After a short initial post-election shock, many financial market participants seem to have adopted a Dr. Strangelove attitude (“How I Learned to Stop Worrying and Love the Bomb”) toward the election of Donald Trump. Developed market (DM) equities, bond yields and the U.S. dollar rallied on hopes for fiscal stimulus and less regulation. (The notable exception to this apparent market optimism is in emerging market (EM) assets, which dropped sharply on fears of more U.S. protectionism and adverse repercussions from a stronger dollar and higher “risk free” rates.)
I’m not Dr. Strangelove, and I believe it’s too early to stop worrying. A more differentiated view of the potential long-term economic and policy consequences of President-elect Trump must take on board both the considerable uncertainties still surrounding the next U.S. administration’s economic policies and the global links between economies and markets (which have become closer over the years).
Here are five things investors may want to consider before “embracing the bomb”:
First, both right-tail and left-tail risks for the global economy and markets will likely become fatter under President Trump. If the new administration focuses on reforming taxes, increasing infrastructure spending and easing regulations, both demand and potential output growth could be lifted without creating excessive inflation. Conversely, a strong focus on punitive tariffs and immigration bans could risk retaliatory responses from other nations and potentially provoke a trade war that fuels deglobalization. It is too early to tell which of these two scenarios, if either, will prevail. In the meantime, markets are likely to oscillate between hope and fear.
Second, while a U.S. recession over the next year or two may now look less likely, the risk that the current expansion ends in tears in 2019 or 2020 has increased. This is because more fiscal stimulus will lift demand at a time when the labor market is close to full employment and the first signs of wage pressures have already started to emerge. Wage and inflationary pressures would be exacerbated if President Trump gets serious about the curbs on trade and immigration he campaigned on. It is possible the Federal Reserve would initially welcome higher inflation and tolerate an overshoot of the target for some time. However, under that scenario the Fed eventually would likely need to raise rates more aggressively than in a scenario without fiscal stimulus and cost-push inflation through protectionism, which could push the economy into recession in 2019 or 2020.
Third, central bank independence as we know it is likely to come under further attack, given both the long-standing criticism of the Fed in conservative Republican circles and the President-elect’s attacks on the Yellen Fed. At a minimum, the new administration is likely to appoint two hawkish candidates to the two vacant seats on the Federal Reserve Board. Also, a new Fed chair might be appointed when Janet Yellen’s term at the helm expires in February 2018. All of this would be common and legitimate practice and does not, per se, constitute an attack on the Fed’s independence. However, it remains to be seen how closely the policy promoted by any new appointees will hew to the new administration’s views. More importantly, the Republican majority in Congress may well start to push forward some of the proposals to narrow the Fed’s mandate that conservative circles have made in the past. The mere rumor of changing the Fed’s mandate may have an impact on monetary policy decisions.
Fourth, in the face of the sharp sell-off in bond markets, the Bank of Japan’s new strategy of “yield curve control” looks even smarter now and might become a blueprint for other central banks, potentially including the Federal Reserve. Consider a scenario where a large fiscal stimulus (or the expectation of such stimulus) pushes up bond yields so sharply that risk assets and the economy suffer. To prevent a bond tantrum, the central bank may want to limit the rise in yields by intervening in the bond market directly. The cleanest way to do this is to announce a cap on yields and stand ready to buy unlimited amounts to preserve the cap if needed.
Fifth, the market reaction to Donald Trump’s election provides a serious test case for the “Shanghai co-op,” as I have called an informal understanding by the world’s major central banks that excessive dollar strength is bad for everyone and should be avoided. The dollar strengthened not only against emerging market currencies but also against the euro and the yen in recent days. While the European Central Bank and the Bank of Japan probably welcome some weakening of their currencies given persistent “lowflation,” too much dollar strength would hurt the dollar debtors in EM, commodity prices and the U.S. energy sector, and could induce China to aim to devalue the yuan more aggressively against the dollar in order to prevent a sustained appreciation against the currency basket.
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO blog.