will trumpflation trump protectionism? · an acceleration in capital outflows is also a risk to...
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WILL TRUMPFLATION TRUMP PROTECTIONISM?
February 2017
Multi asset views from RLAM
Royal London Asset Management manages £99.6 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 31/12/2016
This month’s contributor
Ian Kernohan
Senior Economist
In the latest UK Inflation Report, the
Monetary Policy Committee (MPC) of the
Bank of England reduced their estimate of
the equilibrium unemployment rate, from
5% to 4.5%. This is an important change
and comes after a lengthy period when
MPC forecasts of a pick-up in wage growth
have consistently undershot. Given that
wage pressures in the UK remain subdued
(see chart opposite) and well below growth
rates seen prior to the financial crisis, we
think monetary policy settings will remain
very loose for some time. Even aside from
Brexit uncertainty, this will weigh on
sterling versus the dollar, at a time when
the Fed look set to tighten their policy
stance further.
The major market surprise of recent months is that the election of
Donald Trump as US President has acted as a positive catalyst for risk
appetites. Global economic data has also shown good signs of
improvement. Investors will need to see greater detail from the Trump administration on fiscal stimulus, tax reform and deregulation, if the
equity market rally is not to be undermined.
Summary
A key element of the “Trumpflation” trade is the anticipation of US corporate tax
reform. If these plans get bogged down in Congressional politicking, an important
plank of the post-election equity market rally will be undermined. We look at this
issue in greater detail. Ahead of any news on fiscal stimulus however, most
economic indicators in the US suggest a robust start to the year. We expect the US
Federal Reserve (Fed) to continue to tighten monetary policy.
A year ago, fears of China exporting deflation was a major market theme, however
twelve months on, the situation looks very different. Faster nominal GDP growth
in China has eased a revenue squeeze in the corporate sector, while the large
domestic savings pool, closed capital account and lack of foreign debt has reduced
the risk of a classic Emerging Market crisis. We are not complacent however, and
will maintain a close watch on economic indicators as we exit the New Year holiday
period.
Inflation is rising globally, even in the Eurozone, although most of this reflects the
diminishing drag from past falls in commodity prices, rather than a pick-up in
underlying inflation. Despite the fall in unemployment, wage growth has remained
muted, at just 1.4%yoy in Q4 2016, and we expect the ECB to maintain its dovish
stance, especially during a period of heightened political uncertainty.
UK GDP growth was 0.7% quarter-on-quarter (qoq) in the final three months of 2016, driven mainly by activity in the service sectors and indicating continued robust growth in household spending. Excluding the volatile oil & gas sector, GDP growth was even stronger, at +0.8%qoq. Looking ahead, growth is likely to be hampered by a squeeze on real household incomes, as inflation rises.
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ECONOMIC OUTLOOK
Global: momentum in the global economy has
improved, however reviving global trade will be
key to a sustained recovery
Growth in global trade has gone through several phases, and a
number of key developments since World War 2: the 1947
General Agreement on Tariffs and Trade (GATT) which
morphed into the World Trade Organisation (WTO) in 1995,
the rise of China post the 1978 market reforms (culminating in
joining WTO in 2001), the end of the Cold War in 1989, the
launch of the Single European Market in 1993, and the Great
Financial Crisis (GFC) of 2007/8.
The chart of world exports shows how far global trade has
slowed in the post-GFC period, with the five-year moving
average slipping towards zero. Reviving global trade will be
key to sustained economic recovery, which is why the
protectionist rhetoric of the new Trump administration has
raised so many concerns. A sustained contraction in global
trade would hit overall global GDP growth, and worsen the
growth/inflation trade off.
US: business and consumer surveys suggest a
strong pick-up in economic growth
US GDP growth fell from 3.5% (annualised) in Q3 2016 to 1.9%
in Q4, as a one-off boost from net trade unwound. By contrast,
the more important payroll data showed employment growth
remained robust in the three months to January, and while the
unemployment rate has risen a little, this was due to a rise in
labour market participation. Despite the fall in unemployment
over recent years, growth in labour costs, as measured by the
Employment Cost Index, has remained modest, at just
2.3%year-on-year (yoy) in Q4 2016.
Our base case assumes GDP growth picks up in 2017, and the
most recent survey indicators of output growth, as well as
measures of consumer and business sentiment, tend to support
this.
Looking further ahead into 2018, growth should also be supported by a fiscal stimulus, although there is considerable
uncertainty over the scale, timing and composition of this.
Mr Trump’s inauguration speech was uncompromising in its
tone - “we’ve defended other nation’s borders while refusing
to defend our own”, “we will follow two simple rules: buy
American and hire American”. Protectionism, heightened
geo-political risk, and the new President’s general
unpredictability seem to be the greatest concerns for investors.
