Buckle up for a Trumpy Road

After a small initial dip, the stock markets seem to have recovered from the shock of the American presidential election result. The Dow Jones even ended the week of the elections on a record high of 18,847, 3% up on the index when markets closed on the Tuesday afternoon. Investors are expecting certain sectors to profit substantially from Trump’s policies, such as the building trade, the defence industry, oil companies, steel companies, coal mines, life insurers and banks.

However, this enthusiasm in the stock markets might not last long. After all, there is little concrete information so far on Trump’s policies. He seems to be more of a pragmatist than an ideologist, which means that all kinds of surprises could lie ahead. His recent remarks qualifying his pledge to repeal Obamacare are a good example.

Under such conditions, it is still perfectly possible to work out a  plausible scenario. Let us look at trade policy and government finances, two areas with major geo-economic consequences for the business community.

We start with Trump’s trade policy. His rhetoric during the election campaign has led people to paint him as a protectionist. Yet it is still too early to draw this conclusion. Ever since the 1980s, Trump has been saying that he is in favour of free trade but that it does also have to be ‘fair’. He has also often accused China of unfair free trade. According to Trump, the Chinese are competing dishonestly because they manipulate their currency, give companies state-guaranteed funding, impose mergers on Chinese firms to make them stronger, apply lower standards for environmental requirements and working conditions, and so forth. Trump wants to force a level playing field by ripping up and renegotiating existing trade agreements.

The question is whether China will be open to the accusations coming from America. The Chinese and others like them are likely to point to the hypocrisy in US and European trade policy. The extremely expansionist monetary policy being pursued in the US and Europe is often mentioned as an example as it has led to lower exchange rates for the dollar and the euro — making it effectively a form of currency manipulation. The Fed and ECB’s low interest rates can also be seen by the Chinese as a kind of subsidy for Western companies. Both parties have arguments on their side and any new negotiations to create a level playing field will therefore not go smoothly.

That may mean that Trump will at some point decide to increase tariffs on imports of Chinese products to 45%. One initial effect could be that China would then take retaliatory measures — a tit for tat. China, with its growing consumer market, could decide to restrict imports of American products. This has happened before, back in 2009, when the US increased import tariffs on Chinese tyres. China hit back with higher tariffs on American chicken products. A second effect for the global economy is that China may start dumping its products on the rest of the world. We have already seen this in the steel sector, which is why European steel producers are now in the red. That scenario would be repeated for many other products if the Chinese had to start looking for new markets. Europe therefore needs a resolute trade policy of its own that  deals with this. A third effect is that higher import tariffs would push inflation up in the US, as America cannot simply switch from importing products from China one day to manufacturing them itself the next. After all, it takes time to build up the capacity needed to produce import substitutes. On top of that, production in America would probably work out more expensive than the cheap imports. Inflation would increase as a result.

Trump’s policies could also have a major impact on American government finances. He wants lower taxes for both businesses and private individuals. The corporate tax rate would be cut from 35% to 15% and the top income tax rate from 39.6% to 33%. American companies that currently credit much of their revenue in their accounts to foreign countries as a way of reducing the amount of tax they have to pay would be able to repatriate their cash at a tax rate of 10%. This would have an adverse effect on tax havens like Ireland, Luxembourg and the Netherlands. The Tax Policy Center has calculated that reduced tax revenues would cause the US national debt to increase by 7 trillion dollars over the next 10 years.[1]

Trump also wants to boost the economy with a stimulus in the form of a 550 billion dollar investment in the USA’s infrastructure. This means new roads, tunnels, bridges, ports, airports and railways. However, the question is whether the American economy can cope with such a boost in expenditure. The US economy is not performing badly and unemployment is low. Moreover, what unemployment there is, is mainly frictional rather than cyclical. This could therefore lead to the labour market quickly overheating and inflation rising.

America’s national debt already stands at 14.3 trillion dollars, 45% of which is held by foreign investors: 1.3 trillion by the Chinese, 1.2 trillion by the Japan and 3.7 trillion by other countries. The rest is in the hands of American pension funds, private individuals and the Fed. So a considerable proportion of the extra 7 trillion dollars in national debt resulting from Trump’s plans would have to be purchased by the Chinese and Japanese. If they stop buying — for example in response to Trump’s trade policy — the treasury bonds would have to be offloaded elsewhere, probably in return for higher yields. This would increase financing costs for Trump.

It seems inevitable that Trump will cause inflation to rise — and therefore interest rates too. We can already see that happening in the capital markets. The yield on American 10-year government bonds increased by 0.35% in the first three days after the election and is likely to soon rise further. At the same time, monetary policy will tighten in the US, causing the entire yield curve to move upwards. Many investors will decide to change the asset allocation in their investment portfolios as a result, which in turn will cause a great deal of volatility in the financial markets.

Higher American interest rates will push up the value of the dollar, and interest rates in many other countries will then have to increase in line with this. Firms in emerging markets that have borrowed funds in dollars, which is the case for many companies in for instance Turkey, will run into financial problems. Another consequence is that countries such as the Gulf states that have pegged their currencies to the US dollar will either have to increase interest rates substantially or abandon the dollar peg.

Declining growth in many emerging markets, a possible trade war and financial war between China and the US and highly unstable international financial markets are just a few of the potential outcomes in this scenario. Companies and direct and indirect investors will face much more geo-economic uncertainty. You have been warned: do not take the opportunistic enthusiasm in the stock markets at face value, and fasten your seatbelts. We could be in for a Trumpy ride.