In this debate series, GRI asked what will be the impact of President Donald Trump protectionist measures. Jeff Moore argues these decisions will hurt markets.
Among the multitude of political and economic implications surrounding the election and subsequent inauguration of U.S. President Donald Trump, his protectionist rhetoric and proposals represent perhaps the most nuanced (and potent) risk to markets across the globe.
President Trump has proposed scrapping and reworking “unfair” trade deals, enacting tariffs on products imported from international markets and decrying other nation’s monetary regimes. This is intended to protect and restore American jobs and interests; however, these measures are likely to have negative effects on the American economy and serve as a source of market volatility in the short term.
U.S. equity markets have moved to record highs following Trump’s surprise victory, climbing higher on the notion that his proposed fiscal stimulus and protectionist measures will be reflationary and thus deserving of even loftier equity valuations. Further, this narrative drove bond prices down significantly since his election as investors re-positioned for yield.
Approaching inauguration, Trump reiterated calls for protectionism and indicated general support for congressional border-tax adjustment policies, tax cuts, and infrastructure spending which helped the Dollar propel higher, thus creating its own litany of risks in the increasingly sensitive and volatile global currency markets.
Analysts at Deutsche Bank recently expounded on the Trump effect:
“More than two weeks removed from President Trump’s Inauguration, politics and policy remain key market drivers,” the note reads. “We continue to believe that Trump’s victory marked a positive regime change in the US. Tax cuts and deregulation are expected to jolt the economy toward a better long-term equilibrium of higher growth, inflation and interest rates. But this regime change also brings a greater degree of policy uncertainty.”
To wit, despite the apparent resilience of U.S. equities marked by the stubbornly low volatility index amid a world awash in uncertainty, markets are now more sensitive than ever to political risk developments. This is true not only because of the increased interdependence of markets across borders and asset classes brought on by globalization, nor solely accounted for by the potential for tectonic shifts in the world economic order, but especially due to the speed and scale at which mere tweets can mobilize traders and move markets.
Moreover, the super-charged reaction functions of markets have in many cases yielded unexpected results. Political events such as Brexit, Trump’s election, and the Italian referendum, to name a few, were all categorized as unlikely and predicted to have calamitous and immediate effects on equity markets if realized. Instead markets absorbed the surprise events and reversed future expectations literally overnight.
At the outset, substantial moves in capital markets predicated on the eventual implementation of drastic legislative changes are inherently at risk because political fortunes of such proposals can rapidly diminish or disappear altogether. Interestingly, this makes the nearest term risk for investors in U.S. equities the potential for legislative gridlock that stalls or rejects the protectionist thesis the latest equity rally was built upon.
Already, Trump has dismissed one congressional border-tax proposal as too complicated, and expectations for the passage of comprehensive corporate tax reform and fiscal stimulus are being pushed further and further out into the future. While not reflected in major U.S. stock indices as of yet, signs of deterioration in the Trump reflation trade are evident as the Dollar and other Trump-oriented positions have softened in recent weeks.
More from Deutsche Bank:
“The focus in markets has been on the underperformance of Trump trades – US equities stalling, the dollar softening, and rates declining. Positioning and the perceived lack of policy progress are behind this under-performance.”
If the political will to enact Trump’s economic nationalist agenda fades, current positioning will be at risk of further correcting as investors re-calibrate shifting expectations. However, a full implementation of Trump’s aggressive protectionism does not necessarily guarantee that markets maintain the Trump friendly trend.
Trump fueled much of his campaign with distinctly economic nationalism by tapping in to popular grievances against trade discrepancies and the offshoring of jobs. To discourage American companies from locating manufacturing facilities and jobs in lower cost countries like Mexico and China, he suggested the enactment of tariffs on imports and has since flirted with support for border-tax adjustment schemes that play into a larger reform of corporate tax laws.
In simple economic terms, the implementation of tariffs or similar mechanisms represents a cost to importing businesses that is overwhelmingly reconciled through adjustments to product prices, not profit margins. Similarly, those domestic businesses insulated by trade protections are so enabled to charge the consumer higher prices for their product because the competition is restricted arbitrarily.
To be clear, tariffs are not new to the United States and select industries such as steel, sugar and many others have enjoyed the “protection” they provide for decades. However, the protection afforded to politically favored industries and the associated jobs come at the economic expense of the consumer, who can ill afford it.
