Trump, Policy, Markets
David R. Kotok
Cumberland, January 17, 2017
As Don Rissmiller of Strategas Research Partners succinctly points out:
“There are four types of government policy that can be used to steer the economy: 1) monetary policy, 2) fiscal policy, 3) regulatory policy, and 4) trade policy.”
We will use Don’s framework for today’s discussion. Monetary comes first.
After eight years of zero-interest-rate policy, the United States’ central bank finally raised its policy interest rate by a quarter point in 2015 and by a second quarter point in 2016. For the last 10 years, the Fed has missed on all of its forecasts of inflation (PCE) and unemployment (U3) and growth (GDP). The originally famous dot plot has become infamous, and one member of the FOMC did not even hazard a forecast as of the last meeting. (See “December FOMC Minutes,” by Bob Eisenbeis.)
Markets seem to be expecting two Fed hikes in 2017. So our base-case forecast for the end of 2017 is a policy rate range of 1.25% to 1.5%. That would put three-month LIBOR at about 2%. We expect the 10-year US Treasury note to yield around 3% or so. We believe the tax-free bond market sell-off was wildly overdone, and we expect the present 4% level on tax-free high-grade Munis to give way to the 3% handle level. Beyond 2017 is still guesswork, since the details of Trump policies are only guesses. We think this will change quickly, and then markets can refine estimates of Fed policies and rate forecasts.
This lack of clarity and base-case assumption about the Fed was well articulated by Phillipa Dunne & Doug Henwood in the Liscio Report:
“There now seems to be a consensus that the Fed has intensified its likely tightening schedule for 2017. The labor market is showing signs of tightening, and wage pressures are rising — an inflationary danger with productivity as poor as it is. But we’re also seeing signs that this expansion is maturing, and that growth may disappoint in the coming months. We’re not arguing that a downturn is imminent; we are suggesting that bullish expectations may be overdone. Sure, we may get some fiscal stimulus, but if it’s tax cuts tilted towards the upper bracket, the stimulus might be limited. The moral of this story is not to put much stock in forecasts and take each day as it comes.”
Thank you to the Liscio Report. We wholeheartedly agree.
Fiscal policy is clearer when it comes to the direction. Magnitude is uncertain. The federal deficit was at a nearly $2 trillion red-ink run rate at its worst in the Great Recession and in the midst of the 2007–09 financial crisis. The recovery of the last few years narrowed the flow of red ink to under $500 billion while the economy grew steadily but slowly. It now appears that the fiscal deficit contraction is over. The deficit is worsening, but so far only at a gradual rate. What happens to it under the Trump administration is unclear, but the policy proposals we hear about are likely to widen it. In the beginning, that widening will have mild effects on markets and interest rates.
Here is why we expect the initial deficit-widening phase to be benign. From 2006 to 2016 the United States issued about $10 trillion of additional debt in the form of Treasury bills, notes, and bonds. It also expanded the use of the federal guarantee. At the same time the Fed’s monetary policy took interest rates to historic lows and kept them there. Thus the budget impact of interest cost was neutralized by falling rates. And that is in addition to the Fed’s purchases (QE) of Treasury securities and federally guaranteed mortgages. The bottom line is that the interest paid by the United States has changed little in 10 years even as the debt more than doubled. Interest expense in the federal budget has been running around $400 billion a year.
With interest rates now rising, that period of totally benign impact is ending. But much of the intermediate and longer-term debt has been fixed, and low interest rates are in place. So the process of raising interest rates starts with a slowly inclining path of interest costs in the budget. Over the years that cost will accelerate and intensify, but we think that it is not likely to become meaningful for three or four years. Markets may anticipate some of this. And interest rates are certainly dependent on what the Fed does. Bottom line for us is that the initial fiscal stimulus will be positive as an economic force, but that may be a mild force at work. We just don’t know. We have no estimate now but expect the first few months of Trump & Company will clarify what may lie ahead.
Regulatory policy is predictable to the extent that it will be delivered as a broadly applied structural easing. The Trump administration will start reversing Obama’s regulatory tightening on its first day. We expect that stance to continue throughout the presidential term. Where possible we expect Trump to attempt to legislate lifting of regulations that have mandates. Only the Senate 60-vote rule is a barrier to that effort; and the question is how much can be lifted by using the 51-vote, simple majority, continuing resolution (CR) method. But readers need to consider that the Trump appointments will have immense power to reverse regulations. These several thousands of folks and those they hire to fill slots previously held by Obama administration personnel are the people who make the rules and implement them.
