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TRUMPFLATION AND OTHER STORIES
November 2016
Multi asset views from RLAM
Royal London Asset Management manages £101 billion in life insurance, pensions and third party Funds*. We have launched six Global Multi Asset Portfolios (GMAPs) across the risk return spectrum with a full tactical asset allocation overlay.
*As at 30/09/2016
This month’s contributor
Ian Kernohan
Senior Economist
Mr Trump won a majority in the electoral college, but not in the popular vote. The
Republicans have retained a majority in
the House and Senate, however their
majority in Senate is slim. While the US
political system includes checks and
balances, the President has broad powers
in trade and foreign policy to act without
Congress. In contrast to many
Congressional Republicans, Mr Trump is
conservative on global trade, but not
conservative on fiscal matters. We look at
the economic and market implications of
the election result.
The election of Donald Trump as President is a major watershed event,
not just for the US economy but for geopolitics in general. The market’s
initial response has been to focus more on the prospect of domestic
fiscal stimulus next year, rather than possible greater geopolitical and
economic risk further down the line.
Summary
While global growth remains below pre-crisis rates, it is still some way above global
recession levels. Given that backdrop, the outlook for monetary policy is mixed:
interest rates look set to rise in the US, while a period of policy easing in China has
come to an end. We still think the European Central Bank (ECB), Bank of Japan
(BoJ) and Bank of England (BoE) have a bias in favour of easing. Meanwhile, the
election of Donald Trump points towards a significant fiscal stimulus in the US,
and is part of a general trend away from excessive reliance on monetary policy.
Political risks in Europe will build from now on, beginning with the Italian
referendum on constitutional change, to be held in December. Next year, there are
major elections in the Netherlands, France and Germany. Markets will be watching
for signs that the Eurosceptic vote is growing.
So far, the UK economy has seen little impact from Brexit, aside from sterling
devaluation. We expect growth to slow next year, as rising inflation squeezes real
household incomes and the whole complex process of Brexit impacts corporate
decision making. Given the current legal issues surrounding Article 50, the
government’s Brexit timetable has been thrown into doubt.
US election
Source: BBC
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ECONOMIC OUTLOOK
Global: International Monetary Fund (IMF)
maintain global growth forecasts
The latest global Purchasing Managers’ Indices (PMIs) suggest
global growth remains within its post crisis range of 3-3.5%. If
anything, the pace of expansion has picked up in H2, with
stronger activity data in the US, China and some emerging
markets (EMs).
While global growth remains below pre-crisis rates of 4%+, it is
still some way above global recession levels. Given that
backdrop, the outlook for monetary policy is mixed: interest
rates look set to rise in the US, while a period of policy easing
in China has also come to an end. We still think the ECB, BoJ
and BoE have a bias in favour of easing, however there is
limited scope to go beyond measures which have already been
put in place. The election of Donald Trump points towards a
significant fiscal stimulus in the US, and is part of a general
trend away from excessive reliance on monetary stimulus.
US: labour market data remain consistent with a
post-election hike in US interest rates
We cover the economic implications of the US election result in
greater detail below. In summary, any impact from the
planned fiscal stimulus is unlikely to appear before late 2017 at
the earliest. In the meantime, the US Federal Reserve (Fed)
will be sensitive to the rapid rise in the dollar and in long bond
yields, making them, if anything, more cautious on the pace of
any tightening early in 2017.
Third quarter data showed that real consumer spending
increased at 2.1% annualised pace in the three months to
September, driven by continued job growth and rising
household wealth. Net trade was also a major contributor to
activity. By contrast, business investment has declined in each
of the past three quarters, with a notable slowdown in
residential investment. These early estimates are subject to
revision and the National Association of House Builders
(NAHB) index points to stronger residential investment (see
chart).
While GDP growth picked up in Q3, at just 1.5% year on year
(yoy) it remains weaker than pre-crisis rates. Despite this, it
has been strong enough to trigger a marked improvement in
labour markets. Although we think headline inflation will rise
for mathematical reasons related to oil price volatility, we
think the relationship between the unemployment rate and
inflation (aka Phillips curve) has shifted, with the Fed happy to
allow further falls in unemployment without an aggressive
policy tightening. The major caveat to all this is the scale and
timing of any fiscal stimulus. Tax cuts focussed on higher
earners may be saved rather than spent, while increased
infrastructure spend would take some time to have an impact
on the economy. Looking out beyond 2017 however, there are
clear upside risks to the pace of Fed hikes.
