Macro musings: Will global optimism be Trumped by reality?

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March 16, 2017

Many pundits predicted Hilary Clinton would win the US election and got it wrong. Many others predicted Britain would remain in the European Union. They got it wrong, too.

Now that Trump is in the early days of his presidency, it’s time to assess what risks are on the horizon – and whether markets have truly thought them through.

Don’t count on stronger economic growth

Equity markets have surged since Trump’s election victory last November and bonds have been heavily sold off. Bond proxies such as listed real estate have also fallen as markets bet on Trump’s new infrastructure spending, tax-cutting policies finally reviving inflation and spurring economic growth.

However, the US economy is already growing at about 1.5 to 2 per cent a year and Trump wants to double it to 4 per cent. The path to achieving this is far from clear but, even if it occurs, strong economic growth rarely equals strong equity market growth.

Economic growth is underpinned by increased labour force participation and rising productivity growth. US unemployment has already dropped to 4.7 per cent from 10 per cent in 2009 and inflation is slowly rising.

While the participation rate (those employed or looking for work) has fallen significantly since the GFC, many of those unemployed workers are unskilled – even if they are employed, they’re unlikely to drive the type of economic growth Trump is targeting.

Meanwhile, population growth in many developed countries such as the US is slowing and immigration levels are likely to fall under Trump’s anti-immigration policies.

That leaves productivity as the final saviour of economic growth. Unfortunately, productivity gains have been dropping over the past decade.

For example, the well-known Moore’s Law, which states that the number of transistors in an integrated circuit doubles about every two years, has begun to break down. Other proposed technological improvements, such as autonomous vehicles, are likely to cost jobs at least in the short term.

We certainly agree that investment in infrastructure, if effectively executed, will lead to efficiency and therefore productivity gains – but enough to double real GDP growth?

A more likely scenario is that Trump’s stimulatory policies drive inflation up but, without increased substantial labour force participation or productivity growth, economic growth remains only moderate.

This scenario is not a certainty by any stretch, but investment markets seem to be pricing it as a zero per cent chance of occurring.

This would be a negative for a range of assets and a significant risk that markets are ignoring.

Don’t discount the impact of protectionist policies

Market volatility has fallen away dramatically since Trump’s election despite the high levels of uncertainty about what policies he will enact. Nowhere is this more apparent than in his protectionist policies.

He has threatened to impose a 45 per cent tariff on imports from China and vowed to name China a currency manipulator in an attempt to correct the trade imbalance between the two countries and bring jobs back to Americans. Tariff increases of this size are unprecedented and would cause inflation to surge.

The renminbi did, in fact, appreciate strongly against the US dollar from 2007 through to 2014. It wasn’t until 2014 that the currency began falling against the USD – but the Chinese Government has been attempting to prop up its currency over this period as the downward pressure has come from locals increasingly sending money offshore. So the Chinese Government is doing the opposite of what Trump is accusing them of.

But the impact of a ‘trade war’ with China would still have major repercussions, including retaliation from those countries affected.

As unlikely as it is to occur, China could let markets decide what the renminbi is worth in response: it would plunge in value and rock markets. A much smaller event occurred in August 2015, when China devalued its currency for a second consecutive day, prompting a massive equity market selloff over the ensuing months.

These events could ultimately spell the end of globalisation and free trade which has benefited markets.

It’s impossible to predict just how these scenarios may play out but investors need to understand these potential risks and their probabilities, and then hedge against them.

Managing risk in the face of uncertainty

A rise in long-term inflation is bad news for equities and fixed-rate bonds as it eventually flows through into higher official interest rates (markets have now accepted that the Fed will raise rates multiple times this year).

It causes long-term bond yields to rise (and so bond prices to fall), and erodes the equity risk premium (driving down share prices).

Buying expensive equities in a rising inflation environment is a dangerous mix. Unfortunately the risks we have discussed in this paper are not reflected in current US equity market valuations, which are sky high.

While Asian and European equities may get caught up in a sell-off, their long-term return outlook looks reasonably attractive while Australian equities are trading at about their historical fair value level.

Valuations play a key role in determining long-term returns and managing downside risk, as does owning a diversified portfolio of assets with different underlying risk factors.

For example, we own floating rate notes, inflation-linked bonds and some alternative strategies such as managed futures, diversified beta, and volatility trading strategies.

While markets may continue to react positively for some time as Trump attempts to roll out his policies, focusing on the positives and ignoring the risks creates a combustible mix that threatens to explode.

Wise investors will continue to stay the course, take a balanced view, and stick to proven risk management strategies.


TOPICS:  Donald TrumpeconomieseconomyMoore's Law