We expect the US Federal Reserve (Fed) to continue to raise
rates this year, although they will be wary of excessive dollar
appreciation, and the impact of higher bond yields on
mortgage rates. A further hike of the Fed Funds rate is likely in
Q2.
The long-term drivers of economic growth are workforce
growth, capital investment (technology, buildings etc.) and
how labour and capital combine to boost efficiency (Total
Factor Productivity (TFP), or Innovation). In the US, TFP grew by an average of 1.8% per annum from 1995-2004, but
has since slowed to around 0.5% per annum. One possible
explanation is that compared with previous decades, the most
recent technological innovations have been more focused on
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leisure than on businesses. At same time, labour force growth
has slowed, while educational attainment has plateaued.
Taken together, trend growth could be as low as 1.75% pa,
compared with 3-4%+ in most of the post-war period up to
2005, which was boosted by rising female and baby boomer
participation, at a time when productivity growth remained
close to 2% pa. Immigration reform and protectionism will
weigh on trend growth, while tax reductions and deregulation
will be offsetting factors. The Fed will have to weigh
“Trumpflation” against “Trumprotection” in assessing the pace
of interest rate hikes.
China: faster nominal GDP growth helps ease
China’s debt concerns (for now)
Real GDP growth has been stable in recent quarters, however
nominal GDP growth has risen. Survey indicators point to
continued robust growth in the near term. GDP grew by
6.8%yoy in Q4, led by the services sector. This sector now
accounts for more than half of economic activity, and there is
still scope for further growth in many areas, such as healthcare
and leisure, which are underdeveloped. The rise in nominal
GDP growth has eased revenue and debt servicing pressures in
the corporate sector. Thus, a mild pick up inflation has been a positive for China.
On the expenditure side, a rising share of GDP accounted for by consumption suggests continued rebalancing away from a
reliance on net trade. On the surface, this is a positive
development, however domestic demand growth has become
increasingly dependent on credit growth, which poses a risk to
the medium-term sustainability.
China’s non-financial sector debt to GDP ratio was estimated
by the Institute of International Finance (IIF) to be 255% in
Q316, around 100 percentage points higher than in 2008. On
the plus side, the debt burden has shifted in recent years, away
from more vulnerable areas such as local government and
corporate sectors, towards central government and the
household sector. Faster nominal GDP growth has eased a
revenue squeeze in the corporate sector, while the large
domestic savings pool, closed capital account and lack of
foreign debt, reduces classic EM crisis risk.
An acceleration in capital outflows is also a risk to domestic
demand. Over the past six months, the renminbi has fallen
against the dollar, despite intervention by the authorities. In
response, the authorities have placed restrictions on domestic
households’ and corporates’ overseas transfers and
investments.
House price inflation has slowed, and with housing by far the
largest share of household wealth, a large property crash
remains the biggest downside risk to the economy.
The People’s Bank of China (PBoC) want to curtail speculative
housing purchases, while avoiding any collapse in prices. They
have provided some support by reducing minimum down
payments for First Time Buyers from 30% to 25% in 2015 and
then to 20% in 2016, although these are still high by
international standards. On second homes, down payments
have been lowered to 30%, while mortgage rates have also
fallen.
Increased trade friction with the US is also a downside risk for
China, though to date there have been some signs of
rapprochement here, with Mr Trump acknowledging the “One
China”1 policy.
This year will be critical for President Xi Jinping, as he
prepares for a leadership transition, which will 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
weaken materially during 2017. Over the longer term however,
the pace of economic growth will slow further, due to
demographic factors and a slowdown in productivity gains. At
some point the official GDP growth target will be reduced to a
range below 6%, to take into account shift to services and peak
in working population size.
Eurozone: stronger global growth will provide
support, however the boost from cheaper energy
is waning
Eurozone GDP growth was 0.4% in Q4 2016, the same as in
Q3. Employment growth has picked up, while the
1 This refers to a diplomatic understanding by which the US does not
challenge China’s claim over Taiwan.
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unemployment rate has fallen from 12% three years ago, to less
than 10% now.
Headline Consumer Price Index (CPI) has risen sharply, to
1.8% in January, although this reflects the diminishing drag
from past falls in commodity prices, rather than a pick-up in
underlying inflation. Despite the fall in unemployment, wage
growth has remained muted, at just 1.4%yoy in Q4 2016.
We expect activity to be supported by loose monetary policy, a
more expansionary fiscal stance, and stronger global demand,
however rising longer-term interest rates and the cost of
energy will offset this to some extent. In contrast to the US,
which will see a stabilisation in energy investment, the boost
from cheaper energy in the eurozone (a large net energy
importer) is now waning, with headline inflation set to rise,
squeezing still modest nominal income growth and consumer
demand.
