A nice note here from Bill Evans at Westpac:
For the last two weeks, I have been in the US visiting investors; hedge funds; corporates and officials. I still have more meetings to complete, including with other Fed officials, but I would like to set out some assessments so far.
It will come as little surprise that the Trump factor dominates discussions and thinking. Investors who have traditionally focussed primarily on central banks now focus primarily on Trump. One debate is whether current pricing for interest rates; the USD; and the stock market is dependent on a successful fiscal policy outcome for Trump.
Alternatively, pricing might be factoring in some economic reform (particularly banking) and not much more. The answer is probably that the share market is more optimistic about a successful policy outcome than the bond market. Bank deregulation (freeing up bank lending) would be stimulatory as long as confidence holds and, with the Fed now proclaiming that the US economy is at full employment, the higher bond rates are justified. However, if the share market needs a successful fiscal plan (centred on tax cuts) to hold current levels, then equities would be vulnerable to a marked sell off in the share market should the plan prove to be elusive.
The problems with a significant tax cut are manifest. It seems that there are around five Republicans in the deficit hawk camp who are firmly opposed to any policy that is not “revenue neutral” and five are “soft no’s”. The current controversy over Russia will only harden opposition within the party.
Failure to deliver a package by the summer would expose the initiative to a Democrat filibuster. The Ryan/Brady Plan, which was laid out last summer when the Republicans appeared unlikely to win the Presidential Election, does deliver a revenue neutral result (after assuming a fairly optimistic growth response to the plan) but it requires the Border Tax (featuring no tax deduction for costs of imports and no tax on export sales). This would be an effective tax on the trade deficit. Such a tax would be hugely disruptive and is encountering significant opposition, we understand, from within the White House. Other “nasties” in the Ryan/Brady Plan are to allow interest cost or state tax deductions and no real allowance for retaliating moves from trading partners.
Another possible funding channel might be to impose large tariffs to help fund the tax cuts and achieve some of Trump’s protectionist objectives. Tariffs can be introduced by Executive Order without the need to go through Congress, although they may be subsequently challenged in the courts and by the WTO.
Overall, arbitrary tariffs are likely to be a more distortive mechanism than the Border Tax. However, that option, linked with some unpopular entitlement reform, might be back-end loaded and more modest tax cuts might constitute a plan that could be manipulated to “look” revenue neutral.
In such circumstances, the USD would rise further but the inevitable response from other trading countries would likely trigger a disruptive trade war – the recent encouraging lift in global PMI’s and global equity markets would soon dissipate.
It was disappointing to hear generally, that infrastructure reform was a low priority well behind dismantling the Affordable Care Act, tax cuts, banking deregulation and trade. For instance, Trump could establish an infrastructure bank capitalised with $150-$200 billion in Federal funds. That would be funded by the repatriation of deferred foreign profits (taxed at 7.5% – 10.0%) and geared at 6×1 with a Federal government guarantee (the impact on the deficit would only be the funding cost). That would deliver on a key promise and probably gain full Democrat support along with enough Republicans to pass Congress. Such an initiative would encourage growth optimism and, if well managed, boost productivity expectancy.
Alternatively, there could be a national effort to privatise current infrastructure (for example, most toll roads are state owned) with a commitment that funds would be reinvested in other infrastructure assets (not used to fund other contingent liabilities of the state). Complex issues between city/local/state/federal governments would need to be resolved with a likely solution being that the Federal government would need to provide incentives to the cities and states to sell the assets.
There are solutions to the successful implementation of an infrastructure plan. If markets saw genuine progress in banking and other sectorial deregulation along with an infrastructure plan, the inevitable shock to confidence that is likely to occur in the summer if trade and unfunded tax initiatives dominate the agenda could be avoided.
So where does the Fed stand in all of this uncertainty? I expect that it will be comfortable to “skip” a March move until we see more clarity on these issues and, more importantly, the impact such developments have on confidence and markets. For example, the Fed sees that “financial conditions” have eased due to narrowing credit spreads and a rising stock market despite higher rates and a higher USD. A reversal in markets would tighten financial conditions and associated drop in confidence would force a review of the growth outlook.
I also expect that the “asymmetric” approach to policy-setting is still a key majority view amongst FOMC members – better to err on the side of higher inflation than risk entrenched low inflation. With the slow response from wages to “full employment”, there is little risk of getting too far behind the curve. On the other hand, I assess that the Chair now believes that the US has reached full employment and, therefore, the normalisation process should proceed (but with two hikes not three in 2017).
I remain comfortable with the June/December call for Fed policy in 2017.
What do investors think of all these issues for Australia? In short, the key channel will be Trump’s trade policies. Any indiscriminate large tariff or Border Tax would pressure China’s foreign reserves and growth outlook. This would likely trigger a protectionist response from China, which while not impacting our resource exports, would most likely threaten our services exports to China.
My central thesis is that the Australian economy is likely to slow in 2018 due to a construction downturn and falling terms of trade. Commodity prices are likely to fall sharply under the weight of a supply response from Australian and Chinese (private) producers; an unwinding of speculative positions in China; and a slow-down in growth associated with a resumption of reform in China following the November Congress.
Downward pressure on the AUD will only intensify in the event of Mr Trump taking the “trade option”.
You can feel the love for the coming switch to further RBA easing…
