Q & A with Sandy Nairn

What are the implications of Donald Trump's election victory?

28th November 2016

Mr Trump’s victory in the US presidential election, like Brexit earlier in 2016, was a shock to many, including professional investors, the pollsters and the betting markets. Jonathan Davis, the founder of Independent Investor, asked Sandy Nairn, CEO of Edinburgh Partners, for his considered thoughts.

Should we have been surprised?

Perhaps not. The economic background to these surprise political events may be well known, but is still worth repeating. The starting point has to be that the global financial crisis of 2008 came close to bringing down the global financial system and precipitating a repeat of the Great Depression of the 1930s. At that point it became clear that big banks and other financial institutions had been taking an ever larger piece of the economic pie, whilst ratcheting up the risks they were running. Although headline economic growth was robust, wages were still being held down by the stiffer global competition that followed China’s entry into the global economy. In painful contrast, the deflationary pressures this generated has helped to send corporate profits to a record percentage of GDP and executive pay and compensation to reach new highs relative to history and average earnings.

After the crisis, in order to avoid an even deeper financial crisis taxpayers found themselves being asked to bail out the banks and insurance companies for little or no benefit to themselves. At the same time, in order to boost economic growth, policymakers have deliberately been holding down interest rates, leading to higher asset prices, meaning greater wealth for the comfortably off, but precious little improvement for anyone else. Whatever else you may say about the electorate on either side of the Atlantic, they are not stupid. They can see what has been happening. It has clearly helped to produce these dramatic political effects, even if the scale of the upheaval has still been a surprise to many.

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CHART 1: INEQUALITY HAS BEEN GROWING STEADILY OVER THE PAST 50 YEARS

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CHART 2: CORPORATE PROFITS HIT PEAK LEVELS RECENTLY WHILE WORKERS’ WAGES HAVE LARGELY STAGNATED IN REAL TERMS

Mr Trump calls his election “Brexit plus, plus, plus”. Is he right?

There are certainly some similarities. In both cases the vote was close and the poll forecasts were misplaced. In both campaigns, statistics and policy promises were thrown around with wild abandon, many of them having little or no foundation in fact – a feature that was even more marked in Mr Trump’s campaign. So-called informed and expert opinion was summarily dismissed during the Brexit debate, with the sensitive issue of immigration playing a central role. The experts took a similar beating in the US presidential campaign. If anything the level of outspoken rhetoric has been greater.

Until Mr Trump’s victory, however, it was still possible to believe that Brexit was an isolated event, unique to the UK and not part of a wider populist backlash. Not so any more. In both cases it is easier to see what people have been voting against than what exactly they have voted for. In the case of Brexit, we are several months on from the referendum and no closer to knowing what ‘exit’ will actually look like.

The same goes for the US. We know that many of the promises Trump made during the campaign are implausible or impractical. They mainly served the purpose of getting him noticed, which means that they tell us more about the direction of travel than about what he is really going to do. Nevertheless it is clear that his campaign energised a hard core of support which we cannot ignore. If the most powerful nation in the world has signalled a change in direction, it is important to try and understand what this might actually mean.

So what do you think President Trump will do when he takes office in January?

When President Obama was first elected, the biggest criticism was that he was surrounded by Chicago academics and local politicians whose lack of Washington experience restricted his ability to implement policy. It is possible that a similar criticism will apply to a President Trump. Although the Republicans are in control of both houses of Congress, he obviously does not command universal support within the Republican Party. There is no detailed policy action plan ready to be implemented in the first 100 days of office. As a businessman, not a Washington insider, he does not have a finely tuned executive team waiting and ready to go. The interregnum is going to be quite chaotic. This makes it likely that many of his wilder comments and proposals during the election campaign won’t be implemented. Nevertheless, it is clear that he won’t just be sitting on his hands when he reaches office. His plans will surely include some policies that give a return to those who voted for him.

And what will they be, do you think?

I would say that the following are the most likely immediate policy measures he will want to try and implement.

