An Alternative World

After the first week-and-a-half of the Trump presidency many are wondering how to deal with the new reality of this dramatic shift in the US’s stance towards the rest of the world. The message from Trump is clear: he is determined to win at all times and at all cost, which in his view of the world seems to mean that the other side must lose. Win-win situations seem incomprehensible to Trump’s way of thinking, which is why it is probably hard for him to understand that this is essentially what free trade is all about! Clearly the era of US policy action driven by “enlightened self-interest” is over and this implies a serious risk of increased geopolitical and trade tensions.

The era of US policy action driven by "enlightened self-interest" is clearly over

Getting some kind of grip on these risks is extremely difficult at this stage. It takes a few months for a new US administration to be fully up and running, and when the administration changes colour, many new positions need to be filled and around 1,400 of them require Senate confirmation. At the top of the pyramid of power, things change quickly but it takes a while before this reaches the ground floor where policies are implemented. Even once these confirmations are completed a lot of political uncertainty will remain because of some fundamental disagreements between Trump and the Republicans in Congress on issues such as Russia, the replacement of Obamacare, free trade and tax reform. This does not have to imply the kind of political gridlock seen between Obama and the Republican majority in Congress, but it does mean that it will take a lot time to sort out differences. One should bear in mind that from a political perspective all issues are related. If Trump acts unilaterally on trade – which he legally can, within certain limits – this may antagonize Republicans in Congress and make them less willing to cooperate on other issues.

From a market perspective this means that investors will have to live with considerable uncertainty about the Trump policy mix for the next few months. Nevertheless, this uncertainty is bigger in some areas than in others. There is a lot agreement to lighten the regulatory burden on business between the White House and Congress. Doing so could in some cases require a super-majority of 60 votes in the 100-seat Senate and hence necessitate Democratic support, but sometimes there are ways around this. For instance, tax reform can be achieved with a simple majority if the annual budget process is used to achieve it. This process is called “reconciliation” which prevents a filibuster (a tactic to postpone a final vote which can be applied endlessly) in the Senate. Reconciliation requires that the laws governing tax and spending be brought into conformity with the budget. Approval of the budget itself then requires only a simple majority.

Investors will have to live with considerable uncertainty about the Trump policy mix

Besides that Democratic Senators whose seats are up for election in the midterms may be tempted to vote with Republicans on some issues. Whether less regulation is good for the economy and welfare in the longer term remains to be seen. Bear in mind that it was insufficient financial sector regulation that played a leading role in triggering the Great Financial Crisis in the first place. Still, myopic markets clearly love the promise of deregulation, which is part of the reason why the equity market has rallied since November.

The big question is to what extent higher growth momentum will lead to a more hawkish Fed

Another reason is that markets expect some degree of fiscal easing which will push growth momentum higher. The big question is to what extent this will lead to rising inflationary pressures and a more hawkish Fed. Markets have adjusted their near-term Fed outlook since the election, but it is remarkable that the rise in US Treasury yields has been primarily driven by the term premium while markets expect the Fed to remain relatively gradualist from an historical perspective. The implicit assumption seems to be there is either more slack than suggested by the current unemployment rate or that there will be some positive supply side reaction. Both conjectures seem reasonable and will serve to keep inflation pressures muted in the face of an acceleration in demand growth. Still if the markets (and we ourselves) are wrong, we could be in for a nasty surprise. Another potentially unpleasant surprise could come when Trump takes policy actions that actually hurt growth, such as hard-line, across-the-board protectionism.

Over the week protectionism certainly dominated the headlines and weighed somewhat on market sentiment as risky assets moved a bit lower across the board. Whether this was related to higher US policy or protectionist risks is not straightforward, however, as it coincided with a further fall in the VIX index and a rally in trade-sensitive currencies like the Mexican Peso and the Korean Won (see graph). Once again this underscores that just looking at Trump will not help us understand markets better. With economic and earnings data remaining solid and investor sentiment and positioning indicators continuing to hint at further pent-up demand for risky assets, our risk-on stance remains in place despite our worries over the direction of US policy going forward. We have entered an alternative world, but that should never stop us from looking at all alternatives that might explain how this new reality is behaving.

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