered by today’s rather Orwellian re-writing of history.

Indeed, as those that were ‘there’ at the time will no doubt remember, the mid 1980s were very much a consumer-led period of growth that was largely made possible by a collapse in the savings rate, a scenario that, quite simply the USA cannot afford to replicate at this time, given the level of household debt, current demographic trends and of course the state of the financial system.

One thing that did occur very obviously during Reagan’s first term was a relatively sharp rise in real interest rates, something which we doubt would not appeal to Trump in his guise as “the property guy”. Nevertheless, some commentators are expecting US real interest rates (and the dollar) to rise under Trump as fiscal policy is eased relative to monetary policy, despite the impact that this might have on the President’s own ‘portfolio’.

However, even on this subject we find that history and analysis have been rather haphazardly ‘re-written’ by the press. While it is true that that real interest rates did indeed increase in the early years of Reaganomics, what is both interesting and we believe crucial is that the rise in real interest rates occurred because US inflation rates were falling at a faster pace than nominal interest rates for much of the period. This clearly had more to do with the Volcker-led Federal Reserve than Reagan.

Both from a theoretical point of view, and as a matter of recollection, we would argue that the high real rate environment (both dollar exchange rate and interest rates) that typified the US economy in the early to mod part of the 1980s tended to depress capital spending trends and that the higher borrowing costs would probably would have resulted in weaker consumer trends had the consumer credit & mortgage markets not been deregulated at that time.

Certainly, we feel that we must emphasise the fact that Reagan arrived in office just as Paul Volcker was beginning to win the war against inflation and bond yields were beginning their long march downwards. Moreover, we also suspect that consumers may have suffered a degree of ‘money illusion’ as headline interest rates declined and this perception problem, along with the deregulation of the consumer and mortgage markets (that of course was to culminate in the 1989 S&L Crisis) led to sharp rise in consumer borrowing trends that in turn depressed the savings rate and thereby helped to support both GDP growth and stated corporate profits, even as the current account balance deteriorated.

Also, as we well remember, there was not only a consumer credit boom but there was also a marked corporate borrowing binge as well. The decline in nominal yields along with a significant deregulation of the financial sector gave rise to the arguably the ‘prototype’ zaitech boom of the Mid 1980s (former Salomon’s economist Henry Kaufmann’s memoirs and books comprehensively describe what, at the time at least, was considered to be a quite alarming process in which corporate debt rose strongly) with the result that there was a surge in corporate bond issuance in order to fund equity buybacks and, most notably, M&A activity, although for those not wanting to read Kaufman, there is of course Oliver Stone’s Wall Street film of the period. Helpfully, this credit boom began at a low level of corporate indebtedness but it nevertheless succeeded in created a degree of financial market volatility (gyrating currencies in the mid-1980s, the 1987 equity market crash, and finally the S&L Crisis). Indeed, the corporate sector credit boom did finally end quite ignominiously in a credit crunch and recession in late 1989/1990 as the FOMC under Greenspan finally began to raise interest rates as inflation threatened to re-appear. Of course, by then Reagan had retired and George W Bush was left with the ‘electoral blame’. This was also the moment at which the inflation of the Public Employees Retirements System (PERs) appeared to come to an end, at least until the tech bubble later in the 1990s.

Consequently, we would argue that although Reagan & Reaganomics did contain some useful government initiatives and deregulations that benefitted the economy over the next 10 – 20 years (as well as some less helpful features), the key to the economy’s growth revival in the early part of the 1980s was simply the fact that the economy was in any case recovering from the deep Volcker recession of 1981/2 and this recovery was being assisted by a sharp credit-policy driven drop in the savings rate.

However, today, the US economy is not recovering from a deep recession (although we estimate that demand pressure is below trend) and the household sector savings rate is already low. Hence, these factors are unlikely to be able to contribute to the success or otherwise of ‘Trumponomics’. Moreover, and in addition to the presumed economic recovery story, US asset prices during the 1980s gained immensely if somewhat erratically from falling nominal yields and the advent of a corporate borrowing binge whereas in the US today the corporate sector is already highly leveraged, there has already been a zaitech boom and nominal yields are in fact forecast to be rising rather than falling.

Only if the FOMC and the regulators find a way to allow both households and companies to take their debt ratios into extreme ‘Greece-like’ levels could we rationally expect ‘Trumponomics’ to yield the same impact on savings rates (and we would argue PERs) that markets enjoyed in the 1980s and 1990s. This, to us, seems both undesirable and unlikely (although Trump is no stranger to high gearing ratios...) and instead we suspect that Trump is entering the Oval Office at the end of a protracted credit cycle / multi-decade decline in bond yields rather than the reverse. This divergence in conditions seems highly important to us and certainly a key difference between the world that Reagan inherited and that which Trump will soon inherit. Reagan entered his office at the beginning of a long period of dis-inflation and falling yields but Trump will face the opposite problems at a difficult time for the political process and hence we suspect that the current bout of equity market enthusiasm over his election will prove short-lived.

Certainly, if this scenario were to come to pass, then there would seem to be little or no reason to hold zero / negatively yielding bonds unless one believes that the central banks will continue to force bond prices higher through their sheer buying power even as inflation rates rise. In reality, we suspect that few central banks in the West will attempt such a feat (although Japan may...) and therefore, if inflation rates do rise as we expect, bond markets may well be caught ‘off-guard’ over the next few months.

Andrew Hunt International Economist London

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