How much this regulatory easing means for the economy is difficult to estimate, but it is certainly a force of some substance. Financial markets have already priced in a favorable result. We see that at work in stock market sectors like banks and energy. We expect that optimism to continue.
Trade policy is a source of worry for us. History is unkind to tariff and trade barriers when they are used in a policy-making form. And they usually have poor results when they incorporate complex tax structures like those proposed by Trump. Will the United States repeat the extreme approach of Smoot-Hawley in the Great Depression era? We don’t know, but we see few current references to that history, and that concerns us. Remember, it was Smoot-Hawley legislation that took a serious recession and turned it into a depression in the 1930s. And history shows that the premature actions of a Federal Reserve tightening in the late 1930s pushed a gradually recovering US economy back into serious recession. It took World War II preparations to turn the US economy around.
That point leads me to the fifth policy issue. It was not on the original Rissmiller list, which is no criticism of Don. He is a personal friend and GIC colleague, and we have discussed geopolitical risk in detail. We both agree it is there in a big way. Don’s list was an economic one and thus did not include the foreign policy realm. We want to add that factor.
We raise it here because international belligerency, war or near war, may change the trade policy equation. War can override trade, as it has done throughout history. The inventory of trouble includes the South China Sea (Japan versus China and China versus Taiwan), the Baltic buildup (Russia), the Persian Gulf (Shia-Sunni schism) and the Middle East (Russia-Syria, Turkey, Iraq), and especially the unknowns about North Korea (China’s loss of control and influence over dictator Kim).
We want to pause and quote from Michael Auslin’s new book: The End of the Asian Century: War, Stagnation, and the Risks to the World’s most Dynamic Region. Hat tip to the American Enterprise Institute for a ringing endorsement.
“I am hunched over, almost on my hands and knees, nearly 250 feet below ground. Behind me is close to a mile of tunnel, hewn through solid rock. In front of me is a steel door set into a concrete barricade. Through its tiny window I can see another barricade and steel door, maybe another one hundred feet ahead. Beyond that lies North Korea.
“I have crawled into one of the dozens of ‘tunnels of aggression’ dug by the Pyongyang regime into South Korean territory. Discovered in 1978, it lies only twenty-seven miles from Seoul and was designed to bring waves of North Korean saboteurs and special forces under the heavily defended border to wreak havoc in case of war. It is the only tunnel open to the public, and the tour buses that bring visitors to this no-man’s-land pass by hills that still contain hundreds of land mines aimed at stopping an invasion from the North.
“Yet as much as Tunnel Number Three is a reminder that the Korean border, the ironically named ‘Demilitarized Zone,’ remains one of the most dangerous spots on earth, it also is a metaphor for all of Asia. While dynamic and peaceful on the surface, the continent is riddled with unseen threats, from economic stagnation to political unrest and growing military tensions. These risks also threaten the rest of the world, thanks to the extraordinary economic, political, and military growth of Asia over the past decades.”
Here is an assessment by Night Watch, published on January 12, 2017:
“The Chinese are losing control of affairs in their own backyard. Events that have not gone their way include the two North Korean nuclear tests in 2016; the numerous North Korean missile launches last year; South Korea’s decision to install a Terminal High Altitude Area Defense (THAAD) system; Japan’s interest in THAAD, and the sudden prominence of Taiwan in international affairs. Finally, there are no prospects for reviving Six Party Talks on North Korea’s nuclear program, which is a centerpiece of Chinese policy for restoring stability to the Korean peninsula.”
Let’s summarize our item number 5. The least predictable and most apparently rising risk is in the geopolitical sphere. What the Trump administration will do when it is tested remains to be seen. We have no data yet. It is hard to conceive that there will be no test of Trump. We do not expect peace to break out globally.
Let’s end this list with a quote from George Friedman. When I thought about my own experiences in government positions, George’s words gave me pause. On January 11, 2017, George Friedman wrote as follows:
“There are four classes of people in Washington. There are those who research policy papers. There are those who write policy papers. There are those who present policy papers. There are those who throw away policy papers. Political power is in the hands of the latter. For those climbing the hierarchy of the policy-production industry – the think tanks, universities and government departments – writing policy papers is a serious attempt to create deep and comprehensive guidance for leaders. The issue is the relationship between policymaking and the presidency. On the surface, they are the same. In my view, they are at most indirectly connected.
“One of the accusations against President-elect Donald Trump is that he is inconsistent or disengaged from the complexities of policymaking. That is probably true. However, it gives me an opportunity to consider the relationship between policymaking and the American presidency and, by extension, other political systems. I would argue that the idea that policy optimization is at the core of the presidency is incorrect. The president is not the U.S.’ chief administrative officer. He is a leader and manager of the political process. His job is to be a symbol around which a democratic society draws the battle lines of who we are. He must express his vision as something aesthetic, not prosaic. The president cannot spare time from his real job to craft policies. Successful presidents know that and hide it. Trump doesn’t try to hide it.” (For details see George’s newsletter).
