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The Gavekal Monthly
What Price On A Trump Victory?
October 2016
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The Gavekal Monthly – October 2016
Overview
Arthur’s Take What Price On A Trump Victory? Arthur Kroeber 3
Key Calls
US Economy Tight Labor Market = Slower Growth Tan Kai Xian 11
Japan More Shock, Less Awe Joyce Poon 15
India Investment Boom Ahead Tom Miller & Udith Sikand 19
Dashboard
Our Views in Brief Economies, Markets, Themes 23Indicators Growth Prospects Look Brighter 26
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Arthur’s Take What Price On A Trump Victory?
• The US presidential race tightened markedly in September, with Clinton’s poll edge shrinking and Electoral College advantage eroding.• There is little doubt that a Trump victory would have dramatic
economic and market consequences (regardless of whether you think those changes would be good or bad).• Yet market volatility has remained eerily low—much lower than
in the month before the Brexit vote. • This implies the market is severely underpricing the risk of a
Trump win on November 8.• It would be wise to hedge a large stock market fall and increased
US dollar volatility.
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For more than a year Hillary Clinton maintained a steady 3-6pp lead over Donald Trump. But in mid-September this lead tightened noticeably, to its narrowest point of the campaign. More important, state polls began to suggest that the race in the Electoral College was a virtual toss-up.
Expert opinion, however, continues to give Clinton a very strong chance of winning—anywhere from 65% to as high as 85%.
Markets are following expert opinion. The Iowa Electronic Market now assigns Clinton a 75% chance of winning. Stock, bond and currency markets have been eerily quiet—unlike in the uneasy run-up to the Brexit vote.
Yet polls more accurately predicted Brexit than did expert opinion and betting markets. This could well be so in the US as well. And since the impact of a Trump victory would be so extreme, markets are probably under-pricing it.
Arthur’s Take Polls show a tighter race than experts think
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Arthur’s Take Excuses for complacency
• There are several explanations for market complacency:Trump’s extreme rhetoric is just a ruse: he won’t actually try to do what he claims he will. Checks and balances in the US system will prevent Trump from acting
on his most extreme proposals.Politics just doesn’t matter: look at the limited fallout from Brexit.
• None of these reasons are valid:Political science research shows that presidents try to deliver on at least
two-thirds of their campaign promises. Even Obama, despite strong resistance, delivered 70% of what he promised, at least partially.There is plenty Trump can do unilaterally and quickly, without Congressional consent.The most corrosive effects of Brexit—as with a Trump presidency—will become visible only after a few years.
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Arthur’s Take What is—and isn’t—in Trump’s plans
• Several elements of Trump’s economic platform have remained consistent and specific:
Impose duties of 35% and 45% on Mexican and Chinese imports; renegotiate trade agreementsRestrict immigration and deport undocumented migrantsCut corporate and personal income taxesCut US global military engagements and get allies to pay more
• Two things often claimed to be in Trump’s plans aren’t really: Infrastructure spending: Trump sometimes makes vague references in
this direction but has no plan as specific as, for instance, Clinton’s proposed infrastructure bank.Regulatory reform: Almost all of Trump’s specific deregulation
proposals relate to the energy industry and will have a very narrow impact at best; the real problem for energy investment is a low oil price.
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Arthur’s Take What can Trump actually do?
• Some parts of Trump’s program (such as tax changes, full immigration reform and infrastructure spending) would require Congressional approval. But some things could happen quickly:
Tariffs on Chinese/Mexican goods. The president can impose these unilaterally, and the immediate impact would almost certainly be a massive trade war with China. China, more able to offset export losses with fiscal spending, would win; US recession a likely result.Immigration. Trump could ban Muslim or other categories of
immigration without an act of Congress.Rhetorical abandonment of US commitments to free trade/investment and of its treaty-based security obligations. Trump could undermine these commitments in a few speeches. This would encourage more protectionism, more military spending, and cut global confidence.
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Arthur’s Take Inflationary or deflationary?
