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TRUMPFLATION AND OTHER STORIES

November 2016

Multi asset views from RLAM

Royal London Asset Management manages £101 billion in life insurance, pensions and third party Funds*. We have launched six Global Multi Asset Portfolios (GMAPs) across the risk return spectrum with a full tactical asset allocation overlay.

*As at 30/09/2016

This month’s contributor

Ian Kernohan

Senior Economist

Mr Trump won a majority in the electoral college, but not in the popular vote. The

Republicans have retained a majority in

the House and Senate, however their

majority in Senate is slim. While the US

political system includes checks and

balances, the President has broad powers

in trade and foreign policy to act without

Congress. In contrast to many

Congressional Republicans, Mr Trump is

conservative on global trade, but not

conservative on fiscal matters. We look at

the economic and market implications of

the election result.

The election of Donald Trump as President is a major watershed event,

not just for the US economy but for geopolitics in general. The market’s

initial response has been to focus more on the prospect of domestic

fiscal stimulus next year, rather than possible greater geopolitical and

economic risk further down the line.

Summary

While global growth remains below pre-crisis rates, it is still some way above global

recession levels. Given that backdrop, the outlook for monetary policy is mixed:

interest rates look set to rise in the US, while a period of policy easing in China has

come to an end. We still think the European Central Bank (ECB), Bank of Japan

(BoJ) and Bank of England (BoE) have a bias in favour of easing. Meanwhile, the

election of Donald Trump points towards a significant fiscal stimulus in the US,

and is part of a general trend away from excessive reliance on monetary policy.

Political risks in Europe will build from now on, beginning with the Italian

referendum on constitutional change, to be held in December. Next year, there are

major elections in the Netherlands, France and Germany. Markets will be watching

for signs that the Eurosceptic vote is growing.

So far, the UK economy has seen little impact from Brexit, aside from sterling

devaluation. We expect growth to slow next year, as rising inflation squeezes real

household incomes and the whole complex process of Brexit impacts corporate

decision making. Given the current legal issues surrounding Article 50, the

government’s Brexit timetable has been thrown into doubt.

US election

Source: BBC

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ECONOMIC OUTLOOK

Global: International Monetary Fund (IMF)

maintain global growth forecasts

The latest global Purchasing Managers’ Indices (PMIs) suggest

global growth remains within its post crisis range of 3-3.5%. If

anything, the pace of expansion has picked up in H2, with

stronger activity data in the US, China and some emerging

markets (EMs).

While global growth remains below pre-crisis rates of 4%+, it is

still some way above global recession levels. Given that

backdrop, the outlook for monetary policy is mixed: interest

rates look set to rise in the US, while a period of policy easing

in China has also come to an end. We still think the ECB, BoJ

and BoE have a bias in favour of easing, however there is

limited scope to go beyond measures which have already been

put in place. The election of Donald Trump points towards a

significant fiscal stimulus in the US, and is part of a general

trend away from excessive reliance on monetary stimulus.

US: labour market data remain consistent with a

post-election hike in US interest rates

We cover the economic implications of the US election result in

greater detail below. In summary, any impact from the

planned fiscal stimulus is unlikely to appear before late 2017 at

the earliest. In the meantime, the US Federal Reserve (Fed)

will be sensitive to the rapid rise in the dollar and in long bond

yields, making them, if anything, more cautious on the pace of

any tightening early in 2017.

Third quarter data showed that real consumer spending

increased at 2.1% annualised pace in the three months to

September, driven by continued job growth and rising

household wealth. Net trade was also a major contributor to

activity. By contrast, business investment has declined in each

of the past three quarters, with a notable slowdown in

residential investment. These early estimates are subject to

revision and the National Association of House Builders

(NAHB) index points to stronger residential investment (see

chart).

While GDP growth picked up in Q3, at just 1.5% year on year

(yoy) it remains weaker than pre-crisis rates. Despite this, it

has been strong enough to trigger a marked improvement in

labour markets. Although we think headline inflation will rise

for mathematical reasons related to oil price volatility, we

think the relationship between the unemployment rate and

inflation (aka Phillips curve) has shifted, with the Fed happy to

allow further falls in unemployment without an aggressive

policy tightening. The major caveat to all this is the scale and

timing of any fiscal stimulus. Tax cuts focussed on higher

earners may be saved rather than spent, while increased

infrastructure spend would take some time to have an impact

on the economy. Looking out beyond 2017 however, there are

clear upside risks to the pace of Fed hikes.