The current rate of monthly payroll growth would have been
expected to make a bigger dent in unemployment, however
participation rates have begun to nudge back towards pre-
crisis levels, while the share of employees working part time
for economic reasons is still relatively high. One key piece of
evidence that there is still slack remaining is the delayed
recovery in wage growth, which on an average hourly basis has
only just returned to 2009 rates of growth. If the economy was
really firing on all cylinders and rapidly running out of room to
grow, we would expect much stronger wage pressures. More
comprehensive measures of labour cost growth, such as the
Employment Cost Index (ECI), remain subdued.
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This ongoing recovery in the labour market means we still
expect the Fed to hike rates in December 2016, however with
other major central banks on hold or easing policy, we do not
think interest rate rises will get very far, given likely upward
pressure on the US dollar. Of greater importance than dollar
strength however, is the neutral rate of interest, which remains
lower than it was before the crisis. Pre-crisis it would have
been odd for activity and inflation to be at current levels
following such a long period of near zero interest rates, not to
mention quantitative easing (QE). Last month we noted some
of the key factors lowering the neutral rate: productivity
growth has weakened, while demographic change is also
bearing down on trend growth, as has a rise in income
disparity.
China: the recent period of policy easing has now
ended
In recent years, China has attempted to manage a transition
from a growth model based on investment, exports, and debt-
fuelled state-owned enterprises, to one driven by consumption,
services, and dynamic private businesses. This process has not
been without interruption however, and when growth slowed
too quickly in 2015, the authorities stepped up stimulus, via an
expansion in credit, especially for real estate developments and
state-backed infrastructure projects. This succeeded in
stabilising economic activity at the desired rate of growth,
however we still think the pace of economic growth will slow
further over the medium to long term, due to demographic
factors and a slowdown in productivity gains.
Consumption and investment have been the main supports for
growth this year, with retail sales and fixed asset investment
rising by 10% and 8.3% respectively in the year to October.
House price inflation has risen sharply (see chart) and over 20
urban governments have introduced measures to restrain
prices. The housing sector accounts for a large share of total
investment, after factoring in demand for everything from
concrete to household goods.
Debt levels in China have risen sharply in recent years,
however since the government already underpins most
lending, this limits the risk of sudden contagion. China has a
closed capital account and a reasonably strong government
balance sheet, with state controlled banks. In October, the
State Council approved debt-equity swap and other measures
aimed at reducing corporate indebtedness. Chinese companies
have accumulated $18tn in debt, equivalent to about 170 per
cent of GDP. The pick-up in nominal GDP growth, as deflation
eases, should ease some of the pressure on debt levels. In
nominal terms, GDP growth increased 7.8 per cent in the third
quarter, a sign that deflationary pressures are continuing to
ease.
Next year will be critical for President Xi Jinping, as he
prepares for a leadership transition that could determine
whether he will be able to push through difficult economic
reforms during his second term. While the impact of the
2015/16 stimulus will wane, we would not expect growth to
slow materially next year.
Eurozone: with rising political risks in 2017,
economic growth remains tepid and inflation is
still too low
Despite aggressive monetary easing in Japan and the eurozone,
growth rates in both economies remain tepid, while core
inflation rates are well below target levels. To some extent,
both appear trapped in a low-growth, low-inflation, low-
inflation-expectations environment.
Trend GDP growth in the eurozone is so low (poor
demographics is a key reason, especially in Germany) that even
modestly positive growth has been enough to create a fall in
unemployment. Fiscal policy across the region should provide
some support and corporate lending has improved, however
there is no sense that the eurozone economy has reached
escape velocity.
In contrast to the US, which will see a pick-up in energy
investment, the boost from cheaper energy in the eurozone is
now on the wane, with headline inflation set to rise, squeezing
still modest nominal income growth. There is no indication
that last year’s spike in M1 growth fed into stronger GDP
growth this year (chart overleaf) and this indicator has already
weakened.
