Trumponomics: Euro can fall 20% as Europe & Japan pay the bill
- Japan and Europe are set to print the money to pay for the Trump stimulus
- Donald Trump’s fiscal plans are 50% larger than Ronald Reagan’s, when the dollar soared, suggesting the Euro can weaken beyond 0.90, Yen beyond 130
- Stock markets can trend up, especially in US, but Trumponomics intensifies political risks in Europe
The ingenuity of Trumponomics is that it uses cheap money from abroad to pay for a major US stimulus programme. Europe and Japan are trying to boost their sluggish economies through negative short rates and asset purchases, but because their own credit demand is so weak, they will instead end up re-cycling their large current account surpluses to pay for US tax cuts and the rebuilding of America’s crumbling infrastructure, creating US jobs and driving up wages for the workers in the US heartlands who voted for Mr Trump. Large scale fiscal stimulus is risky in normal times, because it can quite rapidly lead to surging inflation, debt crisis, soaring bond yields, and current account/currency crises. But in current circumstances, those risks are pushed far into the future by the availability of cheap money from elsewhere. Donald Trump and his advisers are keenly aware of this:
“I’m the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it’s the greatest opportunity to rebuild everything.” Steve Bannon, Chief Strategist and senior Counselor to the President-elect, interview with Hollywood Reporter.
“All I have to do is show you an infrastructure project that returns zero … And that’s good enough to beat the hurdle rate that the market is choosing right now.” David Malpass, Trump transition team advisor for Department of the Treasury, cited in Wall Street Journal 20th November.
Some stimulus from the US should spill back into Europe and Japan, helped by likely further falls in the Euro and Yen. However, the benefits will probably be muted, because US infrastructure spending has a high domestic content, and because at least some elements of selective protectionism (probably well short of what might trigger a trade war) will likely be imposed to protect US jobs in key sectors. So net net, the US economy is clearly the main beneficiary of Trumponomics. Moreover, with a rising dollar tending to squeeze real wages in the Eurozone without creating that many new jobs, political risk is likely to intensify in Europe.
How large is the Trumponomics fiscal expansion?
Financial markets have already moved a long way since the election. In particular, both the Euro and the Yen have seen high single-digit percentage declines against the dollar. Arguably, this is only the first instalment of much larger moves. To understand why, we need to look at the scale of what is being proposed.
The bi-partisan Congressional Committee for a Responsible Budget published an analysis in September which estimated that Mr Trump’s plans implied a rise in the US national debt held by the public (ie excluding inter-governmental holdings) from 77% of GDP now, to 105% in ten years time (about a third of this due to existing law and two-thirds due to the impact of his plans). The Committee didn’t know how large his infrastructure plans were so they simply costed them at zero – it would be more realistic to use the “trillion” mentioned above, which would add over 5% of GDP to the Congressional numbers.
Going from 77% to 110% in a decade is an average increase of well over 3% a year, and it would represent an enormous stimulus to an economy that is already quite close to full employment on some measures. For comparision, it’s approximately one-and-a-half times faster than the well-known expansion under Ronald Reagan. In modern peacetimes it’s been outpaced only by the debt expansion that occurred in the aftermath of the financial crisis, which is not comparable because the economy was in deep recession.
This is a dramatic contrast with the situation abroad, where the Eurozone still attempting to reduce public debt burdens, while Japan has a more modest fiscal expansion that is meant to be eventually reversed. Moreover, while Mr Trump contemplates abolishing the Dodd-Frank law so as to promote private sector credit growth, the European and Japanese credit systems remain weak and Europe is set on further tightening of banking regulations.