The current rate of monthly payroll growth would have been

expected to make a bigger dent in unemployment, however

participation rates have begun to nudge back towards pre-

crisis levels, while the share of employees working part time

for economic reasons is still relatively high. One key piece of

evidence that there is still slack remaining is the delayed

recovery in wage growth, which on an average hourly basis has

only just returned to 2009 rates of growth. If the economy was

really firing on all cylinders and rapidly running out of room to

grow, we would expect much stronger wage pressures. More

comprehensive measures of labour cost growth, such as the

Employment Cost Index (ECI), remain subdued.

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This ongoing recovery in the labour market means we still

expect the Fed to hike rates in December 2016, however with

other major central banks on hold or easing policy, we do not

think interest rate rises will get very far, given likely upward

pressure on the US dollar. Of greater importance than dollar

strength however, is the neutral rate of interest, which remains

lower than it was before the crisis. Pre-crisis it would have

been odd for activity and inflation to be at current levels

following such a long period of near zero interest rates, not to

mention quantitative easing (QE). Last month we noted some

of the key factors lowering the neutral rate: productivity

growth has weakened, while demographic change is also

bearing down on trend growth, as has a rise in income

disparity.

China: the recent period of policy easing has now

ended

In recent years, China has attempted to manage a transition

from a growth model based on investment, exports, and debt-

fuelled state-owned enterprises, to one driven by consumption,

services, and dynamic private businesses. This process has not

been without interruption however, and when growth slowed

too quickly in 2015, the authorities stepped up stimulus, via an

expansion in credit, especially for real estate developments and

state-backed infrastructure projects. This succeeded in

stabilising economic activity at the desired rate of growth,

however we still think the pace of economic growth will slow

further over the medium to long term, due to demographic

factors and a slowdown in productivity gains.

Consumption and investment have been the main supports for

growth this year, with retail sales and fixed asset investment

rising by 10% and 8.3% respectively in the year to October.

House price inflation has risen sharply (see chart) and over 20

urban governments have introduced measures to restrain

prices. The housing sector accounts for a large share of total

investment, after factoring in demand for everything from

concrete to household goods.

Debt levels in China have risen sharply in recent years,

however since the government already underpins most

lending, this limits the risk of sudden contagion. China has a

closed capital account and a reasonably strong government

balance sheet, with state controlled banks. In October, the

State Council approved debt-equity swap and other measures

aimed at reducing corporate indebtedness. Chinese companies

have accumulated $18tn in debt, equivalent to about 170 per

cent of GDP. The pick-up in nominal GDP growth, as deflation

eases, should ease some of the pressure on debt levels. In

nominal terms, GDP growth increased 7.8 per cent in the third

quarter, a sign that deflationary pressures are continuing to

ease.

Next year will be critical for President Xi Jinping, as he

prepares for a leadership transition that could determine

whether he will be able to push through difficult economic

reforms during his second term. While the impact of the

2015/16 stimulus will wane, we would not expect growth to

slow materially next year.

Eurozone: with rising political risks in 2017,

economic growth remains tepid and inflation is

still too low

Despite aggressive monetary easing in Japan and the eurozone,

growth rates in both economies remain tepid, while core

inflation rates are well below target levels. To some extent,

both appear trapped in a low-growth, low-inflation, low-

inflation-expectations environment.

Trend GDP growth in the eurozone is so low (poor

demographics is a key reason, especially in Germany) that even

modestly positive growth has been enough to create a fall in

unemployment. Fiscal policy across the region should provide

some support and corporate lending has improved, however

there is no sense that the eurozone economy has reached

escape velocity.

In contrast to the US, which will see a pick-up in energy

investment, the boost from cheaper energy in the eurozone is

now on the wane, with headline inflation set to rise, squeezing

still modest nominal income growth. There is no indication

that last year’s spike in M1 growth fed into stronger GDP

growth this year (chart overleaf) and this indicator has already

weakened.

