The past year has been one of multiple surprises. The year started with fears of a sharp deceleration in China, and worries over the implications of rising Fed rates for emerging markets. Some worried that the global economy could slip into recession. Britain was expected to vote to remain in the European Union, and almost all political analysts would have named Donald Trump as the candidate least likely to win the US presidential elections.
None of these expectations proved right. China’s economy barely decelerated. The Fed did not yet hike interest rates. Britain opted to leave the EU, and Trump is president-elect. More surprisingly, however, is that markets moved in the opposite direction of what most analysts had expected. Emerging markets have delivered their best performance in years. The UK and US equity markets reacted positively to what was assumed to be a negative outcome.
The key question is to what extent have markets been simply reacting to a change in risk appetite, compared to a change in outlook? We are inclined to believe that it is mostly the former. Economic data have improved, but do not point to a dramatic improvement in the outlook. At the same time, political changes herald potentially substantial uncertainties around the long term outlook.
The US equity and bond markets have been buoyed by expectations of both deregulation and fiscal stimulus boosting growth in the long term. Both of these policy trajectories, however, are complex, take time to implement, and can entail considerable lags before having an effect on the real economy.
The fiscal policy is the area where President-elect Trump has given most clarity on his proposed policies. We have argued in previous notes that, with monetary policy having reached the limit of what it can achieve to support growth, fiscal policy is the only policy tool that can support growth in the near term. The Trump proposals are largely focussed on tax cuts to corporations and individuals, as well as a simplification of the tax system. Here, one can be reasonably confident that tax cuts will be forthcoming, given the widespread support for such measures within the Republican majority in both, the House of Representatives and the Senate. It is less obvious that a substantive simplification of the tax system can be easily implemented. There are many competing interests in support of various exemptions and loopholes, and reaching a compromise will likely mean a significant dilution of Trump’s proposals.
While a fiscal stimulus through tax cuts is likely, increased spending is less likely. Despite the rhetoric regarding increasing infrastructure spending, the Trump proposals have not entailed promises regarding increasing spending, but rather a “deficit neutral system of infrastructure tax credits” to provide incentives for private businesses to undertake projects. Whether businesses actually find incentives for infrastructure projects sufficiently attractive depends on a lot of other factors, especially regulations.
What we know of Trump’s fiscal proposals so far leads us to believe they are likely to increase consumption (by increasing disposable incomes). It is less obvious if they will increase aggregate demand by businesses that may or may not react to increasing investment.
Deregulation, in our view, is the more promising element of Trump’s proposals. There is little doubt that, since the early 2000s, regulatory complexity has been increasing. The 2008 financial crisis accelerated the process to create a body of regulatory requirements that is expensive to maintain. Broad-based deregulation could be the right impetus to reduce business costs and boost productivity, which has been languishing at exceptionally low levels. Unfortunately, this is an area where we have little clarity on the precise nature of the regulatory changes, other than a broad promise to eliminate two rules for every new rule that is created.
Taken together, the above suggests that the trajectory of fiscal policy and regulation has the potential to boost growth, but it is difficult to have a high degree of confidence that it would actually do so. There are meanwhile, some important downside risks.
The US economy does not operate in vacuum. The success of Trump’s policies will depend on developments in the rest of the world. It is here where we see the most prominent risks to outlook. The anti-globalisation rhetoric in the US, UK, and elsewhere in Europe is an atavism. It harks back to an era where production supply chains were national. The potential for protectionism escalating into a trade war is especially damaging in an era where production supply chains are globally integrated in complex ways.
In addition to trade risks, policy risks in Europe are also substantial. There is little visibility on how Brexit will be negotiated, and the markets have discounted little of the potential damage to UK GDP. Elections in France and Germany are looming, and early signs suggest a significant change to the political landscape. The failure of Italy’s referendum is effectively a vote for continued policy lethargy at a time when the banking system of the Eurozone’s third largest economy is near-insolvent.
We look to 2017 with a mixed message. We recognize that potential policy changes offer hope of a reinvigoration of growth and productivity. But we also recognize that markets have focused almost exclusively on the opportunities, and have discounted few of the significant risks of policy failure.
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