“One voice that is hardly ever raised is the consumer’s,” wrote famed economist Milton Friedman on the issue of tariffs in 1980. “That voice is drowned out in the cacophony of the ‘interested sophistry of merchants and manufacturers’ and their employees. The result is a serious distortion of the issue.”
Friedman continues, “The misleading terminology we use reflects these erroneous ideas. ‘Protection’ really means exploiting the consumer.”
If enacted this will have a deleterious effect on markets in coming quarters because the more a consumer pays for certain goods, the less capital is available to him or her for discretionary spending and investable savings.
Already suffering from a combination of low wage growth and rising costs, the addition of an effective tax on imports could raise prices by an estimated 20 percent on the American consumer. Even though proponents and economists theorize long-term Dollar appreciation would also occur and offset price disruptions, the added costs must come from somewhere in the short-term, in turn depressing discretionary spending activity and dragging on market sentiment.
Markets hate uncertainty. There is no greater source of economic uncertainty than in the emergence of transformative political upheavals such as the world has recently witnessed. Because the likely policy vehicles for Trump’s agenda would by design upend the status quo, the room for unintended and negative capital market consequences rises exponentially.
Although Trump has dismissed initial GOP border-tax adjustment proposals as ”too complicated,” the protectionist thrust of such border plans are a pillar of his economic agenda. A critical assumption in those plans is an appreciation of the Dollar that leads to greater import purchasing power and nullifying prices increases.
Though, even now, Trump’s political risk has weighed on this assumption as he has made attempts to talk down the Dollar, calling it in interviews “too strong” versus other currencies.
Historically it has taken years for currency exchange rates to adjust to the current account rebalancing that import-tax schemes aim to produce. If Trump does succeed in implementing a border-tax scheme that necessarily raises the price of imports and the Dollar fails to appreciate amid headline risk or other FX factors, stagflationary pressures would saddle U.S. growth prospects in the medium term and give investors cause for concern.
What’s more, even if the Dollar appreciates by the 15-20 percent predicted under such plans inadvertent outcomes abound that risk serious market volatility. U.S. multinationals, foreign Dollar debt holders, emerging markets and competing monetary regimes all face serious risks if the greenback rises too far, too fast.
We need only consider the British Pound’s performance after Brexit to understand how severe politically induced currency shocks can be, even while equity markets escape seemingly unscathed.
U.S. corporations that draw significant international revenues will suffer currency conversion losses as the Dollar outpaces foreign earnings. Depending on currency sourcing practices, some companies such as apparel producers won’t be able to adjust pricing and supply, decimating margins and leading to bankruptcies. The balance sheet pressures of multinationals are exacerbated more by heavy corporate debt loads coming due over the next few years.
Additionally, according to the Bank of International Settlements the amount of offshore debt denominated in Dollars has reached almost $10 trillion. This includes virtually all of Turkey’s sovereign debt, adding to their economic problems, and healthy majorities of corporate debt obligations in places like China and South Korea. A substantial increase in debt financing costs due to a rising Dollar will saddle these markets with tightening financial conditions that carry their own risk in fragile emerging markets.
Making matters worse, the Dollar strength would attract foreign capital to America in a manner that holds a potential for creating a self-feeding loop that pulls more capital away from the already burdened emerging markets. The deflationary effect caused in international markets by such a loop would risk awakening still festering sovereign debt crises and recessions. All before a backdrop of central banks that have exhausted the tools and capacity to combat such trends.
The combination of dramatic capital market shifts in anticipation of Trump protectionism with the extreme level of uncertainty around the real effects of such creates an environment of unprecedented political risk.
From failing to reach expectations, potential for burying consumers, and squeezing corporations and emerging markets, President Trump’s economic nationalism agenda is riddled with financial landmines in the near- and medium-term horizons.
As markets of all kinds become more intermingled and the speed and severity of market reactions to unforeseen events become more extreme, more and more capital is dependent upon nuanced political risk factors such as Trump’s policy reforms and the unintended consequences.
Should Trump’s fortunes of implementing the changes the market is expecting fade, markets will be forced to reallocate for a new reality sooner rather than later. Unfortunately, even if he is successful in his efforts, market realities are unlikely to match current optimistic perceptions and a rising trend in surprising events, evidenced by Trump himself, heightens the chances of sudden, yet unforeseen, dramatic changes.
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