Abolishing Obamacare has been a goal of the Republicans in Congress ever since the legislation was enacted. It is hard to see much resistance to it being replaced, or at least amended.

Reducing corporate taxes will be more problematic, not least because of the adverse budget implications. To the extent that it happens, a likely outcome is a tax amnesty (or reduced tax rate) on the repatriation of overseas cash balances by corporate America. This would boost short-term tax revenues and at least cover part of the tax shortfall.

Increasing anti-dumping tariffs on steel is another logical early policy measure, given the importance that votes from the rust belt played in swinging the election his way. Attacking China, ‘the job stealer’, would help to appease this section of the electorate, limited though its impact on steel capacity may well prove to be.

Will the populist agenda lead to a broader repudiation of free trade? That is a much larger issue, and one which would cause most concern if there was a radical change in a policy area where there has been broad consensus for many years. The Trans-Pacific Partnership is surely now dead, but repealing and replacing NAFTA would be a long and arduous process that might end up consuming Trump’s presidency.

Tightening immigration controls will play well with populist sentiment. It is possible that, outside of the infamous ‘wall’ along the Mexican border, not a huge amount actually needs to be done. The Obama administration had already been working on repatriation and other measures to restrict illegal immigration. Everyone knows that migrants have made a huge contribution to economic growth in the United States for generations, as well as strengthening its demographics. So while any significant change in direction would be to the detriment of long-term US growth, in all likelihood any further measures will be populist and incremental, rather than seismic changes.

Appointing the next Supreme Court judge may have profound long-term implications for social issues, but with a majority in both houses of Congress, the Republicans should be able to agree on nominees. It is unlikely to become a major political obstacle.

You seem to be implying that a Trump presidency will have only a limited impact?

Not necessarily. The obvious initial actions that the next administration takes are one thing. They are not going to turn the world upside down overnight – at least I suspect not. There is, however, a much bigger question to be answered about the potential future direction of the global economy in the wake of changing political dynamics around the world. The issue here is whether what we are seeing are simply manifestations of a protest vote against current economic conditions, or whether the orthodox view about the benefits of global free trade, economic integration and international security treaties that have guided policy since the Second World War is now in danger of breaking down. That to me is a much bigger and more serious question than how many specific campaign promises Mr Trump ends up fulfilling.

Some of the key questions

I: ISOLATIONISM AND FREE TRADE

Do we end up with Smoot-Hawley Mark II?

Or George W. Bush Mark II – sporadic anti-dumping tariffs?

II: ISOLATIONISM AND GLOBAL SECURITY ALLIANCES

Has the post-war consensus on defence ended, and NATO with it?

Will regional security blocs emerge?

III: END OF QE?

Will US infrastructure expenditure plans signal an increase in fiscal policy?

The end of QE and suppressed interest rates?

IV: GLOBAL POPULISM

Will the coming plebiscites in Italy, Austria, Holland, France and Germany yield similar results?

Can the EU survive rising nationalism?

So what are the key issues? Let’s start with trade – how great is the threat of a breakdown in this area?

The risk we are facing is that the kind of populist anti-trade, anti-establishment movement we have seen emerge in the US spreads to other developed nations. If Trump as president genuinely believes that economic isolationism is a sensible policy, then this would be highly dangerous for the global economy, as it could pave the way for a global trade war. The last thing we want to end up with is a repeat of the Smoot-Hawley legislation, the aggressive tariff policy that caused so much damage in the 1930s. Let’s not forget, either, that there are a number of potential flashpoints in Europe, where the EU’s anti-competitive and tax investigations into Google and others could easily incite a retaliatory response from the US.

Smoot-Hawley was fiercely resisted by experts from academia and commerce at the time. They pointed out the futility of unilateral measures in a world where retaliatory action could be expected. This cut no ice. In the US economy back then, productivity gains in an old industry (agriculture) had led to labour shedding and increased price competition, and pressure mounted to protect agriculture with tariffs. Such was the power of the lobby that the legislation passed and as pork barrel politics came into play, the demand for tariff protection spread across to industrial goods. The disastrous tariff regime contributed to the depression which followed (and both Smoot and Hawley lost their seats two years after the legislation was passed).

