Financial markets finally received a dose of reality, as the first quarter of 2017 came shuddering to a full stop. Spring was in the air, but “animal spirits”, the latest phrase to describe the irrational exuberance that has overtaken the mindset of investors, could only take pause, as the Trump administration failed miserably in its first legislative attempt to deliver on its broad business-focused agenda. The vote to repeal and replace Obama-care never reached the floor of the House. It was pulled at the last minute for lack of Republican support, making many mutter, “Make America wait again”.
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Despite the dire messaging from doomsayers that markets are due to correct over sixty percent, major stock exchanges around the globe barely bobbled at the news. A host of headlines from pundits that write about such market tribulations, however, were not so kind. The basic theme of most articles has been that, if Trump cannot deliver on his first agenda item, then what will happen when really important matters, like, tax reform, foreign profits repatriation, and infrastructure spending, are on the line? Crucial debt ceiling deliberations are also in the near-term offing. What will happen there?
The basic question is can Trump deliver on key economic issues? Equity valuations have soared since the November elections in anticipation of economic stimulus packages that could conceivably boost GDP growth back into the realms of three and four percent and even higher, if campaign promises are to be taken at their word. Foreign exchange markets have greeted this uncertainty with calm. Major pairings are ranging, waiting for volatility to take hold at some point. The Mexican Peso, however, is a different story. It and local stocks have rallied 15% since January. The “USD/MXN” pair has fallen from 22 to 18.7, its November resting place, seen by many as evidence that skepticism regarding Trump and his team is beginning to flow into the mainstream.
Are elevated GDP growth predictions a figment of Trump’s imagination?
It does not take a chart wizard to interpret the trend in the above diagram. In trading parlance, there has been a lengthy downward channel that has gripped these data elements tightly for the past six decades. The desired minimum level of 3% GDP growth was last witnessed in the nineties and into the new millennium, but economists will tell you that it was artificially maintained at that level by expanding consumer and public debt that was used to buttress existing spending habits beyond reasonable limits.
Where did the growth go? Five decades of outsourcing and off-shoring activities on behalf of corporations in both North America and Europe have literally pushed higher growth dynamics into the developing economies of the world, the most massive redistribution of wealth across the planet that the world has ever experienced. What is done is done, and the momentum of shifting labor-intensive processes to lower labor cost arenas is continuing, as well as the widespread use of technology to automate those same processes.
If jobs ever do return to developed economies, they will require higher skill sets and more than likely will involve a higher degree of automation. This conclusion is not to say that fiscal stimulus cannot win the day, but we are presently at a peak or trough, depending on your perspective, on more than a few key financial indicators. Central banks have also concocted a Gordian Know of sorts, driven by QE, ZIRP, and what have you, that will be difficult to untie. Even under its most favored scenario, the Fed’s forecast for GDP growth through 2020 never tops 2.5%. Do they know something that Trump and his advisors do not know, or are they just being extra conservative?
If Ronald Reagan was able to achieve miracles in his presidency, why not Trump?
Is there anyone that would not want to have a surge in economic growth to the tune of 3 to 4% or higher? Or, is this really a siren’s call that will lure us to a momentous crash upon the rocky shore? Republicans are quick to point out that Ronald Reagan was able to achieve wonders during his presidency, and, if he was able to do it, then why cannot an accomplished businessman and billionaire like Donald Trump do even better under today’s circumstances?
One pundit summarized the challenge, as follows: “First, when Reagan took office, the total debt to GDP of the United States was just over 30 percent. Can you imagine? The headlines back then were all about getting debt spending under control, and that the nation needed to work towards a balanced budget. When President George W. Bush took office the debt to GDP ratio was 57 percent. Today debt to GDP ratio is around 105 percent, 75 percent higher than when Reagan began, and around the levels at which warnings bells were going off concerning Greece a few years ago.”
