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Last Friday, Andrew Neil interviewed Henry Kissinger on Donald Trump. Kissinger opined that “…reality will impose certain requirements, as it does on every president… and I have yet to see the president who escapes the fact that he is part of a continuum and that he cannot re-invent history". Kissinger, as might be expected, was commenting on the urgent requirement for Trump to define a foreign policy, and the elder statesman’s words were somewhat reassuring. However, while Trump may be brought round by his advisors to recognise his duty as ‘part of a continuum’ when it comes to foreign policy, on economic policy he seems hell-bent on ending the status quo as soon as possible.
Trump will seek to generate jobs and growth through a fiscal stimulus package that includes a $1 trillion spending programme on infrastructure. Whether this approach is deemed sensible depends on whether the judge is of a Keynsian, or neo-classical, economic persuasion. A Keynsian would argue that well-targeted spending on infrastructure will produce a multiplier effect and that GDP will consequently grow by more than the $1 trillion invested.
The IMF has estimated the growth multiplier to be 1.5 in the case of developed economies. However, the size of the multiplier is almost impossible to measure and most certainly changes over time. It is clear that the multiplier effect will work best where there is a good deal of spare capacity in the economy. Without this spare capacity, government spending tends to simply crowd out private sector investment, reducing the effect of the multiplier and, in extremis, sending it into negative territory.
Neo-classical critics may argue that, with unemployment at an historically low level of 4.9% (a level which in the past has caused inflation to take off) labour market capacity is already substantially constrained. They might also contend that Trump’s ambitious spending plans will simply raise wages as an army of extra engineers, architects and builders are pressed into action. However, the labour market participation rate is only 62.8%, supporting anecdotal evidence that many Americans have simply given up looking for work and consequently do not appear in the unemployment numbers. If that is not the case, it is difficult to imagine how Trump was elected.
Apart from labour, Trump’s infrastructural ambitions will require fuel, steel, concrete, copper, lumber etc, all of which are in plentiful supply and in some cases considerable over-supply. Thus there would seem to be plenty of spare capacity in the US at the moment, meaning that crowding-out as a result of capacity constraints is unlikely.
The second major constraint on the successful workings of the multiplier effect is interest rates. If the additional government borrowing required to fund the spending causes bond yields to rise, private sector investment projects may be cancelled in response to higher borrowing costs. This is much more of a problem for Trump, since US bond yields began to rise last Wednesday morning the instant it became apparent that he was likely to become President. Ten-year yields have already increased by 50 basis points. This is grist to the neo-classical mill. The doomsters will shriek that all Trump will achieve though massive infrastructure spending (and tax cuts) is panic in the bond markets, and that any multiplier-induced benefits from infrastructure spending will be more than offset by the negative impact of higher rates on the wider private sector economy.
Unfortunately, the interest rate argument seems to hold water, particularly given last week’s bond market price action. However, Trump has already proven himself to have an interesting attitude to government debt, insofar as during his campaign he discussed the possibility of reneging on it! While he will doubtless be dissuaded from such idiocy by his advisors, it is quite likely that a case could be made for an expansion of the Fed’s asset-purchase programme to ensure that bond yields do not rise to inconveniently high levels once the stimulus package gets underway.
It always used to be said that central banks could only control short-term rates and that term rates were decided by market forces. Since the advent of QE that is no longer the case. However, infrastructural stimulus accompanied by more QE to contain term rates and artificially flatten the yield curve would be a trick straight out of Jeremy Corbyn’s book, and would risk a huge spike in yields when the Fed eventually stopped buying bonds. It will be very interesting to see whether Trump’s apparent antipathy towards ultra-low interest rates (he has suggested removing Janet Yellen and having the Fed rapidly normalise rates) extends to allowing term rates to be decided by the market. If it does, we could be in for a substantial upward movement in yields and considerable dollar strength.
Other markets were remarkably calm last week, given Trump’s victory. Stock markets took it all in their stride after a sell-off in Japan on Wednesday morning that was quickly corrected the next day. Unsurprisingly, with yields on T-bonds rising so aggressively, the US dollar was a major beneficiary and this wrong-footed the market as many speculative participants had been expecting dollar weakness in the event of a Republican win.
As markets pondered the implications of the US election for European politics, the euro came under pressure. 4 December sees an Italian referendum on constitutional reform which Matteo Renzi stands a good chance of losing, potentially ushering in the anti-EU Five Star Movement. On the same day, extreme right-winger Norbert Hofer will stand again in the Austrian presidential election. He only lost by 31,000 votes earlier this year and a victory this time would send out some very negative messages. Furthermore, the French presidential election in April is already starting to concentrate minds. EUR/USD trades at 1.0742 at the time of writing, having spiked to 1.1300 early last Wednesday morning.
Despite the ongoing uncertainties over Brexit, sterling traded strongly last week, being viewed as a safe haven compared with the euro which is increasingly seen as entering a period of political fragility. GBP/EUR reached a high of 1.1672 last Friday, its best level for six weeks.
This week will see UK inflation data for October, and we shall get a better idea of how sterling’s post-referendum depreciation is feeding through. Tomorrow sees CPI, core CPI and RPI – expected to be 1.1%, 1.4% and 2.3% respectively. There will also be the release of PPI input and output prices (also tomorrow, expected 9.3% and 1.8%). Wednesday sees unemployment (expected to be unchanged at 4.9%) and average earnings (expected to be up a notch at 2.4%). Finally, we should see relatively upbeat retail sales data on Thursday (expected up 5.4% year-on-year in October).
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