Whilst there are a number of parallels today, the background unemployment position bears no resemblance to that of the 1930s. I think it is more likely that what we will get from Mr Trump is what I might call George W. Bush Mark II, a policy of persistent posturing and sabre-rattling on a range of trade issues, probably accompanied by a ‘Buy America’ policy in public procurement. Technically this might be a violation of World Trade Organisation rules, but that is unlikely to worry Trump too much. No doubt the lawyers can come up with some cleverly framed arrangements that avoid that outcome. I expect to see the sporadic imposition of tariffs in specific sectors, accompanied by strident public statements that play well to the domestic audience. Let’s hope that I am not being too optimistic about this.

Is global security threatened by the changing political order?

Definitely. Mr Trump’s isolationism could well extend beyond trade. His rhetoric about NATO and defence, whether sincerely meant or not, can only heighten geopolitical concerns in Eastern Europe and the South China Sea. Layered on top of this, Mr Trump has clearly revealed a personality which does not take easily to criticism and looks to find culprits whenever events turn against him – not something that you want to be tested too often on the international stage.

The biggest threat may well lie with how Europe and Asia respond to any shift in America’s foreign policy. Europe is already starting to talk up the importance of European armed forces. Mr Abe in Japan wants to re-open a military state. China is flexing its muscles in the Pacific and Putin is doing the same in Eastern Europe and the Middle East. There are dangers if Mr Trump’s language remains too bellicose. As the world’s policeman, the US has a huge influence. Stepping back from that policing role inevitably reduces its ability to control events. On balance I suspect that President Trump will in practice be unwilling to lose the influence that leadership of NATO gives the US. The most likely outcome is that he succeeds in forcing US allies to ramp up their military spending and share the burden – giving back a little of the peace dividend that the collapse of the Soviet Union gave us, if you like.

What about QE and monetary policy – are you expecting changes there?

It looks likely to me. Mr Trump has been openly critical of the Federal Reserve for its easy money stance. He cannot fire Janet Yellen, but she can be replaced when her term expires in 2018. In any event, the tide is already turning against the central banks and their current policies. With balance sheets repaired in the financial sector and increasing evidence that wages are starting to grow, it was almost inevitable that the Fed would have been starting to reverse policy anyway. The pressure to do so will be accelerated if President Trump acts on his promises to cut corporate taxes and embark on a programme of infrastructure spending. The mere threat of such measures should be enough to cause the bond market to question whether pricing bonds to offer negative real rates any longer makes sense.

This is not to say that we are necessarily looking at a very large fiscal change. Because of the debt constraints already in place, there is a limit to what a Trump administration can achieve (though that may not stop him announcing unrealistically ambitious targets). Look out for a series of eye catching initiatives where the substance proves to be less than a first glance might suggest. Some argue that Trump as president may, by accident or design, create a modern version of FDR’s big-spend Tennessee Valley Authority plan of the 1930s. However, as requirements for fiscal stimulus go, there is little comparison between the two periods. US unemployment is currently somewhere around 5%, whereas in 1933 the figure touched 25%. In 1933 the national debt to GDP ratio was 33%. It is now three times that level.

Nevertheless it is clear that there is likely to be more infrastructure spending and given the vintage of the existing capital stock in the US, there are likely to be efficiency gains. Against the backdrop of a tight-ish labour market and a headline inflation number set to rise as recent oil price declines fall out of the numbers, we have reached a situation which bond markets can no longer ignore. Trump’s election has already caused bond markets to reassess current valuations, with yields rising across the curve. He did not cause the excess valuation and neither is he responsible for the reset, but his victory seems to have caused it to occur sooner than otherwise would have been the case.

What are the wider implications of the populist trends we have seen in the US and UK?

