Why the Trump-inspired rally in US stocks is fragile
The assumptions driving US stocks to record highs might not hold.
In June 2015, Donald Trump, brandishing a piece of paper showing his net worth at US$8.7 billion (A$11.5 billion), called journalists to Trump Tower in New York and announced that, as only someone “really rich” could make America great again, he was a candidate for the US presidency. At the media conference, he famously promised to build a “great wall” along the border with Mexico to keep out criminals and vowed to be “the greatest jobs president that God ever created”. Soon the world will see how President Trump enacts these and other pledges made during the campaign.
Investors have already made their assumptions on how the Trump era might manifest itself across politics, economics and ultimately returns. And their judgements are optimistic enough to have boosted US stocks to record highs. They assume that Trump will prove more moderate in power than on the campaign, perhaps the core basis for investor optimism. Another expectation is that fiscal policy will play a bigger role in driving the US economy. At a more micro level, they expect Trump to override regulations that stifle the private sector, especially banks, and improve the corporate tax system. Investors assume that Trump will adopt a more protectionist approach to trade but only in token ways so as not to sabotage the US economy. They expect that he won’t repeat his campaign criticism of the Federal Reserve, that, if it were to come from a president, could be seen as an attack on its independence.
These presumptions need to be tested in two ways – first to see if they will hold and what that might mean. The other is to think through all possible consequences if they don’t. Of concern is that the assumptions appear to be on flimsier footings than investors assume and, if enacted, they carry risks that appear underplayed. The Trump-inspired stock rally is thus brittle. Don’t be surprised if it unwinds once investors get a better grasp on Trump and the policies of his administration.
To be sure, the consensus views may prove largely true. Trump has already shown signs of being tempered by the responsibilities and limits of power, which will help the other assumptions come to fruition. Policies may be enacted that justify expectations that the US economy under Trump will achieve growth rates of 3% to 4% a year, and thereby outdo the 2.1% average US annual growth rate of the past three years. The Trump rally could well flounder for reasons that have nothing to do with Trump. A banking crisis in Italy or a shock from China would be among countless possible blows to US stocks. Trump has stirred political forces that will demand he react in the way investors are assuming and, presumably, keeping investors happy is one of his goals, or at least a constraint on his actions. But other forces are in the mix that perhaps will overwhelm or counteract the Trump effect in some areas while magnifying it in others. A Trump administration is likely to underwhelm the expectations of US stock investors. That could set up a turbulent year on financial markets.
US stock markets sank the maximum allowed on the shock news that Trump had beaten Hillary Clinton. The plunge in the e-mini futures on the S&P 500 reached the 5%-loss limit that triggers a halt at 11.53 pm in New York time on election night. But such a recovery began soon after Trump gave a measured speech from about 3 am New York time and the 5% loss was eradicated within 12 hours of the “limit down” being hit. The S&P 500 Index then surged to a record high on November 21, beating its previous record set on August 15 when polls showed Trump losing the election.
Why such a rebound in US stocks? Trump’s victory signalled more fiscal stimulus, which was occurring in the debtor eurozone countries because policymakers saw that austerity was helping populists. Trump is promising fiscal stimulus in the form of tax cuts and infrastructure spending, while foreshadowing the ripping up of regulations and easing of capital rules for banks.
But a dose of fiscal stimulus in the US is not assured. (Nor is it certain in Europe because EU countries have legal constraints on fiscal deficits and Angela Merkel won’t win a fourth term as chancellor of Germany by easing Berlin’s headlock on southern Europe or relaxing austerity in Germany where Keynesian economic management has never taken hold.) Trump has to get laws through a Congress controlled by Republicans, who may baulk at extra spending – apart from on the military that does nothing for productivity – while waving through tax cuts, a recipe that would ruin government finances.
It’s true that Republicans get more riled by fiscal deficits when a Democrat president proposes them. So perhaps Trump can get his budget through Congress. But Trump’s proposals diminish in detail because they rely on private sector investment – only about US$150 billion is fresh public spending, much less than the US$500 billion Clinton was proposing. Most of the new investment is to come from the private sector induced by tax breaks (82 US cents for every US dollar of equity). Such money might be redirected business investment rather than fresh spending. His proposed changes to tax code and regulation shedding might do little to spur business investment, the missing ingredient of the US recovery.
