Reading the Policy Tea Leaves: 3 Potential Outcomes
By now it is becoming quite clear that the cyclical momentum in the U.S. economy will lead to significant fiscal policy divergence between the U.S. and the rest of the world.
That policy divergence, in turn, will lead to strengthening of the dollar and significant inflows into the U.S.
So far so good.
However, as various Trump cabinet appointees have articulated their respective positions during their confirmation hearings, it has become quite challenging to figure out what fiscal policies the Trump administration will implement, and what the consequence of any of those policy actions might be.
In my view, three possible scenarios may play out.
Scenario 1: Stimulus Spurs U.S., Global Growth
The first scenario, of course, is that President Trump follows through on his campaign rhetoric and over the next year unleashes a policy of deficit-financed fiscal stimulus that includes some elements of corporate and personal tax cuts and infrastructure spending. The key aspect of this scenario for me, coming at it from a funds flow standpoint, is that it is deficit-financed and, as a result, the U.S. Federal Government budget deficit widens. With that increase in the deficit, we will get a supply of U.S. Treasuries to absorb the flow of funds from overseas, and U.S. growth momentum can be maintained and may actually accelerate.
This is a very good and classic economic scenario: Growth spurts up, interest rates move higher, the dollar strengthens, and the trade deficit grows. In other words, there are no dislocations. We can have an era of persistent dollar strength that does not kill the U.S. growth rate, and emerging market (EM) economies are not jeopardized as the U.S. trade deficit helps them from a growth and funds flow standpoint.
Ironically, for President Trump anyway, this scenario creates more jobs in the U.S. but may not revive low-level manufacturing and the U.S. trade deficit actually widens. For this scenario to play out, it is worth remembering that you can’t have open and uncontrolled financial flow markets with controlled goods and services markets and expect growth to be unaffected. In this scenario, the Trump administration policy priority goes for growth and jobs and does not worry much about trade deficit.
Scenario 2: Deficit Reduction Slows U.S., Global Growth
However, an alternate scenario, call it Scenario 2, is looking quite probable as well. If you listen to the rhetoric from Office of Management and Budget nominee Mick Mulavaney or you go into the details of the Congressional tax proposals, it is not at all clear whether the fiscal deficit is going to widen or not in the Trump administration.
Mulvaney’s stated position of reducing the deficit now (Scenario 2a) or the Congressional Republican proposal for paying for tax cuts through a border-adjustment tax (Scenario 2b) are both aimed at preventing the deficit from widening. Unfortunately, neither of these scenarios are growth positive.
Given the cyclical momentum of the U.S. and global economies and the path the U.S. Federal Reserve (Fed) has chosen, the policy divergence between the U.S. and the rest of the world will cause the dollar to stay persistently strong; however, if the fiscal deficit does not widen, there would be no way to absorb the ensuing flows. As a result, U.S. growth will have to eventually slow and the strength of the dollar will create dollar flows away from EM.
Scenario 3: U.S. Fiscal Deficit Widens – Or Else
My bottom line is Scenario 3. Irrespective of which policy the Trump administration implements, the U.S. fiscal deficit has to widen. If the U.S. deficit does not widen and the overall U.S. debt growth rate does not increase, the strength of the dollar due to policy divergence will be highly detrimental to U.S. growth. In turn, that will have negative effects on global growth, including EM countries. The bloom will be off of the market’s rose rather quickly.
Furthermore, if inflation picks up, the risk of a Fed policy-induced recession will most certainly increase. While these policy initiatives may seem growth and market boosting on the surface, my hunch is that without a widening of the fiscal deficit they end up being growth and market negative.
But all is not lost on this front.
Trump himself has stated that he does not like border taxes, and Mulvaney’s hawkishness on deficit and debt reduction now may be subdued by other policymakers in Congress and the executive branch. I remain hopeful that the Trump administration’s economic policies will eventually be helpful for growth and markets, but I strongly believe they need very close monitoring.
The acid test for me remains whether the fiscal deficit widens or not. If the deficit widens, current dollar strength will prove to be benign. If it does not, U.S. growth will come down in the not-too-distant future. In that case, the Fed would be well advised not to raise interest rates and instead normalize its balance sheet by ceasing reinvestment and selling assets, but my hunch is they will not do that.
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DISCLOSURE:
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.