From a global perspective it is clear that Brexit and the US election are milestones on a journey towards greater nationalism. If that journey ends in a world of isolationism and tariffs, then the ability of the global economy to cure its debt overhang through an extended period of nominal GDP growth will be badly compromised. All asset markets would in serious trouble. The next potential stops on this journey are the Italian constitutional referendum on December 4th, the rerun of the Austrian presidential election, the French presidential and Dutch general elections in spring 2017 and the German federal elections in autumn 2017. The results will be critical in showing us how far the Brexit/Trump dynamic has spread to other countries. A break-up of the EU with at least one common currency member leaving the euro is not impossible. It is the most obvious near-term threat to the stability of the financial sector.

Whilst Brexit was a shock, the UK is not a member of the common currency and so cannot be taken as a direct model for how other EU member countries will vote. Nor can the benign outcome in financial markets be assumed if a common currency member were to follow the same path. So it is not in any way inevitable that populism will win the day. There are legitimate arguments that Brexit would not have happened if the UK Labour Party had provided a more robust defence, or that Mr Trump might not have won if the Democrats had put forward a different candidate.

It is possible therefore that any trend away from free trade, which is the worst-case outcome, is neither as inexorable nor as deeply rooted as some pundits suggest. It will be some time before we are able to judge how sustained the trend will be. The most powerful antidotes to populism are rising employment and higher wages. Will they take root in time to prevent further political upset? It is possible. We just don’t know.

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CHART 3: BOND YIELDS HAVE BEEN DECLINING FOR MORE THAN THREE YEARS; ARE WE NOW AT A TURNING POINT?

It could be that we are over-reacting?

Yes. It is possible that a Trump presidency will turn out to be more benign than markets have anticipated. This is contingent on the idea that in practice he will adopt a less strident anti-free-trade view than he expressed during the campaign. If this is the case, then the main effect will be an acceleration of trends which I believe were already in train and for which our portfolios were already structured.

The most important lesson to take away right now is that markets are already reacting to the demise of QE. As we discussed earlier this year, so stretched were the valuations of QE-related assets, that this was only a matter of time. It is not the election of Trump per se which is causing the moves in asset markets. It is simply that his election makes it harder to avoid the inevitable conclusion that QE has achieved all that it is able to do and asset prices will increasingly be evaluated within more historically normal parameters.

Fiscal activism will increase, labour markets will tighten and the yield curve will steepen. The outcome is a world where historic normal valuation parameters are likely to come back into play. This will favour investors who have maintained their discipline on valuation. It will be negative for the assets most inflated by the QE monetary regime, the most obvious being: bonds, bond equivalents and ‘growth’ companies whose valuations have been sustained by an ultra-low discount rate, rather than by actual growth. The discontinuities in valuation are very large, which suggest the potential rebalancing will be substantial and sustained.

And what if the outcome is not as benign as you seem to be suggesting?

Whilst all this unfolds one will have to keep a very close eye on the spread of populism. Ironically the biggest threat to the benign outcome may potentially lie not so much with President Trump, as with a similar populist result occurring in Europe. The main reason to hope that we do not see a replay of isolationism and a potential break-up of the euro is that underlying economic conditions do not resemble the 1930s. The financial system has not collapsed and employment and wages are increasing, not falling. Labour markets are recovering and the voices in favour of free trade still remain powerful. However, should we end up in an environment characterised by tariffs and the creation of powerful and antagonistic trading blocs, then the impact on asset markets would be very substantial.

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CHART 4: THERE ARE MORE IMPORTANT ELECTIONS COMING UP – A CHANCE TO TRACK THE STRENGTH OF THE POPULIST VOTE

Engines That Move Markets

Sandy Nairn spent ten years in the 1990s working directly for Sir John Templeton in a variety of roles, latterly as Head of Global Equity Research. A new and revised edition of Dr Nairn’s classic historical study of how technology makes and breaks investors will be published by Harriman House in 2017.

sandynairn

Dr Sandy Nairn

Chief Executive & Investment Partner
Edinburgh Partners

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