Putting Geopolitics, Fiscal & Monetary Policies in Play

Viewpoints

January 23, 2017

Since the financial crisis, monetary policy has driven markets. With the Trump administration taking over Washington, geopolitics (trade deals, shifting alliances) and fiscal policy (tax cuts, infrastructure spending) will gain significance. Thus, we are leaving a regime of stable geopolitics with little fiscal developments and supportive monetary policy. We enter into a new regime where geopolitics, fiscal policy and monetary policy will all be simultaneously and rapidly adjusting. This transition should result in heightened volatility across markets.

A New Geopolitical Order

Before even taking office, Trump has stated his intention to withdraw from the Trans-Pacific Partnership, renegotiate NAFTA, and label China a currency manipulator. While the goal of new trade deals may be to benefit the United States economy, it is hard to anticipate the auxiliary impacts they will have on the global economy and their potential for future quid pro quo responses from other nations. Furthermore, it remains unknown if labeling China as a currency manipulator will lead them to taking various actions in response.

From a global stability standpoint, there is also increased uncertainty about what the United States’ role will be going forward. While the “pro-globalization” stance of the past resulted in an official strong dollar policy with the U.S. acting as a stabilizing force of the global order, Trump’s labeling of NATO as “obsolete” and his seemingly cozy relationship with Russia signal drastically changing global dynamics.

While it remains unclear how the U.S. role in global politics will develop, as alliances fluctuate and the U.S. looks more inward, markets will have to re-price rapidly, altering global equilibriums and their larger economic implications.

Fiscal Policy Stimulus

President Trump intends to cut both personal and corporate taxes, simplify the tax code and encourage repatriation of the more than $2 trillion currently being held overseas by corporations. If enacted, each of these measures should help stimulate the economy. Yet, many details remain to be ironed out and any ultimate impact would occur with a significant lag. While markets are forward looking, consumers and small business are as well, and both of these cohorts reported significant increases in confidence, which is a positive sign for the future.

Infrastructure spending is also on the agenda as Trump promises to repair the country’s crumbling roads, bridges and airports. As with tax cuts, it is uncertain if the fiscally conservative Republicans will be supportive of increased federal spending that may not be “revenue neutral.” Assuming infrastructure spending does materialize, there is also uncertainty as to the fiscal multiplier with which it will impact the economy. The common trend here is that uncertainty abounds.

One additional element on the policy agenda front that could be supportive of growth is the removal of regulations. While Trump’s proposal of removing two existing regulations for every new federal regulation is straightforward, there remains a lack of clarity on exactly what will be repealed.

Thus, the fiscal side could best be described as promising, but with a lot of uncertainty on specifics.

Monetary Policy – A more Hawkish Fed?

President Trump will also have the ability to significantly shape the Federal Reserve through his two board member appointments and his eventual selection of the next chair after Yellen’s term is up in the beginning of 2018.

Who is Trump most likely to appoint? Kevin Warsh, John Taylor and Glenn Hubbard are the most cited academics to fill the open seats, but President Trump’s Rex Tillerson selection for Secretary of State shows he is not afraid to think outside the conventional box. Accordingly, Trump may choose to nominate financial market practitioners over traditional academics. This could lead to more rapid disruption of a current Fed regime that is staffed primarily by academics.

Yet, even if Trump does change leadership at the Fed, he may not wish to have a significantly hawkish Fed during his presidency. Four of his recent statements hint at this.

First, Trump recently rejected the United States’ strong dollar policy by saying that “our dollar is too strong… and it’s killing us.” While many factors influence foreign exchange appreciation, the most direct is when central banks significantly increase rates thereby augmenting yield differentials versus other currencies. A hawkish Fed that is aggressively hiking rates would lead to a much stronger dollar. If Trump doesn’t want a strong dollar, he doesn’t desire a hawkish Fed.

Second, Trump claims that he “will be the greatest jobs producer that God ever created.” Replacing Chair Janet Yellen (a labor economist) with an inflation hawk who rapidly hikes rates would not coincide with this desire, as hiking the economy into a recession would coincide with significant job losses.

Third, Trump has delighted in calling the post-election equity rally the “Trump rally,” despite criticizing equity valuations during his campaign as a Fed-induced “equity market bubble.” This reveals that Trump is closely monitoring the stock market and is favorable of higher valuations. Given his propensity to promote that to which he attaches his name, it is hard to imagine him welcoming a large market correction that may be caused by a recession due to a more hawkish Fed.

Finally, Trump has claimed numerous times that he is “the king of debt.” While corporate debt has very different characteristics from U.S. sovereign debt, if Trump is able to pass his ambitious fiscal agenda it will have to be funded by increased Treasury issuance. Treasury Secretary Mnuchin’s recent comments favoring longer-dated issuance show this is a concern. A less hawkish Fed results in this debt being issued at lower outright yields.

It could be argued that tighter monetary policies need not necessarily cause a recession if they are met with aggressively easier fiscal policies. Yet, the degree to which these contrasting policies would offset is uncertain. The safest approach towards a weaker dollar, more job creation, continued equity strength, and cheaper debt issuance would be to avoid an extremely hawkish Fed regime.

Like so much of Trump’s presidency, details remain to be seen. It is surely possible that Trump could do the unexpected and radically upend the Federal Reserve.

Conclusion:

In the past, investors could trust that the only game in town- the central banks - had their backs. Any indications of dovishness from Ben Bernanke and Janet Yellen proved suitable support for risk asset longs and complacency in rates. While it is unlikely that the Fed turns extremely hawkish, going forward, watching the Fed will not be enough. Investors must now simultaneously take heed of adjusting global dynamics, evolving fiscal agendas and monetary policy uncertainty. With more variables in play, more volatility should be expected across all asset classes.

 

 


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