These times, they are different, and this analyst added, “Eight Centuries of Financial Folly, have shown that as sovereign debt levels get above a threshold level, growth becomes increasingly hampered. In other words, Reagan had a lot more wiggle room for fiscal stimulus.” Many economists have already warned that we are at the peak of long and drawn out debt cycle. Something has got to give, but there are other issues to take into account, as well, as listed below:
- Tax Reform: Businesses and wealthy individuals are literally foaming at the mouth in anticipation of major tax cuts. When Reagan was in office, the top marginal tax rate was 70%. Today, the same rate is below 40%. In other words, Trump does not have as much room to enact really stimulative changes;
- Workforce Demographics: In Reagan’s day, the labor pool was much younger and growing rapidly. Times have changed: “Today the United States has both the oldest population and the weakest population growth in its history.” Reagan’s tax reductions could then get more bang for the buck;
- Savings Rate: We were saving at a 10% clip during Reagan’s era, but that rate has dropped to 5.4%. A higher savings rate is indicative of more disposable income per household, a necessity to bolster a consumer-driven economy. Families are struggling to make ends meet: “Disposable personal income per capita growth over the past ten years has been less than 50 percent of the norm since World War II.”
- Interest Rates: Does anyone recall that 10-Year Treasuries were at 16% in the early eighties? Yes, Reagan and his policies were able to drop that figure down to 7% during his term in office, but contrast that situation with today’s near-zero or even negative rate reality. Dropping rates are stimulative. Rising rates are not;
- Bank Lending: Banks are at the end of a lending cycle, where low interest rates may have encouraged a multitude of sins. Many are already preparing for an avalanche of non-performing loans and tightening credit standards, as a result. The prospect of greater lending activity is not on the table, or as one analyst quipped, “This is typical of the later stages of the business cycle and regardless of what the Trump administration does, is a headwind to growth.”
- Shiller CAPE Index: We have written several articles citing the high altitudes of the Shiller CAPE Index, a well respected indicator that uses P/E ratios in a unique way to suggest when equity valuations have peaked. Here are more sobering words from a concerned analyst: “When Reagan took office, the Shiller Cyclically Adjusted Price-Earnings ratio was under 9, dropping to less than seven as Paul Volker hiked interest rates dramatically to crush inflation. By the end of his term, it had risen to just over 17 then continued to increase during the 1990s, peaking in 1999 at over 43. Today this measure stands just shy of 30, nearly four times what it was shortly after Reagan took office.”
What are other economic headwinds that the Trump team must face?
Reagan actually had an easier time of it, much more conducive than the present situation facing the Trump administration. Like it or not, we have consumer-driven economies in developed countries, nearly a 70% dependency in the United States. Disposable Personal Income Per Capita has languished (See below):
If Trump is to approach 4% in GDP growth, several analysts have done the math and contend that:
- Non-farm job growth must exceed 400,000 per month for more than a year, and employees must spend their new found income;
- We will need a $1 trillion infrastructure spending program spread over four years to create many of the new jobs;
- Repatriation of foreign profits, destined most likely for stock buyback programs, would have to add another $200 billion of stimulus.
Tax reform and infrastructure spending fly in the face of cutting the deficit and the national debt, and this postulation presumes no impact on exports, while the Dollar reigns supreme and trade re-negotiations do not run amuck.
The reality of these numbers caused one disillusioned critic of Trump-onomics to opine: “The longer it takes to get anything accomplished, the lower the probability that ‘big changes’ are ultimately delivered. The markets may soon tire of the administration’s new mantra of ‘Make America Wait Again’”.
Healthy skepticism within the investor community is building, as to whether Donald Trump and his executive team can make good on their economic promises made during his campaign. You need only look at the recent action of the Mexican Peso for confirmation. Enthusiasm is on the wane. Confidence is eroding and inexorably going down the path toward disillusionment, a predictable human nature response to a situation that is turning negative. Can this train put the steam back in the boiler? It will not be easy. Historical precedents are numerous, and the situational dynamics this time around may not be as forgiving or as conducive, as in the past.
Whatever the outcome, Mr. Market needs to make a few critical decisions about the future, at least ones based on a new narrative regarding Trump’s ability to deliver. One thing is for sure. The recent upward spiral is unsustainable and could morph into a deathly dive on a moment’s notice. The deckchairs will be scrambled. Chaos and volatility will reign, but trading opportunities in the forex space will leap off the computer screen. The time to pick your horses and plan your strategy for the inevitable race to the finish line is now. Timing is everything in this type of battle, and it is always best to be prepared for any outcome, whatever it might be. Stay cautious! Happy trading!