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Political risks will build from now on, beginning with the
Italian referendum on constitutional change, to be held in
December. A “No” vote will not automatically trigger a general
election, even if Prime Minister Renzi resigns, with a
temporary arrangement likely until scheduled elections are
held in 2018. Renzi’s coalition has 377 of 630 seats in the lower
house and 164 of 315 seats in senate, so it would be difficult to lose a vote of confidence. Next year, there are major elections
in the Netherlands, France and Germany.
Longer term, we think the current arrangements for the euro
remain sub-optimal, in the absence of greater fiscal and
political union. Brexit may open up an opportunity to create
such a union, however even among euro member countries,
there will be differences of view in the right direction to take.
euro stresses will reappear if a sharp rise in global bond yields
puts pressure on peripheral spreads, the global economy falls
into recession, or a political crisis in a key member state puts
its euro membership under question.
UK: no evidence of post referendum slowdown,
however the Brexit timetable looks less certain
than it did
We now have quite a lot of official and survey data covering the
immediate post referendum period and the general conclusion
has to be that not much has changed in terms of economic
growth. The substantial fall in sterling has been the most
important economic development of recent months, and this
has both winners and losers. There has been some speculation
that the economic impact of Brexit won’t show up yet since “we
haven’t left the EU”. On that argument, any noticeable
economic impact would be delayed until 2019 at the earliest.
Our base case is for growth to slow next year, as rising inflation
squeezes real household incomes and the whole complex
process of Brexit impacts corporate decision making. Given
lead times, any hit to investment would not have shown up in
Q3 GDP, while a spike in political uncertainty post the High
Court ruling on Article 50 (A50) creates more known and
unknown risks to the government’s timetable.
There are risks to our base case on both sides: we may have
exaggerated the impact of Brexit on corporate investment, in
which case growth should hold up. If, however, households
respond to the squeeze in real incomes and rise in uncertainty
by raising their savings rate, then the hit to consumption and
economic growth could be greater than we are assuming. Since
we expect global growth to hold up well in 2017, this should
limit the downside to the UK, as a medium sized open
economy with a flexible currency.
We expect Consumer Price Index (CPI) to rise from <1% now
towards 3% in 2017, though we do not expect a repeat of the
2010/11 spike in inflation to 5% - this was driven by two VAT
hikes, a jump in oil price from $35 to $127 per barrel over 24
months, plus other factors, such as phasing in of university
tuition fees. Global foodstuffs inflation has spiked in sterling
terms (chart), but not to the same extent as earlier episodes.
On monetary policy, although our November BoE rate cut call
was based more on a reading of prospects for the UK economy
in 2017 than it was on the Q3 GDP, it wasn’t totally insensitive. Despite the fact that early estimates of GDP are often quite
inaccurate, the 0.5% quarter on quarter (qoq) print and recent
sterling weakness led the BoE to pause and wait for another
opportunity to ease if the economy slows during the Brexit
process, which we assume it will.
Looking further ahead, we think there is room for a
compromise deal between so called hard and soft Brexit
options. Key states such as Germany with substantial surpluses
in UK trade will not want to see a complete trade rupture. Also,
the UK is the second largest net contributor to an EU in need
of cash, so this may be used as leverage. A new FTA could be
rolled up with the A50 process, to shorten the ratification
timetable. Since it is unlikely that trade with the EU will
become more rather than less open, any reduction will have to
be offset by increased integration with the Rest of the World if
UK potential growth is not to be hit.
The government’s budget position is not independent of the
rest of the economy, since sectors in the economy borrow and
lend from and to each other. As a sovereign borrower, any
government can be more flexible than households and firms.
By dropping Mr Osborne’s plan to run a budget surplus by
2020, the new Chancellor has created room for households
and firms to borrow less than they otherwise would have, in
order to maintain growth in demand.
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SPECIAL TOPIC –
IMPLICATIONS OF US
ELECTION RESULT
We outline the main economic and market
implications
In the previous edition of this report, we noted that:
“while polls suggest a Trump victory on 8th November is unlikely,
such polls have failed to call important votes in the recent past. The
fact that Donald Trump is a candidate at all, is evidence of the
continued backlash against globalisation.”
