James Bevan: What lies ahead for the US in Trump world?
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James Bevan
Conservatives feared that if Hillary Clinton won the US presidential election, her economic policies would be a continuation of Obama policies with higher taxes and more regulations. Now liberals fear that Trump’s policies will be the reincarnation of Reaganomics, with lower taxes and fewer regulations.
Conservatives might also be in for a shock. On 23rd November, Steve Moore, one of the founders of supply-side economics and now a Trump economic adviser, told a group of top Republicans that they “now belong to a fundamentally different political party” and at the closed-door whip meeting last Tuesday he told them they should no longer think of themselves as belonging to the conservative party of Ronald Reagan. They now belong to Trump’s populist working-class party. He said “‘Just as Reagan converted the GOP into a conservative party, Trump has converted the GOP into a populist working-class party”.
Moore has been a long-time advocate of huge tax and spending cuts and free trade. On the subject of spending, he says: “I don’t want to spend all that money on infrastructure. I think it’s mostly a waste of money. But if the voters want it, they should get it.” He believes that Mr Trump has channelled the will of the people, so if he wants to “build a wall, then he should build it”. And if Mr Trump wants to renegotiate trade treaties, then so be it. Mr Moore reckons that free trade must adapt in ways that benefit American workers more, or free trade is not going to flourish.
Moore helped to write Mr Trump’s tax plan and predicts that the cuts will boost economic growth and create new jobs. Soon after taking office in 1981, Mr Reagan signed into law one of the largest tax cuts in the post-War period. That legislation, phased in over three years, pushed through a 23% across-the-board cut of individual income tax rates.
By way of context, when Mr Reagan cut taxes, the economy was in a recession with the unemployment rate rising from 7.5% during January 1981 to peak at a post-WWII record high of 10.8% during December 1982. When Mr Trump moves into the White House, the jobless rate will likely be the same or lower than October’s 4.9%, down from the latest cyclical peak of 10.0% during October 2009.
Full employment and GDP growth
Despite all the chatter about a “New Normal” economy, that decline in unemployment was actually remarkably similar to the decline following the severe recession of the early 1980s. So, Trump’s proposed tax cuts and infrastructure spending will stimulate an economy that is widely believed to be at full employment. Trump reckons that this will boost real GDP growth to 4%, but a supply-side analysis of real GDP raises some serious challenges to that forecast.
For starters, there are already plenty of stories about labour shortages and the underlying year-on-year (yoy) growth trends in the 12-month average of the civilian working-age non-institutional population and the civilian non-institutional labour force were only 1.1% and 1.2% during October.
There has been a slowdown in the growth rate of those who are NILFs, i.e., “not in the labor force” – there were 94.6mn of them during October, and the vast majority aren’t likely to enter the labour force because they’ve either retired or are in school. Those NILFs who may be willing to enter the labour force may not have the skills for the available jobs.
Meanwhile, the latest productivity report, released by the Bureau of Labor Statistics, showed that total hours worked in the non-farm business (NFB) sector rose 1.7%yoy through Q3. It has been fluctuating around 2.0% since mid-2010. If it continues to do so, then productivity would have to grow about the same to achieve Trump’s 4% growth in output. That’s certainly conceivable, though NFB productivity growth has averaged just 0.6%yoy since mid-2010.
‘Old
If the ‘old normal’ productivity growth rate doesn’t return, then ‘old normal’ inflation rate likely will, and given the current labour shortages and the coming fiscal stimulus, wage inflation is very likely to move higher. If productivity doesn’t do the same, then employers will try to raise prices. If competitive pressures, including those resulting from deregulation, keep a lid on prices, then profits will suffer, with repatriated earnings likely used for buybacks and M&A. So counter-intuitively, pressure on profits could be very bullish for stocks thanks to over $2tn in repatriated cash and a significant cut in the corporate tax rate.
So far, the two main reasons to remain relaxed about the inflation outlook are the strength of the dollar and the price of a barrel of crude oil, which is likely to remain range-bound between $40 and $50, as we have been predicting since the spring. OPEC and other oil exporters can’t agree on production cuts because they all recognise that technological innovations are likely to reduce the value of their oil sooner rather than later. The widely circulated chart showing that the US oil rig count tends to lead weekly US oil field production by 18 months depicts a correlation that isn’t working now. The latter stopped falling six months ago, while the former is still in a free fall (using the 18-month forward series). Frackers obviously are finding ways to lower their costs so that they can continue to extract oil at lower oil prices. Another important correlation that isn’t working is the one between the CRB raw industrials spot price index and the inverse of the JPMorgan trade-weighted dollar. In the past, a soaring dollar would have been very bearish for dollar-priced commodity prices. Not so in Trump World so far.
‘Old normal’ & markets
It’s obvious why the dollar is strong – the US seems to be heading back toward the Old Normal, while Japan and Euroland remain mired in the New Normal. So the Fed is likely to continue normalising US monetary policy at perhaps a more normal pace than pre-Trump.
Meanwhile, both the ECB and the BOJ are likely to pursue more QE (quantitative easing) and continue NIRP (negative interest-rate policy). Equally, commodity prices may be rising on expectations that economic growth could be surprisingly strong in Trump World, at least in the US. That should benefit emerging market economies. However, the past positive correlation between the CRB raw industrials index and the Emerging Markets MSCI stock price index (in local FX) seems to have broken, with the former rising and the latter falling.
So what of markets? Forward P/Es have soared since the Election on 8th November, through Friday’s close with the S&P500 up from 16.4x to 16.9x), the S&P 400 from 17.2x to 18.7x, and the S&P600 from 17.4x to 19.9x. The valuation multiple for the S&P600 is now the highest of the current bull market, while the S&P400’s is back at its previous cyclical high. The S&P500’s forward P/E is still below the February 2015 high of 17.2x.
These market moves look to be consistent with the melt-up scenario but these multiples can’t be justified by the outlook for inflation and interest rates if both do head higher. They can be justified only if real GDP growth does rise to 4% and is led by productivity. That might boost profits as long as companies can increase prices at least as fast as wages increase.
For now, the melt-up can continue and valuations riser still higher until all the repatriated foreign earnings have been spent on stock buybacks and M&A. Forward caution is warranted if one reflects that during 1980, the S&P500 rose 43.1% — from the year’s low on 27th March to its high on 28th November — as investors anticipated a Reagan victory and revolution. They got Mr Reagan but they also got Mr Volcker’s recession, which triggered a bear market that lasted until the summer of 1982. Against this backcloth, quality growth may be unfashionable but looks prudent given that prices will equilibrate around earnings, and earnings looks more assured with ‘quality growth’ than cyclicals.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
*CCLA is a supporter of Room151