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Political risks will build from now on, beginning with the

Italian referendum on constitutional change, to be held in

December. A “No” vote will not automatically trigger a general

election, even if Prime Minister Renzi resigns, with a

temporary arrangement likely until scheduled elections are

held in 2018. Renzi’s coalition has 377 of 630 seats in the lower

house and 164 of 315 seats in senate, so it would be difficult to lose a vote of confidence. Next year, there are major elections

in the Netherlands, France and Germany.

Longer term, we think the current arrangements for the euro

remain sub-optimal, in the absence of greater fiscal and

political union. Brexit may open up an opportunity to create

such a union, however even among euro member countries,

there will be differences of view in the right direction to take.

euro stresses will reappear if a sharp rise in global bond yields

puts pressure on peripheral spreads, the global economy falls

into recession, or a political crisis in a key member state puts

its euro membership under question.

UK: no evidence of post referendum slowdown,

however the Brexit timetable looks less certain

than it did

We now have quite a lot of official and survey data covering the

immediate post referendum period and the general conclusion

has to be that not much has changed in terms of economic

growth. The substantial fall in sterling has been the most

important economic development of recent months, and this

has both winners and losers. There has been some speculation

that the economic impact of Brexit won’t show up yet since “we

haven’t left the EU”. On that argument, any noticeable

economic impact would be delayed until 2019 at the earliest.

Our base case is for growth to slow next year, as rising inflation

squeezes real household incomes and the whole complex

process of Brexit impacts corporate decision making. Given

lead times, any hit to investment would not have shown up in

Q3 GDP, while a spike in political uncertainty post the High

Court ruling on Article 50 (A50) creates more known and

unknown risks to the government’s timetable.

There are risks to our base case on both sides: we may have

exaggerated the impact of Brexit on corporate investment, in

which case growth should hold up. If, however, households

respond to the squeeze in real incomes and rise in uncertainty

by raising their savings rate, then the hit to consumption and

economic growth could be greater than we are assuming. Since

we expect global growth to hold up well in 2017, this should

limit the downside to the UK, as a medium sized open

economy with a flexible currency.

We expect Consumer Price Index (CPI) to rise from <1% now

towards 3% in 2017, though we do not expect a repeat of the

2010/11 spike in inflation to 5% - this was driven by two VAT

hikes, a jump in oil price from $35 to $127 per barrel over 24

months, plus other factors, such as phasing in of university

tuition fees. Global foodstuffs inflation has spiked in sterling

terms (chart), but not to the same extent as earlier episodes.

On monetary policy, although our November BoE rate cut call

was based more on a reading of prospects for the UK economy

in 2017 than it was on the Q3 GDP, it wasn’t totally insensitive. Despite the fact that early estimates of GDP are often quite

inaccurate, the 0.5% quarter on quarter (qoq) print and recent

sterling weakness led the BoE to pause and wait for another

opportunity to ease if the economy slows during the Brexit

process, which we assume it will.

Looking further ahead, we think there is room for a

compromise deal between so called hard and soft Brexit

options. Key states such as Germany with substantial surpluses

in UK trade will not want to see a complete trade rupture. Also,

the UK is the second largest net contributor to an EU in need

of cash, so this may be used as leverage. A new FTA could be

rolled up with the A50 process, to shorten the ratification

timetable. Since it is unlikely that trade with the EU will

become more rather than less open, any reduction will have to

be offset by increased integration with the Rest of the World if

UK potential growth is not to be hit.

The government’s budget position is not independent of the

rest of the economy, since sectors in the economy borrow and

lend from and to each other. As a sovereign borrower, any

government can be more flexible than households and firms.

By dropping Mr Osborne’s plan to run a budget surplus by

2020, the new Chancellor has created room for households

and firms to borrow less than they otherwise would have, in

order to maintain growth in demand.

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SPECIAL TOPIC –

IMPLICATIONS OF US

ELECTION RESULT

We outline the main economic and market

implications

In the previous edition of this report, we noted that:

“while polls suggest a Trump victory on 8th November is unlikely,

such polls have failed to call important votes in the recent past. The

fact that Donald Trump is a candidate at all, is evidence of the

continued backlash against globalisation.”