• The most likely outcome of a Trump presidency is a severe deflationary shock:
Trade volumes would shrink from already depressed levelsIncreased likelihood of US recession would prompt a major risk-off
move, with equities declining and long bonds rallyingPerversely, this loss of confidence in the US would strengthen the US
dollar by prompting a flight to safety in treasuries (as in 2008)
• Longer term, one can imagine a stagflationary scenario: If Trump gets everything he has talked about fiscally, the budget deficit
will expand sharplyRemoval of 11.5mn undocumented workers would tighten a labor
market where wage pressures are already risingGlobal loss of confidence in the US would prompt a search for dollar
alternatives and lead to a long-run erosion of the dollar’s value
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Arthur’s Take What a Trump win means for markets
• Short run: Markets now rate a Trump win as unlikely, so a victory on November 8 would cause a sudden re-rating of markets:
US equities would fall sharplyThe US dollar would strengthen on flight to safetyEM equity/bond markets would fall
• Long run: Our clients divide on whether Trump is inflationary or deflationary. Enduring uncertainty means a rise in volatility:
Currencies: Dollar subject to strengthening (flight to safety) and weakening (inflation/loss of US influence) crosswinds Bonds: Depending on the Tea Party-dominated Congress, Trump’s fiscal
policy could be massively expansionary or mildly contractionaryEquities: A true deregulation agenda would be positive, but would it
be enough to offset protectionism and recession?
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US Economy Tight Labor Market = Slower GrowthWhat’s happening What it means
Average monthly US nonfarm payrolls growth has slipped from 251k in 2014 to 181k in 2016
• The decline is due to a tighter labor market rather than weakening labor demand. The actual unemployment rate is now lower than the CBO’s estimated natural rate of unemployment.• The NFIB job opening index is at a cycle high, showing that firms remain keen on hiring (see The Dissonance In Jobs).
Average hourly earnings grew at 2.5% YoY in August 2016. In 2014 the average of this data point was 2.1%
• Demand for labor exceeds its availability. • The current state of the US labor market shows that the economy is in the late phase of the cycle.
Non-financial corporate profit margins shrank to 9.3% in 2Q16, from a peak of 11.8% in 4Q14
• Rising labor costs are a key reason for the decline in corporate profit margins.• This does not necessarily presage recession: growth could reaccelerate in this “late” stage of the cycle (as in the mid-1990s).• But restarting the growth engine will be tough given that the economy is hitting labor capacity constraints and a productivity surge is unlikely.• On balance, conditions are not in place for a mid 1990s-like rebound.
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The US unemployment rate is very close to falling below the CBO’s natural rate of unemployment. This is indicative of a maturing cycle.
More often than not, such late cycle periods involve slower real GDP growth and reduced corporate profit margins. At such points, catch-up growth has run its course and the economy does not have much slack.
Shortly afterwards, a recession usually hits.
That said, a reacceleration of economic growth at this late stage of the cycle is not unprecedented. The most recent case was in the mid-1990s, when a productivity surge associated with the IT boom drove a new burst of growth in both output and new hiring. This happened despite tight labor market conditions.
US Economy Tight Labor Market = Slower Growth
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But a replay of the mid-1990s is unlikely for three reasons:
1. A productivity-fired rebound in growth is a non-starter due to capital misallocation stemming from ultra-low rates, which has likely resulted in the US’s version of zombie companies (see The Untimely Demise Of US Productivity). An example may be the retailer Sears, which in a different monetary policy environment might already have gone bankrupt.
2. Unlike in 1995 when the Fed cut rates by 75bp, there is little scope for easing this time as the Fed has indicated that it will not take rates negative.
3. The risk to US inflation is on the upside (see How Long Can The Rally Last?, pp 13-16). Even if it wanted to, the Fed’s scope to ease further is constrained.
Our base case for the next 12 months is a muddle-through: slower growth, but no recession.
US Economy Tight Labor Market = Slower Growth
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What’s happening What it means
The Bank of Japan announced it will pursue quantitative easing “with yield curve control”
• The BoJ believes its policies will achieve its inflation target, and that their failure so far is due to external weaknesses.• It also acknowledges that negative rates and a flat yield curve are hurting the banks. • To relieve that pain, the BoJ now aims to tailor its JGB purchases—now running at a net ¥80trn a year—to keep 10-year yields at “more or less” zero.
The 10-year JGB yield fell from zero to -0.09%
• Investors are skeptical that the new policy approach will prove any more successful at boosting inflation expectations.• As the 10-year yield falls further below the zero target rate, the BoJ faces increasing pressure to reduce its 10-year JGB purchases or even to sell 10-year bonds. This would amount to QE tapering.
Household spending fell-4.6% YoY in August
• Consumer inflation expectations are no higher than the market’s. Tokyo CPI ex-food and energy fell to -0.1% in September from 0.1%.• With interest rates at “zero or negative forever” now taken for granted, far from spending more, the Japanese are increasing their savings to make up for poor anticipated returns. This makes it even more difficult for the BoJ to meet its 2% inflation target.
