Salman Ahmed, chief investment strategist of Lombard Odier Investment Managers, re-assesses the US policy matrix in light of Mr. Trump’s victory and considers potential policy spillovers for Europe.
Arrival of a “fiscal bazooka”?
Fiscal policy easing in the US is expected to manifest in a meaningful way because tax cuts and spending increases (mainly for infrastructure) are key planks in Mr. Trump’s domestic economic agenda.
On the surface, assuming a fully implemented Trump fiscal stimulus programme, the fiscal deficit would widen to between 5% and 6% of GDP, with public debt projections reaching 129% versus our 86% baseline scenario over the next 10 years (source: Committee for a Responsible Federal Budget, CRFB).
The boost to US growth under an aggressive Trump fiscal policy programme starting in second half of 2017 is potentially significant and shifts the end of the economic cycle by one to two years, in our view.
It is perhaps also worth noting that although Mr. Trump’s proposed policy measures echo Reagan-era supply side economics, the starting point for any potential shift in the direction of the US economy and its debt dynamics is very different.
Specifically, with a much higher unemployment rate, lower debt ratios and a more manageable deficit profile, the early-1980s plan was a counter-cyclical policy deployment that was implemented at a time of significant excess capacity.
This is very different from what appears to be a pro-cyclical change in fiscal policy under Mr. Trump. In our view, Mr. Trump’s proposed “fiscal bazooka” is without doubt inflationary because the US economy is operating at full employment.
Even so, we believe fiscal policy is now in the driver’s seat when it comes to US economic dynamics, as eight years of monetary policy predominance in America draws to a close.
In our view, Europe is still far away from a shock-and-awe fiscal programme given the current political realities and resistance towards using a pro-cyclical policy impulse.
Three key challenges facing fixed income investors
1. Widespread low/negative interest rates: The sharp, US-led rise in bond yields has reverberated across the globe. However, we think diverging economic realities in the US versus the rest of the world limit the potential spillover effect into non-US markets.
Here, the effective use of yield curve controls by Japan is an important template. We believe this policy may be deployed by the ECB sometime next year as the scarcity of assets comes back on the table, though the post-election rise in yields has alleviated pressure on the central bank to further extend quantitative easing.
2. Increased market risk: the risks associated with the extension of duration undertaken by investors in recent years have been underscored by US bond market dynamics; the increased volatility implies the risks associated with this issue will remain firmly on the table, especially if monetary policy uncertainty rises on the back of a changing policy mix.
3. Fractured liquidity: In the days following Mr. Trump’s victory, anecdotal evidence suggests that liquidity conditions in various segments of many bond markets, most notably in emerging markets, suffered severe pressure.
Overall, the structural weakness brought about by the low liquidity environment, itself created by tightening regulation and central bank intervention, has been brought into sharper focus over the recent weeks.
In our view, we have seen the lows for global bond yields in this cycle. Considering this context and potential shifts in non-US monetary policy changes that are in the pipeline – including the potential use of yield curve controls in Europe – we think that the case for accessing credit risk over duration risk has strengthened.
A new risk factor: The global populism movement
The Brexit and Trump victories show that popular discontent is starting to shape political, and by extension, economic outcomes in advanced economies.
The European Union’s political calendar is very full over the next 12 to 18 months, with an Italian constitutional reform referendum, Austrian and French presidential votes, and general or federal elections scheduled in the Netherlands and Germany.
These are being held against a backdrop of significant rises in support for extreme right/left parties, and there is now a sizeable risk of a populist government coming to power that will then put membership of the EU on the table. Almost all populist parties we monitor in various European countries have anti-EU or at least anti-Euro agendas.
Markets have rightly focused their attention on the upcoming Italian referendum on constitutional reforms, where the “No” vote was in the lead, according to the final polls before next week’s vote. The referendum has been depicted as a vote on the performance of the current pro-EU government.
It is quite possible that Prime Minister Matteo Renzi will resign if the “No” vote succeeds in blocking his reforms, though the prospect of snap elections remains low in our view. A more likely outcome would be for a coalition government to be formed, with elections held in late 2017/early 2018.
The factor to watch beyond the constitutional reform referendum is the electoral law change (which most political actors support). This will move Italy away from the current bonus seat structure, which increases the probability of a “winner takes all” framework (where the largest party is given bonus seats) to a more proportional representation-based system.
If this measure passes, we think the likelihood of a populist-led government in Italy declines sharply, despite the Five Star Movement’s strong showing in recent polls.
Last but not the least, Article 75 of the Italian constitution bars a referendum on international treaties and instead requires a two-thirds parliamentary majority for such measures to pass. This further reduces the risk of an Italian exit given the backdrop of still relatively high support for EU within the country.