One month on, and it is this tension between globalism and

nationalism which helps explain the outcome. Mr Trump won

a majority in the electoral college and not in the popular vote,

however it was blue collar states such as Ohio and Wisconsin,

which gave him his victory. The Republican Party has also

retained a majority in the House and Senate. Their majority in

Senate is slim: many issues will require a super majority of 60

votes, however fiscal votes require only a simple majority.

Though the US political system builds into its structure

important checks and balances, the President has broad

powers in trade and foreign policy to act without Congress. In

contrast to many Congressional Republicans, Mr Trump is

conservative on global trade, but not conservative on fiscal

matters. Many Republicans are against deficit financing per se,

and believers in smaller government overall. This is not the

platform which Mr Trump stood on, and so there is a general

question about the likely size of the gap between his campaign

rhetoric and policies which will need the consent of Congress.

We outline the key policy areas below. Markets are most

concerned about Mr Trump’s anti-free trade rhetoric, which if

implemented, would be a long-term negative for US and global

growth.

Tax reform and deregulation

Mr Trump proposes personal and business tax reform: cuts in

personal tax rates, a reduction in the corporate income tax rate

to 15%, and a one-off 10% tax on all foreign earnings not yet

taxed by the US (companies will be free to repatriate these

earnings without additional tax, once this tax has been paid).

There is broad support for tax reform within the Republican

party. There is also support for Trump’s policies of

deregulation in the energy and financial sectors, including a

partial repeal of Dodd-Frank.

Trade and immigration restrictions

Congressional Republicans are much less keen on Trump’s

policy proposals in this area (as is consensus market opinion),

however the new President-elect has considerable support in

so-called rust belt states, which he will be reluctant to ignore.

Trade policy is an area where a US President has significant

room for discretion to act without Congressional approval:

Congress must approve trade agreements, but the actual

legislation usually authorises the President to ratify an

agreement which has already been concluded. Presidents have

the authority to withdraw from bilateral and multilateral trade

agreements, such as the North American Free Trade

Agreement (NAFTA).

Together with more general fears about a shift in the post-cold

war defence arrangements, investors are likely to be most

concerned about any retreat on global free trade. The

consensus amongst economists is that, while freer trade raises

income distributional questions (which should be offset by

other policies), trade restrictions are negative for everyone,

including those who are supposed to lose from greater free trade. Freer trade allows countries to specialise (comparative

advantage), helps keep inflation low and boosts productivity.

Additional tariffs would most likely boost inflation, and have a

mixed short-run but negative long-run impact on growth,

especially if met by retaliation from other large economies,

such as China.

Spending on infrastructure and defence

Mr Trump specifically mentioned infrastructure spending in

his acceptance speech. His pre-election plan was for up to $1

trillion of additional spending over ten years, or $100bn per

year (c.0.5% of GDP). Congressional Republicans are less keen

on unfunded infrastructure spending than they are on tax cuts,

however Congressional Democrats would be keen on such

spending. There may have to be some compromise on the

spending plan, with many in Congress keen to save such a

major spending boost until it is really needed in the next

downturn.

The Fed

Mr Trump has been critical of ultra-low interest rates and QE,

and has accused the Federal Reserve of being too “political”.

His advisers will no doubt tell him that a battle with the Fed is

best avoided and as with many issues, he has said different

things about monetary policy on different occasions. In any

case, we believe that interest rates are set to rise before the end

of this year. Janet Yellen’s term is due to end in 2018 and she

has confirmed that she will serve out this period.

Impact on US economy

Although there will be compromise on the scale of the package,

a significant easing in US fiscal policy is likely. Tax cuts for

higher income brackets will have some impact on household

spending, however savings ratios for these groups tend to be

higher, so the impact will be limited. The impact of corporate

tax cuts and infrastructure spend will also take some time to

feed through to aggregate demand, especially given a shortage

of shovel-ready projects. In short, we think any significant

economic impact from the fiscal stimulus will not appear until

late 2017 at the earliest.

We haven’t changed our US economic base case for 2017: we

already expected faster GDP growth and further hikes in

interest rates. Given trends in wage pressures, rising bond

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yields, easier monetary conditions overseas and a lower neutral

rate, there is little need for the Fed to step up the pace of

tightening beyond what they have already signalled. To shift

expectations now towards “one hike per quarter in 2017”

would be premature, when Mr Trump hasn’t even been

inaugurated and the timing and scale of any fiscal stimulus is

not known.