Japan More Shock, Less Awe
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In September’s “comprehensive assessment” of its policy stance, the BoJ acknowledged that excessive yield curve flattening would do more harm to the economy than good by eroding financial-institution profits.
With QE apparently approaching the limit of its effectiveness, more deeply negative interest rates are the BoJ’s remaining option. If so, the BoJ needs a way to relieve the pain before cutting rates further.
The BoJ has now pledged to keep the 10-year JGB yield at zero while maintaining its net purchases of JGBs at the current pace of ¥80trn a year. In response, a skeptical market promptly pushed the 10-year yield below zero.
If it is serious about its zero target rate, the BoJ must push back by slowing its purchases of 10-year JGBs, buying other durations instead. But its heavy buying has already caused the yield curve to invert steeply at the short end.
Japan More Shock, Less Awe
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To hit its target yield, it is even conceivable that the BoJ could start selling from its massive portfolio. This would amount to a stealth tapering of QE.
With inflation expectations low, that would threaten to push up real yields, which would be bullish for the yen. A stronger yen would mean further deflationary pressure and even higher real yields. Even if the BoJ were to lower its yield target rate, it would still be vulnerable to market attacks.
Can the BoJ manage to boost inflation expectations? This is unlikely, but not impossible—if Fed tightening leads to yen weakness against the US dollar. This would be good news for Japan, but less so for the rest of the world.
As super-long rates normalized, Japanese institutions would find overseas yield-chasing less attractive. With US treasuries already very overvalued, a retreat of Japanese buyers could amplify volatility in the US bond market.
Japan More Shock, Less Awe
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India Investment Boom AheadWhat’s happening What it means
Over the summer, India’s Parliament approved a flurry of reform measures
• Modi is proving his doubters wrong after his government passed a slew of reforms. The biggest is the Goods and Services Tax, which creates a true common market and will eventually add 1-2pp to annual growth (see India’s Great Leap Forward). • Another reform, the new bankruptcy code, will help clean up bank balance sheets (see India’s Significant Step Forward).• The net impact should be an acceleration of capex growth.
Urjit Patel was appointed the new governor of the Reserve Bank of India
• Patel’s appointment scotched fears that the government would appoint a political stooge to do its bidding. Patel is known as a monetary hawk who will put macro fundamentals before growth (see India’s Reform Agenda After Rajan). • The new quasi-independent Monetary Policy Committee will set interest rates, targeting inflation of 4%. With CPI currently around 5%, there is limited room for rate cuts.
The government eased FDI rules, allowing 100% ownership in defense, pharma and civil aviation
• Scrapping onerous FDI regulations has helped push India to the top of the global FDI rankings for greenfield projects, ahead of China.• Government approval is still required for high-equity stakes in some sectors. But the trend toward greater openness is clear.
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Capital spending has slumped since 2010, as banks have cut lending. Private investment remains especially muted.
But banks are cleaning up their balance sheets by recognizing NPLs, restructuring loans and repossessing assets. The new bankruptcy code will speed up this process. This lays the way for faster credit growth. As investment in infrastructure picks up, we expect India’s stalled investment cycle to turn in 2017.
Public investment in infrastructure is gaining traction, with US$32bn allocated in the 2016-17 budget, up 22%. The road, rail and power ministries are headed by India’s most capable ministers.
New Delhi is reforming financing requirements, taking responsibility for greenfield investments, and freeing up its land bank. Next year we should begin to see private investment “crowd in”.
India Investment Boom Ahead
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India is the sum of its 29 states, not a single entity, and states now account for nearly two-thirds of public investment. “Competitive federalism”—a policy to devolve power to states and stimulate healthy competition among them—is encouraging states to invest in infrastructure to improve their competitiveness. This is bearing fruit: India leapt 32 places in the World Economic Forum’s Global Competitiveness Index in the last two years, ranking 39th
out of 138 countries, and 24th for transport infrastructure.
More public spending is needed to kick-start the investment cycle, but the government is required by law to shrink the central deficit to 3% of GDP by 2017-18.
State governments are less financially constrained, with an aggregate deficit of 2.4% of GDP. Greater fiscal devolution—taking states’ share of central taxes to 42%, up from 32%—has given them more spending power. States will have to take the lead on public investment.
