The enthusiastic market reaction to US President Donald Trump’s big speech on Tuesday night can be interpreted in two ways, both bullish for equities and bearish for bonds, but only one of them positive for the dollar.
The first interpretation is that investors were genuinely impressed by Trump’s comments and reassured about the new President’s willingness and ability to implement his economic agenda of fiscal stimulus, financial deregulation and corporate tax reforms designed to support exports and discourage imports. The consequences would be a return to the Trumpflation trades that did so well in the weeks immediately after the election: buying US equities and the dollar, while selling bonds and those emerging market assets that are most exposed to a combination of US protectionism and a rampant appreciation of the dollar.
The problem with this interpretation is that Trump said nothing to justify such confidence. His speech did nothing to resolve the contradictions between House Speaker Paul Ryan’s border tax plan supported by most House Republicans and the seemingly implacable resistance to any new taxes on imports from a large group of senators, including otherwise loyal Republicans from states such as Arkansas, home of Walmart. Neither did Trump give any hint of how he intends to finance his US$1trn infrastructure plans and defense splurge while simultaneously reducing federal borrowing.
And he strongly implied that replacing Obamacare would have to come before reforming the tax code, while laying down conditions for any new health plan that seem almost impossible to satisfy: for example, ensuring that beneficiaries of Obamacare get enough tax subsidies to maintain their health coverage, while simultaneously reducing government spending, deregulating medical pricing and cutting costs. In short, there was nothing in Trump’s speech to show that the new president had finally understood the difference between implementing serious economic reforms with real money and dishing out campaign promises denominated in nothing more expensive than outlandish rhetoric and wishful thinking.
The result is that at the point in the new presidency when Barack Obama had already passed a US$800bn stimulus bill, and when George W. Bush had produced all the essential details of his tax cuts and budget plans, Trump’s economic promises are more than ever shrouded in mystery and negated by internal contradictions.
Why, then, did the markets react in such a risk-on manner to Trump’s speech? Perhaps it is because investors are coming to the conclusion that Trump’s inability to enact his economic policies does not really matter. The fact is that the US economy was already doing well before Trump’s election, as confirmed by strong employment figures, buoyant leading indicators and the best ISM report since August 2014. As a result, US equity prices were already primed for takeoff, even without Trump’s stimulus.
This is, in fact, what I believed before the election, when I argued that political uncertainty was the main factor holding back the next leg of the equity bull market—and that this depressive force would be quickly lifted once Hillary Clinton became president. We will never know whether the upsurge in US equities would have been just as powerful, or maybe even stronger, if Clinton had been elected. What we do know is that the US economy can do just fine without Trump’s fiscal stimulus or his trade restrictions or his medical reforms. It therefore seems quite reasonable for equity markets to celebrate if Trump turns out to be a lame duck president from his first day in office.
But if expectations of political paralysis have replaced hopes of hyperactive radicalism as the main fuel for rising equity prices, there is one big problem and several important investment implications from this change in outlook. The problem is that the policy gridlock which proved so profitable for investors during the Obama period could be much less benign in the present phase of the US economic cycle. Obama took over an economy in deep depression, allowing budget deficits to be readily financed, while interest rates and inflation kept falling. Trump, by contrast, presides over an economy already near full employment, with inflationary pressures building up.
This is a phase of the cycle when fiscal policy ought to be tightened to ensure that inflation and long-term structural deficits do not to get out of control. Yet if Washington gets gridlocked under Trump, the effects will be much less fiscally prudent and deflationary than under Obama. With Republicans in charge of all the branches of government, tax cuts of some kind are inevitable, as are hikes in defense spending. But without strong leadership from the White House such budget-busting measures are unlikely to be matched with structural reforms that would keep deficits and inflation under control.
Thus bond yields are likely to rise, whether Trump delivers on his promises of explicit fiscal stimulus or simply allows fiscal policies to drift in response to political pressures and industry lobbies. In this sense, the bond market sell-off that followed Trump’s speech made even more sense than the rise in equity prices.
What made less sense after Trump’s speech was the modest strengthening of the US dollar—and the ever-stronger dollar is unlikely to be sustained if Trump fails to deliver a credibly structured fiscal stimulus. If Trump proves unable or unwilling to deliver on his economic promises, this will undercut the rampant strength of the dollar, as well as removing the threat of wide-ranging protectionism. Since these were the fears that spooked emerging market assets immediately after the election, the biggest beneficiaries of an ineffective Trump presidency should be emerging market assets of all kinds.
This article was originally published on Gavekal.com. Copyright 2017.