In sum, monetary policy is tightening slowly. Fiscal policy is easing slowly. Regulatory policy is easing quickly. Trade policy may tighten quickly. Geopolitical risk is high and rising. That is how the start of the Trump administration looks to us. And that is why, at Cumberland, we have a cash reserve in our managed accounts.
Since this commentary was first drafted, two other items have warranted some reflection.
The first is a note from Dennis Gartman, which we will append below. He alerts folks to the pitfalls when government is picking winners and losers. We see Trump doing that with tweets and meetings, and I recall my time when I chaired the NJ Casino Reinvestment Development Authority, and Donald Trump and his casinos were among those who had obligations to NJ. Our longest meeting with Donald Trump was two hours. We held hearings on his casino applications, and we watched his staff in action. Drawing inferences now from those times many years ago is a private matter. But I do note that, at the encouragement of and with the support of then-Governor Tom Kean, we did not pick winners or losers. We maintained a level playing field purposefully for Donald Trump and for everyone else. I also recall that the Casino Control Commission, then the licensing board, also maintained a scrupulously level playing field. In fact, that is how the only public tax return of Donald Trump exists. He wanted a casino license, and the only way he could get it was to be public with his tax return just like everyone else.
Here is what Dennis Gartman wrote, and the implication is unhealthy for stocks and companies and markets.
“Finally, we offer up a bit of advice… wholly unsolicited of course… to the nation’s CEOs: in light of the damage that can be wrought upon your company’s stock price should you find yourself in the rifle scope of Mr. Trump’s displeasure, before Mr. Trump can take issue with your company, rush to his home on 5th Avenue in New York for a one-on-one meeting. At that meeting, tell Mr. Trump what a brilliant man he is, appeal to his narcissism and enjoy the benefits that accrue instead, as he inevitably shall tell the world what a fine leader you are and what a wonderful company you lead. It is a fact that the stocks of the compan[ies] whose CEOs or chairmen have visited with Mr. Trump in this fashion have risen even more sharply than the broad market itself has done. ‘Tis a word to the wise that hopefully shall not fall upon deaf ears.” – Dennis Gartman, January 12, 2017.
Lastly, we just saw a weekend essay by Andrew Sheets, Morgan Stanley’s chief cross-asset strategist. He included this sobering reminder of where we are and where we were:
“Good market environments often involve a shift from economic despair to optimism, and a shift in psychology from ‘fear’ to ‘greed’. Both occurred over the last eight years, producing returns well above the long-run average. Whichever party was next to take the White House, it was going to be a tough act to follow.
“And what an act it was. Eight years ago, stocks were in freefall, credit markets were frozen and a highly leveraged US banking system was struggling to avoid collapse. Car sales had fallen 50%, consumer confidence was at all-time lows and the housing market, the single biggest store of wealth in the United States, was witnessing foreclosure rates not seen since the Great Depression. Two foreign wars and falling tax revenues were pushing the budget deficit towards historical highs.
“It was a troubling time. Market pricing, unsurprisingly, reflected that despair. The last time the market cared this much about what a new US president would do, the S&P 500 was at 805, high yield bonds yielded 18.1% and the VIX stood at 56%. Those same numbers today? 2257, 5.8% and 12%.
“Those changed levels reflect a remarkably changed backdrop. Today, US car sales and consumer confidence are historically high, residential and commercial real estate prices are above prior cycle peaks and US banks are now trying to return capital, not raise it. US credit markets saw their highest-ever level of bond issuance (US$1.3 trillion) in 2016, jobless claims have hit a 40-year low and the budget deficit is back to the average seen since 1980. The S&P 500 equity risk premium was 5.8% in 2009, and now it stands at 1.4%. Returns under the outgoing administration, in short, enjoyed both cheap starting levels and a large rate of change. The incoming one may not have either. Things, of course, could get better, and we certainly hope that strong returns continue. But investors looking to keep the good times rolling should remember a key thing from the above: Starting points matter, making it logical to start with things that haven’t had a particularly good time over the last eight years.”
Many thanks to Michael Auslin, Phillipa Dunne, George Friedman, Dennis Gartman, Doug Henwood, Don Rissmiller, and Andrew Sheets. You each added thoughtful contributions to the debate and discussions as we enter this new era and new regime.
David R. Kotok, Chairman and CIO