One month on, and it is this tension between globalism and
nationalism which helps explain the outcome. Mr Trump won
a majority in the electoral college and not in the popular vote,
however it was blue collar states such as Ohio and Wisconsin,
which gave him his victory. The Republican Party has also
retained a majority in the House and Senate. Their majority in
Senate is slim: many issues will require a super majority of 60
votes, however fiscal votes require only a simple majority.
Though the US political system builds into its structure
important checks and balances, the President has broad
powers in trade and foreign policy to act without Congress. In
contrast to many Congressional Republicans, Mr Trump is
conservative on global trade, but not conservative on fiscal
matters. Many Republicans are against deficit financing per se,
and believers in smaller government overall. This is not the
platform which Mr Trump stood on, and so there is a general
question about the likely size of the gap between his campaign
rhetoric and policies which will need the consent of Congress.
We outline the key policy areas below. Markets are most
concerned about Mr Trump’s anti-free trade rhetoric, which if
implemented, would be a long-term negative for US and global
growth.
Tax reform and deregulation
Mr Trump proposes personal and business tax reform: cuts in
personal tax rates, a reduction in the corporate income tax rate
to 15%, and a one-off 10% tax on all foreign earnings not yet
taxed by the US (companies will be free to repatriate these
earnings without additional tax, once this tax has been paid).
There is broad support for tax reform within the Republican
party. There is also support for Trump’s policies of
deregulation in the energy and financial sectors, including a
partial repeal of Dodd-Frank.
Trade and immigration restrictions
Congressional Republicans are much less keen on Trump’s
policy proposals in this area (as is consensus market opinion),
however the new President-elect has considerable support in
so-called rust belt states, which he will be reluctant to ignore.
Trade policy is an area where a US President has significant
room for discretion to act without Congressional approval:
Congress must approve trade agreements, but the actual
legislation usually authorises the President to ratify an
agreement which has already been concluded. Presidents have
the authority to withdraw from bilateral and multilateral trade
agreements, such as the North American Free Trade
Agreement (NAFTA).
Together with more general fears about a shift in the post-cold
war defence arrangements, investors are likely to be most
concerned about any retreat on global free trade. The
consensus amongst economists is that, while freer trade raises
income distributional questions (which should be offset by
other policies), trade restrictions are negative for everyone,
including those who are supposed to lose from greater free trade. Freer trade allows countries to specialise (comparative
advantage), helps keep inflation low and boosts productivity.
Additional tariffs would most likely boost inflation, and have a
mixed short-run but negative long-run impact on growth,
especially if met by retaliation from other large economies,
such as China.
Spending on infrastructure and defence
Mr Trump specifically mentioned infrastructure spending in
his acceptance speech. His pre-election plan was for up to $1
trillion of additional spending over ten years, or $100bn per
year (c.0.5% of GDP). Congressional Republicans are less keen
on unfunded infrastructure spending than they are on tax cuts,
however Congressional Democrats would be keen on such
spending. There may have to be some compromise on the
spending plan, with many in Congress keen to save such a
major spending boost until it is really needed in the next
downturn.
The Fed
Mr Trump has been critical of ultra-low interest rates and QE,
and has accused the Federal Reserve of being too “political”.
His advisers will no doubt tell him that a battle with the Fed is
best avoided and as with many issues, he has said different
things about monetary policy on different occasions. In any
case, we believe that interest rates are set to rise before the end
of this year. Janet Yellen’s term is due to end in 2018 and she
has confirmed that she will serve out this period.
Impact on US economy
Although there will be compromise on the scale of the package,
a significant easing in US fiscal policy is likely. Tax cuts for
higher income brackets will have some impact on household
spending, however savings ratios for these groups tend to be
higher, so the impact will be limited. The impact of corporate
tax cuts and infrastructure spend will also take some time to
feed through to aggregate demand, especially given a shortage
of shovel-ready projects. In short, we think any significant
economic impact from the fiscal stimulus will not appear until
late 2017 at the earliest.
We haven’t changed our US economic base case for 2017: we
already expected faster GDP growth and further hikes in
interest rates. Given trends in wage pressures, rising bond
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yields, easier monetary conditions overseas and a lower neutral
rate, there is little need for the Fed to step up the pace of
tightening beyond what they have already signalled. To shift
expectations now towards “one hike per quarter in 2017”
would be premature, when Mr Trump hasn’t even been
inaugurated and the timing and scale of any fiscal stimulus is
not known.
