“House of Horrors” read the New York Daily News. “W.T.F” read the Daily Telegraph. The Scottish Buchan Observer was more light-hearted, leading with “Aberdeenshire business owner wins presidential election.” Of course, these were headlines which appeared following the election of Donald Trump to the White House.
So, given that Trump is now the president-elect, what are the implications of his proposed policies?
During the campaign, Trump repeatedly promised to renegotiate or withdraw from NAFTA, and he now has the sole power to do so. The 1974 Trade Act empowers the president to withdraw from trade agreements and impose tariffs and sanctions. If Trump was to make good on his promise, it would mark the first withdrawal by the US from a trade agreement since 1866.
Withdrawal from NAFTA could lead to a trade war between the US, Canada, and Mexico. For US companies like GM, IBM, and Ford who manufacture in Mexico, a sudden withdrawal from NAFTA could severely disrupt production and supply chains.
Even if these firms promised to repatriate operations, which is the intended impact of the policy, it could take years to fully do so. In the meantime, if Trump were to slap tariffs on all goods crossing the Rio Grande, it would lead to an increase in prices, impacting consumers and corporations alike. Given that 62% of American have less than $1,000 in savings, and year-over-year growth in corporate profits has been negative for 6 straight quarters, I’m not sure either entities could afford a rise in prices.
In theory, placing tariffs on goods produced by US firms at ‘’offshore’’ locations would incentivize them to repatriate jobs. However, higher labor costs would further weigh on corporate profits, thus reducing their ability to hire.
In response, Mexico could place tariffs on the $214 billion of manufactured products US firms exported south of the border in 2015. Given that the Mexican consumer is no better-off than his American counterpart, tariffs could hit sales hard.
Although Trump has mainly spoken of Mexico during his attacks on NAFTA, Canada is also part of the deal. There was an estimated $663 billion in trade between the US and Canada in 2015, so disruption of any kind to NAFTA would have severe negative consequences for economic activity in both the US and Canada.
Along with having a negative economic impact, it could also create political uncertainty in the region. Which, as described here by Steven J.Davis, could be one of the main reasons there is now $50 trillion in cash sitting on the sidelines.
Besides stating that he will renegotiate or withdraw from NAFTA in his first 100 days, Trump has also promised to impose trade sanctions on China.
Enter, The Dragon
In 1979, one year after taking control of impoverished China, Deng Xiaoping declared ‘’to get rich is glorious.’’ Since Deng’s declaration, China has adopted a largely free-trade policy, growing at an average annual rate of 9.7% ever since. China has experienced this rapid expansion largely as a consequence of capital accumulation and a sustained increase in labor productivity—something Trump must hope to spur if he is to ‘’Make America Great Again.’’
China’s 37-year free-trade expansion may now be in jeopardy, given Trump’s trade promises. In his first 100-days, Trump has promised to ‘’direct the secretary of the Treasury to label China a currency manipulator’’ and place tariffs on Chinese imports if they fail to cease the manipulation. If Trump carries out his aforementioned promises, it could have the same effect as withdrawal from NAFTA, with potential for more escalation.
China is the largest foreign holder of US Government debt, with holdings of $1.22 trillion in bonds, notes, and bills. In response to the US labeling it a ‘’currency manipulator,’’ China could dump large amounts of treasuries on the market and also abstain from future auctions. This would result in an excess supply of treasuries in the short term, causing yields to climb, thus pushing up borrowing costs for the US.
However, given that there is $8.7 trillion in negative-yielding debt currently outstanding, and that $50 trillion in cash is sitting on the sidelines, if rates on US debt were to rise, they may be quickly suppressed by substantial investor demand. This, coupled with the fact that there are no other large, liquid markets in which the Chinese can deploy their capital, would make China hesitant to retaliate in this fashion.
Herein lies the real risk of US trade sanctions; given that the president is considered ‘’the leader of the free world,’’ these policies could usher in a new era of 1930’s style protectionism. 21st Century protectionism could be even worse than what came before, given how interconnected the world is today compared to the 1930s.
Besides potential trade wars, Trump’s policies also risk causing market dislocations.
Caught Between a Rock and a Hard Place
Since the election on November 8th, the 10-year treasury yield has jumped more than 19% to 2.24%, its highest level since December 2015. The spike has been attributed to Trump’s proposed $550 billion fiscal stimulus package, which is expected to push inflation higher.