The European Central Bank (ECB) has given notice that it will
extend its asset purchase scheme to December 2017, albeit
with the rate of purchases reduced from €80 billion per month
to €60 billion per month from April. The ECB remains a major
support for sovereign bond markets, ahead of a series of key elections.
Longer term, we think the current arrangements for the euro
remain sub-optimal, in the absence of greater fiscal and
political union. A monetary union without political and fiscal
union (or something very close), or a convergence in unit
labour costs is flawed. Brexit may open up an opportunity to
create such a union, however even among euro member
countries, there will be differences of view on the right
direction to take.
With large variations in Unit Labour Costs (competitiveness), a
one-size-fits-all monetary policy will mean some economies
run “hot” and some run “cold”. As an example, Germany runs
a large current account surplus, driven up the by one-size-fits-
all euro, and a constitutional balanced budget rule, which stops
German public sector from running a deficit. The size of this
surplus has attracted the ire of the new Trump administration,
however Mrs Merkel has replied that this is an inevitable
consequence of Germany’s membership of the Euro.
UK: the Bank of England sends a dovish signal in
the latest Inflation Report
GDP growth was 0.7% quarter-on-quarter (qoq) in the final
three months of 2016, driven mainly by activity in the service
sectors and indicating continued robust growth in household
spending. Excluding the volatile oil & gas sector, GDP growth
was even stronger, at +0.8%qoq.
What accounts for the strength in consumer spending?
Nominal wage growth has been subdued, however rising
employment levels have pushed up aggregate income, while
very low inflation has supported real incomes. Consumption
has risen faster than incomes, so the saving ratio has fallen.
If households expect any slowdown in real income growth to be
temporary, they may choose to reduce their saving rate further,
and maintain spending growth. Our base case is more
pessimistic however, and we expect consumption growth to
slow, as rising inflation impacts purchasing power.
The official estimate of business investment showed a decline
in Q4, although early estimates are volatile and prone to
significant revision. We believe that the impact of Brexit
uncertainty may take some time to show up in actual
investment, given the lead times involved, although some
investment to satisfy short-term demand may be unaffected.
Certainly, some survey indicators of investment intentions
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stabilised in Q4, but still suggest that investment growth will
remain subdued, especially in the service sector. The most
recent Deloitte CFO Survey indicates that levels of uncertainty
remains elevated.
By contrast, we expect the large depreciation in sterling since
November 2015 to support net trade, by reducing domestic
demand for imports and supporting UK exports in a stronger
global growth environment. Net trade was a significant
contributor to GDP growth in Q4. Overall though, our base
case is for growth to be slower in 2017 than 2016, as household
real income growth weakens and corporate investment is
impacted by uncertainty over future trading arrangements
with the EU.
Despite a decline in the unemployment rate from 8.5% to
4.8%, wage growth has stabilised at rates below those seen
during the pre-crisis period. Poor productivity growth and very low headline inflation are key factors here, however
beyond that, the relationship between pay pressures and the
rate of unemployment appears to have altered, suggesting a
decline in the equilibrium unemployment rate. In their latest
inflation report, the BOE reduced their estimate of equilibrium
unemployment to 4.5% from 5%. This equilibrium rate cannot
be measured directly. Instead, the BOE look at a range of
indicators and wage growth in particular, in order to deduce
any signs of change. The reduction is an important decision,
and reflects persistent undershoot of BOE wage forecasts. If
on the other hand, wage pressures recovery more quickly than
the MPC expect, it will be a clear sign that policy is likely to be
tightened.
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. A combination of cheaper
sterling and stronger global growth could offset any squeeze on
real incomes, via a stronger trade performance. 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 UK, as a medium sized
open economy with a cheaper currency. Thus we have
assumed weaker growth, rather than recession, as a base case.
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SPECIAL TOPIC - US
corporate tax reform
A key element of the current “Trumpflation” trade is the anticipation of US corporate tax reform. If these plans get bogged down in Congressional politicking, an important plank of the post-election equity market rally will be undermined. Fortunately, with Republicans controlling both the White House and Congress, the chances of major tax reform in the US are the highest they have been for many years, however the scale and mix of measures is still open for debate. President Trump has placed tax reductions high on his list of priorities, with the explicit aim of “encouraging” US firms not to move production overseas. House Republicans have also argued for tax reform. With some of the highest corporate tax rates in the G20, there is a long-standing complaint that current global tax arrangements are biased against the US.
The main points of House Republican Corporate Tax Plan are:
A steep cut in corporation tax from its current rate of 35%
A Border Adjustment Tax of 20%, which would “tax” imports implicitly, by removing the ability to deduct the cost of imported goods from taxable profits, while exempting export revenue from tax
An end to taxation of the foreign profits of US companies (ie tax only US based earnings), with a one-off tax on repatriating offshore cash. This reduction in the incentive to hold cash overseas would be a major blow to global tax havens.
