By Ed Omata, Managing Director and Co-Chief Investment Officer, Meketa Fiduciary Management
Now eight years into an economic recovery that should be close to dying of old age by historical standards, markets are instead pricing in a re-acceleration of economic growth in 2017 and beyond. Ironically, the catalyst has been President-elect Donald Trump; the man who was not only considered a long shot at best by the mainstream media, but who was also every market prognosticator’s favorite “tail risk” scenario.
To be sure, removing the potential uncertainty of a contested election outcome has contributed to a relief rally. But grand promises of Keynesian-style fiscal stimulus have also unleashed the latest round of “animal spirits,” while threats of growth-inhibiting reforms to global trade and immigration have been largely dismissed as campaign rhetoric. Will “Trumponomics” prove to be the immediate economic catalyst its supporters make it out to be? And if so, are there any potential negative spillover effects from this U.S. “reflation?”
While there is now a medium-term upside scenario for the U.S. economy—and by extension, global capital markets—that did not exist a few months ago, we caution that markets may have gotten ahead of themselves in adjusting to this new potential outcome. There remains significant scope for policy delay and disappointment in the early days of the Trump presidency, and this potential gap between today’s hope and tomorrow’s reality may lead to some unexpected turbulence as we move through 2017.
While our best case scenario does call for a new fiscal spending package (concentrated in infrastructure and defense) and significant tax cuts (both corporate and individual), the magnitude of each will likely need to be reduced to get through the U.S. Congress. Furthermore, markets appear to be underestimating the time lag associated with fiscal stimulus. By the time new policies are presented, debated, implemented and begin to take real effect, the calendar is more likely to read 2018 than 2017.
Has Stock Market Overreacted?
While the stock market’s rise may prove an overreaction, the potentially more damaging response has come from the bond market. Bonds have sold off dramatically as investors shift from fears of “secular stagnation” to fears of rising deficits and rising inflation, driving interest rates up from historically low levels. While the level of future deficits remains unknown, inflation was set to increase regardless of economic policy. The collapse in oil prices from more than $100/barrel in 2014 to a low of $27/barrel in February 2016 effectively hid the gradual rise in other consumer costs such as rent and healthcare, but that is now over. With oil prices roughly doubling off the bottom, inflation metrics are set to rise meaningfully through the first half of 2017 regardless of what the new president does. Needless to say, higher rates in an environment of record debt levels are a cause for concern, as are rising mortgage rates that threaten to slow the housing sector.
Then there is the dollar. The world’s reserve currency has resumed its upward trend that began in mid-2014 when the Fed first began tapering QE3. Prospects of higher U.S. growth and interest rates have begun sucking in capital from around the world. Indeed, today’s U.S. rates make Treasuries look like high yield bonds relative to the rest of the developed world, which is still stuck in the zero interest rate policy (ZIRP)/ negative interest rate policy (NIRP)/quantitative easing (QE) phase of central bank intervention. Furthermore, if President-elect Trump does make good on his campaign promises to reduce the trade deficit, this means fewer dollars finding their way overseas and the laws of supply and demand exerting added upward pressure on its price. According to the Bank of International Settlements, non-U.S. entities have borrowed close to $10 trillion, with roughly $3 trillion coming from emerging markets. Thus, the rest of the world is faced with the difficult prospect of paying back these debts with dollars that are now more expensive. Furthermore, the translation effect of a strengthening dollar puts downward pressure on the earnings of U.S.-based multinational companies that are already struggling to grow.
In summary, while there are some promising aspects of “Trumponomics,” our concern for 2017 focuses on the potential gap between the negative effects of rising interest rates and a rising dollar, and the positive effects of future fiscal stimulus. As discussed, it may be 2018 before we see the economic impact of any fiscal stimulus; meanwhile, interest rates and the dollar are rising now. This creates the risk that rising rates choke off U.S. economic growth and a strengthening dollar throws a monkey wrench into the emerging markets recovery, all before fiscal stimulus can ride to the rescue. While we do believe that significant fiscal stimulus is coming, the conversation in mid-2017 may be more about fiscal stimulus saving us from a recession rather than turbo-charging current growth.
Ed Omata joined Meketa Investment Group in 2008, and has been in the financial services industry for 16 years. He serves as managing director and co-chief investment officer of Meketa Fiduciary Management and is a member of the firm’s Investment Committee.