At the same time as Trump is proposing fiscal expansion, he has also been extremely hawkish on monetary policy. This dynamic could potentially cause a multitude of problems.
If the Federal Reserve raises the federal funds rate (FFR) in December, which is now widely expected by the market, it would cause interest payments on the debt to rise. The US spent $223 billion on interest payments in 2015 alone (6% of the budget).
Higher rates would increase interest payments, in turn raising the cost of Trump’s proposed $550 billion fiscal package. As the debt-to-GDP ratio is already over 105%, if borrowing costs increased, the proposal could lose support from Republicans.
However, the government wouldn’t be the only entity hurt by higher rates. When the Fed increased the FFR by 0.25% in December 2015, delinquency rates on commercial and industrial loans spiked 50%.
Although US equity markets have reacted positively to the election thus far, given that rates have been excessively low for over seven years, a rise in rates and bond yields could cause market dislocations. This in turn could create headwinds to economic growth, as Mohamed El-Erian explains here.
Even if Trumponomics goes to plan, and we don’t witness rising defaults or market dislocations, there are some other potential pitfalls.
As outlined above, Trump’s fiscal stimulus is expected to increase inflation. However, in the current environment, rising inflation could be problematic.
Given that the US consumer is in a bit of financial peril as we outlined above, an inflationary environment would create further headwinds to economic growth. Inflation would also eat into the already record-low bond returns, having a further negative impact on the economy.
If rising inflation is not coupled with sustained GDP growth, it could lead to stagflation, which Goldman Sachs sees the possibility of. A telltale sign of whether Trump’s policy is working or not will be if we see an increase in labor productivity and capacity utilization, which would signal true economic growth.
Having discussed the potential negative consequences of Trump’s policies, it’s only fair that we discuss some potential positive implications of Trump’s election to the White House.
The Sunny Side
During the campaign, Trump proposed simplifying the tax code—which currently runs for 75,000 pages—and reducing taxes on all Americans.
Highlights of his proposal include: reducing taxes on all American’s, cutting the number of tax brackets from 7 to 3, and eliminating the estate tax. Trump’s plan would also cut the corporate tax rate from 35% to 15%.
Given that Federal tax compliance costs totaled $37 billion in 2015, plus another $409 billion in IRS regulation costs, not to mention the billions of human hours spent filing paperwork, Trump’s proposal is extremely positive for the economy. Trump also stated he would allow US firms to repatriate an estimated $2.5 trillion in cash back to the US, incurring a 10% tax for their troubles.
Another growth-positive proposal contained in Trump’s plan is to scale back existing regulation and place a temporary moratorium on all new regulation. The Code of Federal Regulations has grown eight-fold over the past 55 years and is now 175,000 pages long. The compliance costs of these regulations are estimated to be $1.88 trillion per annum. That estimation doesn’t even include compliance costs for regulation such as the 2,300-page Dodd-Frank Act, which Trump has also said he will dismantle.
Trump also said he will repeal and replace the Affordable Care Act. Given that the ACA is estimated to cost the US taxpayers $1.76 trillion over an 11-year period and that premiums are set to skyrocket once again, it is a growth-positive proposal.
Last, but certainty not least, is the diminished chance of a war. Although many people view the President-elect as hot-headed and volatile, in the months leading up to November 8, it seemed Hillary Clinton and fellow Democrats were posturing up for conflict with Russia. In contrast, Trump’s comments towards Russia have been passive, also stating that he wants to ‘’end the current strategy of nation-building and regime change.’’
Having explored the potential implications of Trump’s policies, what actions can we take to limit downside risk, while also positioning ourselves to profit from the positives?
Patience Trumps Risk
Although equity markets trended higher since the election, whilst precious metals and bonds moved lower, it’s too early to know how Trump’s policies will affect markets going forward. For now, ignoring short-term market moves—and being cautious—is a prudent strategy.
Trump’s 100-day plan contains a lot of major time-consuming proposals, so we will not know where his priorities are until he takes the oath around two months from now on January 20th.
There is plenty of time to profit from the positive aspects of Trump’s agenda. The market gyrations witnessed since November 8th are mainly speculative moves, based on how his policies will affect the economy. Early participants in this move could be shaken-out if Trump decides to go gung-ho on his trade proposals straight out of the gate.
For now, cash is king. Keeping your powder dry will limit downside risk, whilst allowing you to re-allocate it during more favorable conditions, if markets tank before moving higher on the back of Trump’s growth-positive platform.
Chief Analyst, RiskHedge