Can rising uncertainty be followed by rising growth?

The equity market rally that followed Trump’s election was in our view largely driven by expectations of tax cuts increasing corporate earnings. For the positive momentum to be sustained there needs to be firmer prospects of economic growth gaining traction. It is here that the picture is complex. 

Uncertainty has been rising substantially since President Trump’s election.  The future of NAFTA is in question. The manner with which some Executive Orders have been signed, with limited or no vetting by the concerned departments, suggests an executive style that is likely to lead to legal confrontations.  The silence regarding potential action with respect to trade with China, combined with the rhetoric over maritime rights in the South China Sea is not comforting.

If policy uncertainties were to linger, they can begin to take a toll on both markets and underlying economic activity. There are multiple ways in which policies can impact growth, support growth, but we focus on two: tax reform and regulatory reform.

Tax reform and tax cuts, all other things being equal, will increase the deficit and stimulate growth. This can provide a short-term boost to growth. Fiscal expansion, however, cannot remain as a long-term support for growth, especially given a political landscape in Congress which does not favour substantially increasing debt levels.

Reducing tax rates, however, are only one aspect of the potential tax reform. Simplifying the tax code and reducing tax exemptions is another. Critically, there are discussions with respect to changing the Corporate Tax from being a tax on profits to a destination-based cash flow tax.  This would function in a way similar to a VAT system. Like VAT, it would exclude exports from taxable cash-flows. However, it will also exclude imports from being eligible deductible costs.  While there are theoretical reasons to support such a system, it can also trigger substantial changes in the economy. The exclusion of imports from deductible costs would have the same economic effect as tariffs, shielding companies from competition and fostering inefficiencies. 

Regulatory reform is the more sustainable route to supporting growth. This can act to reduce the costs of doing business, increase private credit availability and increase productivity. While the administration has suggested several areas where regulations will become less onerous, there is little clarity on the precise direction and details of the regulatory reform. The Executive Order regarding the financial sector is a road map for potential changes, but the Dodd Frank Act is a complex web of regulations that would take considerable time to untangle.

The considerations above highlight important tension in the policy agenda.  Some elements are unequivocally supportive of higher growth; others are clearly not. Lower taxes can be positive for earnings, but a cash-flow tax can raise the tax bill. The potential for greater protectionism is negative for inflation (via higher import prices) and for growth.

To put things in basic economic terms, it is useful to recall a basic economic accounting definition.

Exports – Imports = Savings – Investment + Tax Revenue – Government spending

Or (NX = SI + FB)

Suppose the administration prioritises the imposition of tariffs, which reduces imports. This implies that NX is higher, which means that either SI or FB need to rise to maintain equilibrium. This can happen if Savings increase, or Investment declines, or Taxes rise or Government spending falls. None of these is supportive of economic growth.

Looking at an alternative scenario, suppose the administration prioritises tax cuts to support growth. This means that FB will decline. To maintain balance, then either exports need to fall or imports needs to rise. Falling exports are not supportive of growth, while rising imports are exactly the opposite of what the Administration is attempting to achieve.

These inconsistencies in the policy agenda suggest that there is a higher likelihood that growth will be the product of regulatory reform than fiscal policies.  Regulatory reform, however is notoriously slow to implement and to take effect. 

What does this imply for our asset allocation?  Over the past weeks we have been overweight US equities, and underweight bonds. More recently we felt that the valuation gap between the US and Europe, coupled with the weak Euro, justified an increase in allocation to Europe as well. While rising uncertainties justify more cautious positioning in equities, we find it difficult to justify reducing equity positions in favour of bonds. With the US economy at full employment, wages rising, and the potential for increasing protectionism to impact prices, we believe that the bond markets are far too sanguine regarding some increase in inflation risks.