With aneamic public and private credit growth, the Eurozone and Japan are relying largely on monetary policy to pull them away from deflation. Both have negative short rates, and in addition the Bank of Japan is in effect promising to print unlimited money to buy bonds, to keep most bond yields below zero. Europe’s ECB is buying a given amount of bonds rather than setting a yield target, and seems set to extend the current programme. By contrast, the US Fed is going in the opposite direction. Janet Yellen has virtually confirmed a December rate hike and although she is still playing down the pace of subsequent moves, it seems likely that rates will rise faster than she is signalling, to head off growing inflation pressures. The entire thrust of Donald Trump’s programme is to increase jobs and real wages in his heartland constituencies, through construction spending, targetted protectionism, tax cuts and credit growth. All this hitting a jobs market that is heating up: narrowly defined unemployment is below 5% and the latest weekly jobless claims were the lowest in forty years.
This monetary policy divergence has opened up a large gap between US and foreign bond yields,. The US ten-year yield is now around 2 percentage points higher than the German equivalent, the widest for 27 years, and the gap is even wider against Japan. This encourages capital to flow from Europe and Japan to the US, helping to drive the dollar up.
Scope for major further moves in currencies
One indicator of how far the dollar might move is what happened when President Reagan introduced his fiscal expansion. Even allowing for the recent rise in the dollar, it would have to rise a further 30% to reach the Reagan-era peak. This uses an inflation-adjusted basket of currencies for US trading partners, the figure would be closer to 40% if no adjustment is made for inflation. And as noted above, Donald Trump is proposing a larger fiscal expansion than President Reagan’s, and while it is quite possible that Congress will not agree to all of his plans, the divergence in monetary policy could end up being larger than in the Reagan era.
With the Euro around 1.06 and the Yen around 107, as we write in late November, a further move of 30% would take the Euro to around 0.80 and the Yen to about 140. This gives some idea of what might be possible, and it does suggest that as a first step, it is not unrealistic for investors to be alert to the risk that the euro weakens below 0.90, and the yen weakens beyond 130.
US protectionism unlikely to trigger a global trade war
The President-elect has said relatively little about his trade policies since the election, and there are reports of significant differences among his advisors, so this is an especially uncertain area. What is known is that all Presidents have wide executive powers to tighten trade rules without needing Congressional approval. The best assumption that can probably be made at this stage is that these powers will be used selectively, to give highly visible wins for some labour-intensive US sectors, while avoiding broad-based measures that might trigger a global trade war. This is a delicate balancing act, but the US is in a powerful position.
A limited amount of protectionism could complement the fiscal expansion and rising interest rates implied by Trumponomics, by mitigating the damage those policies do to the current account. Moreover, for the new President’s core constituencies in the US heartlands, this could produce some very attractive economic outcomes. Nominal wages would rise substantially as infrastructure spending, tax cuts, and selected new tariff barriers cause the labour market to overheat. The rising exchange rate would help to ensure that this did not feed into rapidly rising consumer prices, and so real wages would grow at a good pace. More jobs and higher spending power, after years of being squeezed, would be an attractive reward for those voters who brought Donald Trump to the White House.
Stock Markets : positive forces and political risks
For the US stock market as a whole, the benefits of faster economic growth have to be weighed against the pressure caused by rising wages. Again, the scale of Mr Trump’s proposals are important: a sustained fiscal expansion of the order of 3 percent anually is so large that it would provide ample scope to allow real wages to recover while also allowing profit growth to accelerate. If something even approaching this scale is achieved, then the stock market probably has considerable scope to rise further. And while some sectors would be hurt by further large rises in the dollar, that currency move is overall a major plus for the US investments of Euro-based investors. Meanwhile for equity investments in Europe, the stronger economic growth in the US combined with the improved competitiveness due to the weak Euro would be a big plus. Moreover, the damage from protectionism is likely to be fairly narrow if the arguments presented above are correct.
Perhaps the biggest risk to this outlook is that it could produce a toxic political mix, with European real wages held back yet again as import prices rise, and anger at highly visible job losses caused by US tariffs, even if the numbers involved are small. Ultimately, the economic policy response to this would be simply to adopt the Trumponomics playlist, abandoning fiscal austerity and going for big new spending programmes funded by easy money. The danger is that the mindset of establishment politicians has become so fixed that it will take outsiders to make the change. With elections in France and Germany next year, and key polls in many other countries, political risk will remain high on the agenda for investors in Europe.