Looking further ahead however, we do have some concerns. Mr
Trump’s pre-election proposals included a GDP growth target
of 3.5%, and a pledge to create 25m new jobs over 10 years.
This would be more than three times the rate of job creation
since 2006 and comes at a time when both domestic and global
fundamentals have held back the pace of US expansion. Since
the global financial crisis, potential GDP growth has slowed, as boomers retire and labour productivity has weakened. Even if
productivity picks up a bit, it’s difficult to see the US economy
growing at 3.5% without running into an inflationary overheat,
and a more hawkish Fed.
Impact on the Rest of the World
To the extent that a major fiscal stimulus is positive for US
growth, there will be a knock-on impact to global growth. On
the other hand, a more hawkish Fed and greater trade
restrictions would be negative for growth, especially in many
EM economies.
On Europe, Mr Trump has said that the continent ought to
bear more of the financial burden of its own defence. His election also raises political risk ahead of some key EU votes,
while a US-EU trade deal now looks less likely.
In the UK, Mr Trump’s election has changed the debate about
a likely US-UK trade deal, however his anti-globalisation
rhetoric is not helpful to a medium sized open economy
seeking to re-orientate its trading relationships. London could
also lose business to New York, if large parts of Dodd-Frank
are repealed, at a time when UK trading relationships with the
EU are unclear.
Mr Trump may well declare China a “currency manipulator”,
although ironically China has been trying to slow renminbi
depreciation in recent years. The more important issue is
whether the 45% tariff idea on China’s goods exports to the US
will prove to be just campaign rhetoric. US firms (including
Apple) have deep connections with China assembly lines. Also,
China has recycled a large share of its export earnings into US
Treasuries, so is not without some leverage in these matters.
Market implications
In summary, tighter immigration controls, greater fiscal
stimulus and anti-free trade rhetoric suggest a more
inflationary bias in the Trump economic programme. So far,
markets have placed greater emphasis on this, than on fears
about global trade, or any likely response by the Fed. For now,
the feeling is that the impact of stimulus will come through
faster than any serious rolling back of free trade: naming China
as a “currency manipulator” is not the same as slapping 45%
tariffs on their goods. Bond markets have taken fright on the
inflationary impact of a sizeable fiscal stimulus, coming at a
time when the headline unemployment rate is low.
Mr Trump appears much less predictable than many new US
Presidents, and it is this unpredictability, together with a sense
that his election is a watershed moment, not just in domestic
economic terms but in geopolitics, which creates a two-way
pull for treasuries. Should they focus solely on the domestic
stimulus, or the greater geopolitical and economic risk? For
now, it is very much the former.
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CHARTWATCH
1. The US Budget deficit has fallen sharply since the Global Financial Crisis, thanks to ongoing economic growth, and fiscal retrenchment in the first few years of the decade. While this is a better place to begin a major fiscal stimulus programme, it is far from ideal, given the current level of national debt. Compared with previous periods of rapid fiscal expansion, US national debt is now much higher; forecast to be 76% of GDP in the current fiscal year. This will give Congress pause for thought when assessing the Trump fiscal package.
2. While we expect Italian spreads to come under some pressure ahead of the referendum vote on Dec 4th, we don’t expect more general pressure on Eurozone spreads. A “No” vote will not automatically trigger a general election, even if Prime Minister Renzi resigns, with a temporary arrangement likely until scheduled elections are held in 2018.
3. Following an immediate post referendum spike, the CBI’s main measure of UK political uncertainty has fallen back, though remains at a high level
4. Although the US labour market has recovered, with headline unemployment rate now just 4.9%, there are still many workers in involuntary part-time work. This represents extra slack in the labour market, and together with relatively modest wage pressures and Fed “lone hiker” dollar risk, means any rates hikes next year are expected to be modest. The Affordable Care Act is sometimes cited as reason for the slow fall in this measure of part-time employment, as it can make employers more reluctant to employ someone on a full time basis.
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Issued by Royal London Asset Management November 2016. Information correct at that date unless otherwise stated. The views expressed are the author’s own and do
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