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Macroeconomics

09 November 2016

AGAINST ALL ODDS 

The election of Donald Trump represents a repudiation of the American political establishment and, more broadly, a wholesale rejection of the promise of globalization and free trade. It is also leading to an immediate recalibration by markets that had priced in an imminent Hillary Clinton presidency.

Trump ran on a platform contrary to traditional Republican Party themes, and was consequently disowned by much of his own party. On his way to the White House, he gave voice to a segment of the population that felt ignored, belittled and left behind in an increasingly globalized environment. 

As he promised in his victory speech: “The forgotten men and women of our country will be forgotten no longer.” 

In the election’s immediate wake, it’s worth stepping back to recall the key elements of Trump’s economic platform, which include:

  • Massive tax cuts (resulting in an estimated $9.5 trillion reduction in revenues over 10 years)
  • Increased military spending, with no cuts to Medicare or Social Security
  • Deportation (voluntary or forced) of close to 11 million undocumented immigrants
  • High tariffs on goods from China and the imported products of any US company that has moved jobs offshore 

Both as a consequence of his policies and because of his perceived impetuousness, international markets will continue to demonstrate heightened volatility following Trump’s upset victory – which marks the most prominent rejection of international trade in generations and opens an era of profound uncertainty in international relations. That includes here in Europe, where far-right leaders in France, Hungary and the Netherlands have already responded with glee. 

“I want to tell the world community,” Trump insisted in his victory speech, “that while we will always put America's interests first, we will deal fairly with everyone.” Clearly, the global community – and global markets – are not yet convinced. 

Bonds are likely to rise, but only as a sign of short-term safe-haven flight. In the longer term, bonds will decline because Trump’s plans will likely lead to higher budget deficits and an increased debt position, as well as likely selling pressure out of China. 

Meanwhile, inflation-linked bonds are likely to rise under Trump, as inflation will increase due to higher government spending, as well as imported inflation due to trade restrictions. 

The price of oil and coal will rise, partly because of Trump’s preference for “old” energy resources. Gold should also be supported because of its safe-haven status. 

The outlook for the dollar is less clear. The greenback is declining due to fears of trade wars and the possible sale of Treasuries by the Chinese government. A flight to safety, on the other hand, could lead the dollar upwards. What is more certain is a further decrease in the Mexican peso and some other emerging-market currencies. 

While Republicans have retained control of both the House of Representatives and the Senate, it’s unclear how the new president will work with Congress since many Republicans rejected his candidacy.  

However, given the Republican majority, Trump is more likely to succeed in implementing at least some of his controversial ideas. Lower taxes and increased infrastructure spending appear to be certainties. 

Assuming all his proposed measures were implemented, the immediate effect would be stimulative: the domestic economy would receive a boost from increased government spending and higher wages from employers competing to replace lower-cost immigrant labor.  

In the slightly longer term, the US would witness rising inflation due to increased costs, higher wages and increased government borrowing to fund an additional annual shortfall of $1 trillion. This, in turn, would lead the Federal Reserve to raise interest rates to combat inflation, leading to a drop in employment and, potentially, domestic recession. 

Earlier analysis by Moody Analytics suggests the following specific outcomes for the United States: 

  • Unemployment would increase from 5.5% to 7% (representing a loss of 3.4 million jobs)
  • Inflation would rise from 1% to 4.2% (leading the Fed to hike interest rates)
  • National debt would grow from about 75% of GDP to more than 130%
  • 10-year Treasury rates would increase from 2.4% to 6.7% 

While such conditions would of course negatively influence worldwide growth, an international trade war would pose an even more serious challenge to the global economy, with higher costs to consumers worldwide and multiple countries falling into recession. 

Today, though, we are not convinced that such an extreme scenario will prove more than hypothetical. Working with Congress, President Trump (who has never held public office) may prove less an ideologue than a pragmatist – reassuring markets and investors. 

For the moment, we expect equities to decline, but less than the 10-15% some market commentators have predicted. Monetary policies remain accommodative, and an anticipated December Fed hike is now less certain. Such ongoing uncertainty could lead to spikes in volatility, reinforcing the need for portfolio diversification. 

Volatility will present opportunities. Firms that are strong domestically have better prospects than those that are dependent on international trade or overseas profits. 

Additional infrastructure investment is likely to support the construction sector. Defense, ”old”  energy, mining, pharmaceuticals and insurance are also likely to benefit.

For financials, the outlook is less clear. On one hand, an immediate repeal of the Dodd-Frank Act could support the banking sector. On the other, it could increase uncertainty and risk premia. 

Finally, likely losers include renewable energy, exporters, consumer staples and healthcare services. The biggest loser of all may be the polling business – which, in Brexit’s wake, has once again gotten an extremely important vote absolutely wrong.