India Investment Boom Ahead
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Our Views In Brief EconomiesRegion Analyst View Read more
United States Will Denyer/Tan Kai Xian
Weak growth weighs on corporate sales; rising labor cost hurts profit margins. Do not expect US corporate profits to rebound strongly
Don’t Count On US Profits Riding To The Rescue; On Profits: There Will Be No Revolution
China Andrew Batson/Chen Long
The property rebound is losing steam and private capex is weak, but 2016 GDP will still grow 6.5% thanks to loose credit and an uptick in industry
The Growth Trade-Off Gets Harder; The Housing Cycle Is Aging Rapidly; Macro Update: Delivering Reflation
Eurozone Nick Andrews / Cedric Gemehl
Brexit will hurt growth. Policy will slowly shift to fiscal stimulus;construction growth is a bright spot
Towards A Fiscal Union By Stealth; The Eurozone Construction Revival
Japan Joyce Poon/Neil NewmanAbenomics has not succeeded in reviving confidence; expect more drastic policies
The Next Monetary Move;Japan: Twice Bitten, Thrice Shy
India Tom Miller/Udith Sikand“Competitive federalism” and infrastructure spending make India a compelling growth story
Why India Can Move Faster; Modi Finds His Mojo
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Our Views In Brief MarketsMarket Analyst View Read more
Global asset allocation
Charles GaveThe best hedge for Ursus Magnus: a balanced portfolio of 40% US and UK equities and 60% 7-year UST zeros
US Bonds As A Hedge: It’s Complicated
US asset allocation
Will DenyerThe spread between the cost of capital and its return suggests underweighting risk assets
Buy The Dip?; Wicksell’s Guide To A Better Portfolio; Wicksell’s Portfolio;
US dividendstocks
Tan Kai XianUS firms' ability to pay dividends has deteriorated; investors still reach for yield. We recommend REITs
Beware The “High Dividend” Lure
Emerging market bonds
Joyce Poon/Udith Sikand
High quality EM yield plays should be part of a core portfolio in a world of rising tail risk
The EM Equity Question
Renminbi Chen LongA strong US$ could continue to put pressure on the renminbi, but this is unlikely to spook markets
The Renminbi Falls; No One Cares; Reduced Chance Of Renminbi Storms
Eurozoneequities
Nick AndrewsTime to turn defensive on Eurozone equities
Eurozone Equities Rise Again
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Our Views In Brief Themes
Topic Analyst View Read more
Political risk Anatole Kaletsky, Charles Gave
The Brexit vote is symptomaticof a new era of political risk in which voters reject the elite
Everything Just Changed; Trump And The Prisoner’s Dilemma; Renzi’s Great Gamble
Negative interest rate policy (NIRP)
Louis-Vincent Gave, Joyce Poon, Nick Andrews
By accident or design, NIRP will kill bank profits and prove ineffectual/counterproductive
NIRP: Machiavellian Design?; Japan’s Point Of No Return
The low-rate fallacy Charles GaveZero rates are destroyingproductivity and leading to a deflationary recession
Vertigo And The US Economy; Bloodhound And Swedish Economist
Oil: lower for longer Anatole Kaletsky Abundant supply means US$50/bbl is a ceiling price
Oil: Lower For Longer;Oil’s Busted Flush
China reform risk Arthur Kroeber
Xi Jinping's preference for political control over market reform could lead China into Japan-style stagnation
Making Sense Of The Economic Policy Mess;Powerhouse, Menace Or The Next Japan?
Renminbiinternationalization
Louis-Vincent GaveBeijing’s drive to globalize its currency to continue despite market turmoil
The Crocodile Mouth About To Close; The New Way To Think About China
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Last month, equity markets were mostly flat, and the same was true for long-dated bonds.
Yet it was very much a month of two halves. The first two weeks of September saw risk assets pull back as growth prospects improved and investors upped the likelihood of less accommodative monetary policies.
However, as the month wore on it became gradually clearer that global central banks—led by the Bank of Japan—are not yet ready to perform the ”big turn”.
As such, risk assets duly moved higher over the last two weeks of the month. But how long can central banks afford to wait given that both growth and inflationary pressures are moving higher?
Indicators Growth prospects look brighter this month
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Indicators Is inflation returning?
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Investors still seem enthralled to the idea that central banks will come to the rescue whenever there is the slightest risk of a market dislocation.
Is this rational logic based on hard-fought experience, or merely complacency?
Given (i) the pick-up in growth, (ii) a tick up in inflation, and (iii) many political uncertainties (US election, Italian referendum, Brexit aftermath, etc.), investors’ seemingly blind faith in central banks’ ability to sooth all problems is certainly plucky.
Indicators Are investors relying too much on central banks?
Indicators Given all that’s going on, long bonds looks very expensive
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