Changing phases

Fiscal stimulus to an American economy at full employment is likely to trigger a tightening of financial and monetary conditions – higher interest rates across the yield curve, a more cautious lending policy at banks, a widening of corporate spreads to government bonds, and a rise in the dollar – which in turn could affect growth prospects and investors' appetite for risk. The route therefore looks well defined. It reflects a monetary policy which will gradually become more restrictive and will end up holding down growth. Thus the current cycle is unlikely to differ much from previous ones, with the exception of the catalyst for acceleration of the Federal Reserve's normalisation process: expansionary fiscal policy.

This said, the timing of the move from one phase to the next is less clear. It will depend on the scale of the fiscal stimulus, the second-order effects, the capacity to create jobs and/or increase productivity (acceleration here would hold back the return of inflation) and, above all, on the response of the Federal Reserve: will it wait for an increase in inflation, or will it act pre-emptively? Each of these five factors is surrounded by numerous uncertainties, which will be further compounded by the reactions of the rest of the world. Stronger growth in the USA, and the rise of the dollar, will be manna to some trading partners such as the euro zone and Japan. However, for emerging economies, the impact could be ambiguous: although US imports could have a knock-on effect, higher US interest rates could put emerging market debt under pressure at a certain point, whilst a rise in the dollar would not be welcome for companies in emerging markets who have borrowings in dollars (this was a major source of concern in 2015). Moreover, the question of the impact of a strong dollar on commodities will arise. The traditionally negative correlation – a strong dollar has a negative impact on commodity exporting countries – has recently changed sign, but it remains to be seen whether or not this switch will last.

The multiplicity of the transmission channels, the interdependencies and the uncertainties surrounding them are likely to result in a fall in the confidence of financial investors in their macro- and micro-economic forecasts, and thus greater sensitivity to economic and (geo)political news (Donald Trump's trade policy to give just one example). In other words, we are entering an era of structurally greater uncertainty about both the policy that will be adopted and the economic effects of the decisions taken. With this in mind, the performance of the stock market since Donald Trump's victory has seen a reduction in volatility. Investors have preferred to focus on the better prospects for earnings growth, whilst enthusiasm for tax cuts, particularly for businesses, has increased their appetite for risk and thus pushed down the required risk premium. Thus the increase in long-term rates, reflecting higher growth forecasts, has not really held back the equity market. In the light of the above, the balance between the three factors that determine equity market performance (growth, interest rates and appetite for risk) is likely to shift, creating an environment that will be particularly rich in challenges. In 2017 we will need to watch for announcements of tax cuts and other fiscal measures, whilst in 2018 the focus will shift to the Fed: we are expecting two rate rises in 2017, and a further four in 2018. There could be some tense times ahead.

William De Vijlder

Chief Economist, BNP Paribas