Looking further ahead however, we do have some concerns. Mr

Trump’s pre-election proposals included a GDP growth target

of 3.5%, and a pledge to create 25m new jobs over 10 years.

This would be more than three times the rate of job creation

since 2006 and comes at a time when both domestic and global

fundamentals have held back the pace of US expansion. Since

the global financial crisis, potential GDP growth has slowed, as boomers retire and labour productivity has weakened. Even if

productivity picks up a bit, it’s difficult to see the US economy

growing at 3.5% without running into an inflationary overheat,

and a more hawkish Fed.

Impact on the Rest of the World

To the extent that a major fiscal stimulus is positive for US

growth, there will be a knock-on impact to global growth. On

the other hand, a more hawkish Fed and greater trade

restrictions would be negative for growth, especially in many

EM economies.

On Europe, Mr Trump has said that the continent ought to

bear more of the financial burden of its own defence. His election also raises political risk ahead of some key EU votes,

while a US-EU trade deal now looks less likely.

In the UK, Mr Trump’s election has changed the debate about

a likely US-UK trade deal, however his anti-globalisation

rhetoric is not helpful to a medium sized open economy

seeking to re-orientate its trading relationships. London could

also lose business to New York, if large parts of Dodd-Frank

are repealed, at a time when UK trading relationships with the

EU are unclear.

Mr Trump may well declare China a “currency manipulator”,

although ironically China has been trying to slow renminbi

depreciation in recent years. The more important issue is

whether the 45% tariff idea on China’s goods exports to the US

will prove to be just campaign rhetoric. US firms (including

Apple) have deep connections with China assembly lines. Also,

China has recycled a large share of its export earnings into US

Treasuries, so is not without some leverage in these matters.

Market implications

In summary, tighter immigration controls, greater fiscal

stimulus and anti-free trade rhetoric suggest a more

inflationary bias in the Trump economic programme. So far,

markets have placed greater emphasis on this, than on fears

about global trade, or any likely response by the Fed. For now,

the feeling is that the impact of stimulus will come through

faster than any serious rolling back of free trade: naming China

as a “currency manipulator” is not the same as slapping 45%

tariffs on their goods. Bond markets have taken fright on the

inflationary impact of a sizeable fiscal stimulus, coming at a

time when the headline unemployment rate is low.

Mr Trump appears much less predictable than many new US

Presidents, and it is this unpredictability, together with a sense

that his election is a watershed moment, not just in domestic

economic terms but in geopolitics, which creates a two-way

pull for treasuries. Should they focus solely on the domestic

stimulus, or the greater geopolitical and economic risk? For

now, it is very much the former.

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CHARTWATCH

1. The US Budget deficit has fallen sharply since the Global Financial Crisis, thanks to ongoing economic growth, and fiscal retrenchment in the first few years of the decade. While this is a better place to begin a major fiscal stimulus programme, it is far from ideal, given the current level of national debt. Compared with previous periods of rapid fiscal expansion, US national debt is now much higher; forecast to be 76% of GDP in the current fiscal year. This will give Congress pause for thought when assessing the Trump fiscal package.

2. While we expect Italian spreads to come under some pressure ahead of the referendum vote on Dec 4th, we don’t expect more general pressure on Eurozone spreads. A “No” vote will not automatically trigger a general election, even if Prime Minister Renzi resigns, with a temporary arrangement likely until scheduled elections are held in 2018.

3. Following an immediate post referendum spike, the CBI’s main measure of UK political uncertainty has fallen back, though remains at a high level

4. Although the US labour market has recovered, with headline unemployment rate now just 4.9%, there are still many workers in involuntary part-time work. This represents extra slack in the labour market, and together with relatively modest wage pressures and Fed “lone hiker” dollar risk, means any rates hikes next year are expected to be modest. The Affordable Care Act is sometimes cited as reason for the slow fall in this measure of part-time employment, as it can make employers more reluctant to employ someone on a full time basis.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.

Issued by Royal London Asset Management November 2016. Information correct at that date unless otherwise stated. The views expressed are the author’s own and do

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