Companies allowed to write off capex in the year it takes place, rather than over a number of years
An end to the deduction of interest payments from taxable profits, as this is thought to encourage over indebted capital structures
Supporters of reform argue that any new plan should be based on the very simple proposition that if something is consumed in the US, it should be taxed at an equal rate. World Trade Organisation (WTO) rules allow countries with VAT based tax systems to offer rebates on exports, however the US system relies much less on taxing consumption. Many countries levy VAT on imports, but not on exports. The most controversial element of the House Republican Plan
is the Border Adjustment Tax (BAT), which has polarised
opinion in the corporate sector. Consumer orientated
companies (eg. retailers) tend to be large importers, and are
very much against a new BAT. They view such a measure as an
inflationary tax on households, the very same low income
households that Mr Trump says he is trying to help. By
contrast, large industrial exporters are in favour of such a tax,
since it would end the current situation, where there are lower
taxes on imports than on US made goods.
Supporters of the BAT proposition argue that it would not have a long lasting impact on global trade, since “according to economic theory”, the dollar would appreciate to offset its impact, making imports cheaper and exports more expensive. Many are sceptical of this dollar view, especially since many economic models assume free-floating exchange rates, which is true for the euro and yen, but not China’s renmimbi. Whether President Trump would be happy to see a soaring dollar is also a moot point. On paper at least, the BAT would raise substantial revenue (a 20% tax is assumed to generate $1trn over 10 years) and help fund a much larger cut in corporation tax than would otherwise be possible. This has obvious attractions, however the position of the Trump administration is unclear. The BAT idea was not part of his campaign manifesto, originating instead from the House Republican Plan. Some voices in the White House, notably Peter Navarro head of the Trade Council, have said that BAT is just one of several options being looked at (higher import tariffs are the main alternative), rather than a central plank of policy. Senate Republicans also appear less keen on the BAT idea, especially if it would breach WTO rules, and help trigger an unravelling of the global trading system - a “beggar thy neighbour” dead end, where everyone loses. Already there are rumblings about a legal challenge by the European Union to the WTO, which does permit tax rebates linked to specific products, but not rebates to overall income. The EU will argue that BAT is not the same as VAT, since the latter does not impact a decision to source from domestic versus overseas. One major concern is that radical reform of US corporation tax, as part of the “America First” agenda, could feed the growing protectionist sentiment seen in recent years, and discourage or even reverse the globalisation process. A trend which has seen many large companies set up global rather than national supply chains. This would represent yet another example of the tensions created when a globalised economic system meets a political system still very much rooted in nation states. We assume some compromise on the overall Trump fiscal
stimulus, with tax and spending plans totalling 1-1.5% of GDP,
rather than the 3%+ outlined during the election campaign.
Mr Trump’s pre-election proposals also 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. Since the global financial crisis, potential
GDP growth has slowed, as boomers retire and labour
productivity has weakened. Immigration has added around
0.4 percentage points per annum to population growth, so any
severe restrictions would also hit trend growth.
What happens next?
President Trump is due to address Congress on 28 February. The White House has also said that tax reform and other plans will be made public at or around this time.
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Republicans hold a narrow majority of 52-48 in The Senate. To avoid filibuster2, they will need 60 votes to pass legislation. There is the option to pass a “Budget Reconciliation” by a simple majority, but only if the proposed tax legislation is deficit neutral over a 10 year period.
Markets will be keen to see that any legislation is passed by the summer recess. Any signs of serious delay and a key plank of the post-election equity market rally will be undermined.
2 The filibuster is a device used in the Senate, which means that
most major legislation (apart from budgets) requires a 60% vote to bring a bill or nomination to the floor for a vote.
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CHARTWATCH
1. Measures of US business and consumer confidence have risen sharply since the November election.
2. In the UK, the number of long term unemployment has fallen, suggesting that this group may have become less “unemployable”, and thus are helping to curtail upward pressure on wages. Surveys of recruitment difficulties have remained close to or below their pre-crisis averages, despite falls in the unemployment rate, which also suggests some remaining slack in the labour market.
3. The Bank of England expects the labour market participation rate in the UK to remain broadly flat. An ageing population will tend to depress the aggregate participation rate, as older workers tend to work fewer hours, however the participation rate among older people has been rising, helping to offset this.
4. Eurozone employment growth has recovered, however wage growth remains weak. This will keep the ECB cautious, and we expect quantitative easing to continue.
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 February 2017. Information correct at that date unless otherwise stated. The views expressed are the author’s own and do not
constitute investment advice. Royal London Asset Management Limited, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited,
registered in England and Wales number 2372439. RLUM Limited, registered in England and Wales number 2369965. All of these companies are authorised and
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