Whatever its shape, fiscal stimulus comes with side effects that act against its intent. Bigger Washington deficits will add to the US net government debt burden that already reaches 82% of GDP (which is even higher than the average 73% reading across the eurozone). At some point, a heavier US debt load could put upward pressure on US bond yields. Extra US government spending could fan inflation, which would pressure the Fed to tighten monetary policy. US bond yields have already reacted to expectations that inflation could accelerate from the 1.7% it recorded over the 12 months to October on the Fed’s preferred gauge – 10-year Treasury yields rose from 1.82% on election eve to 2.38% by the end of November. These higher US interest rates will presumably curb some consumer spending and business investment. They have already bolstered the US dollar, which hampers US exports and could trouble emerging countries holding too much US-denominated debt, another threat to the Trump rally. The US dollar rose 3.6% against the Fed’s “broad” trade-weighted index from election eve to November 30, to set a 14-year high on a month-end basis.
Higher US inflation would turn attention to Trump’s relationship with the Janet Yellen-led Fed, which he attacked during the campaign. The danger for investors is that no one can be certain how Trump would respond to the threat a higher US cash rate would pose to his pledge to make the US economy great again. Any signs that Trump was disrespecting the ability of the Fed to set monetary policy independently or questioning its anti-inflation mandate could devastate investor confidence. Indications of how independent Trump sees the Fed will come when he fills two empty slots on the seven-member board of governors, members of which always vote on interest-rate decisions. Controversial picks would create doubts about the calibre of people he could select when the reappointments of Yellen and Deputy Chair Stan Fischer come up in 2018.
Of all the policy options confronting Trump, investors can be most confident that he will act against free trade, or more correctly preferential trade, agreements, such as the 12-country-strong Trans-Pacific Partnership. Investors appeared sanguine about Trump’s decision to kill an agreement that was to cover about 40% of the global economy. They shrugged because they assume that the US won’t undermine to any extent a system that has served the country and the world so well since World War II ended.
The crux of any damage to global trade will pivot on the relationship between China and the US, the world’s two largest economies. Beijing is likely to retaliate in some form should a Trump administration impose higher duties on Chinese goods and label China a currency manipulator, other campaign promises he is under pressure to honour. (They are core, rather than non-core, promises, to use John Howard’s famous distinction.) His anti-China burst on Twitter on December 12 could be just the start of provocations that trigger a backlash.
As the US’ biggest creditor and trading partner, China has the clout to hurt the US. If you think the two have too many mutual ties to engage in self-destructive behaviour, ponder that Germany and the UK were each other’s biggest trading partners on the eve of World War 1.
Ultimately, the most important assumption about the Trump era centres on the character of the 45th US president. Will he be rich in the temperament, judgment and capacity needed for the task? The fortunes of US stocks and much more pivot to a large degree on the answer.
 The New York Times. “Donald Trump, pushing someone rich, offers himself.” 16 June 2015. http://www.nytimes.com/2015/06/17/us/politics/donald-trump-runs-for-president-this-time-for-real-he-says.html?_r=0
 IMF. World Economic Outlook database. October 2016. http://www.imf.org/external/pubs/ft/weo/2016/02/weodata/index.aspx
 Bloomberg News. “S&P 500 reversal is the biggest since crisis days of 2008: chart.” 9 November 2016.
 IMF. World Economic Outlook database. October 2016 edition. General government net debt as a percent of GDP. http://www.imf.org/external/pubs/ft/weo/2016/02/weodata/index.aspx
 Federal Reserve. “Foreign exchange rates – H.10.” Based on the “broad” index, which is a weighted average of the foreign-exchange values of the US dollar against the currencies of a large group of major US trading partners. https://www.federalreserve.gov/releases/h10/summary/
 Trump tweeted: “Did China ask us if it was OK to devalue their currency (making it hard for our companies to compete), heavily tax our products going into their country (the U.S. doesn’t tax them) or to build a massive military complex in the middle of the South China Sea? I don’t think so!”, Bloomberg News. Trump takes on China in tweets on currency, South China Sea.” 5 December 2016.
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