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The unintended consequences of US fiscal policy

The Trump government believe its economic policy will result in a growth rate of 3%; economists believe this is more likely to be 2% at best. What then will be the real impact of US fiscal policy and what will this mean for markets?

The US public deficit is likely to exceed 5% of GDP before too long as a result of tax cuts and higher expenditure on defence, infrastructure et cetera, in the absence of substantial cutbacks in other areas. This cannot be sustained for long. However, it will not get to this point according to Trump and the Republicans. They believe that their measures will result in far more investment activity, as a result of which productivity growth will accelerate in the future. This is expected to result in a growth rate of 3% or higher. It is believed that the resulting additional tax revenue would prevent the public deficit from rising substantially.

Most economists have a different view. To start with, they believe the point of full employment has virtually been reached in the US. They therefore envisage additional wage increases before long (there is more and more anecdotal evidence of this). This means that if US economic growth were to stay well above potential, imbalances would occur to the extent where a recession would soon ensue. In other words, growth would have to be pushed back to potential fairly quickly in order to prevent this.

This brings us to the question as to the exact level of potential growth. In this respect, the views of most economists differ from the optimistic outlook of the White House – said economists expect growth to end up at around 2% at best. However, the Fed prefers interest rates to rise to 3-4% in order to be able to absorb the impact of the next recession.

In the current circumstances, this would only be possible if inflation were to climb to this level as well. Hence, we believe the Fed will pursue a policy that will ensure growth still stays above potential for a while. However, the Fed would have to tread very carefully here because once the markets believe the Fed allows inflation to rise rapidly, the bond market will spin out of control – due to concerns about even higher inflation.

This would be a very risky development given the current soaring debts. Hence, we envisage the Fed setting the target for growth at 2.25-2.5% for the time being – it will therefore aim for a growth rate that is just above potential, as a result of which inflation would only rise slowly.

We therefore draw the following conclusion:

  • The White House and the Republicans overestimate the growth rate with their assumption of 3% growth. We believe growth will be at 2.25-2.5% in the slightly longer term.

  • It also remains to be seen whether the Fed will be able to fine-tune growth so that it reaches this level. It usually failed to do so in the past in any event. If the economy were to grow too fast for a while, with inflation rising too rapidly, a recession would definitely occur before too long. Importantly, the lower the level of productivity growth, the sooner and faster inflation would rise. This is an important point, now growth seems to keep hovering at around 3% for the time being as a result of the tax cuts – this would be well above potential.

  • All leveraged parties in the US could soon be hit by far higher interest charges. In itself, an interest level of approximately 3.5% is still historically low. However, debts have exploded over the past decades because interest charges stayed at more or less the same level as a result of lower interest rates. If the interest level were to increase from 1% to 3.5% now, this would come down to roughly a tripling of interest charges over time.

  • Wage increases will probably reach higher levels before inflation starts rising. In a situation where productivity growth lacks a distinct uptrend, this would soon result in higher unit labour costs. In conjunction with rapidly rising financing expenses, this could soon limit the increase in corporate profits considerably.

If we subsequently look at the consequences all this entails, our first assumption is that the US economy still receives substantial monetary stimulus, with fiscal stimulus coming on top of this now. In addition, fairly high growth in the rest of the world is a stimulating factor as well. This is why we believe US economic growth will amount to roughly 3% for the time being. This, in turn, means the Fed would have to pursue a tighter monetary policy. Both short-term and long-term interest rates would have to be driven to higher levels in order to gradually push back growth to 2.25-2.5%.

Longer-term interest rates will come under (far) more upward pressure anyway in the course of this year:

  • The prospect of higher inflation as per the Fed’s intention will drive up long-term interest rates.

  • The Fed will downscale its bond portfolio increasingly rapidly in the course of this year. The central bank will consequently have to sell more and more bonds.

  • The government will have to step up borrowing considerably in order to finance its deficits.

  • China wants to invest more of its surpluses rather than saving them. This means China would have less demand for US bonds. Should Trump maintain his protectionist stance, this process would be accelerated and the same would apply to other countries as well.

  • The US is developing major twin deficits (on public finances and the current account). Considering the low level of savings in the US, this requires foreign capital – in the event of a well-performing economy. The fact that the dollar exchange rate has declined lately and long-term interest rates have risen shows that foreign capital holders believe the dollar exchange rate is too high and/or US interest rates are too low for substantial investment in the US. This would probably first require monetary tightening. This would only get off the ground if wage increases and/or inflation were to reach distinctly higher levels. This is yet to happen and US monetary policy is still too loose to attract sufficient foreign capital. As long as this remains the case, there will be downward pressure on the dollar exchange rate and/or upward pressure on longer-term interest rates.

Share prices have been driven up enormously since 2009 by ever lower levels of interest rates and an increasing surplus of money as a result of quantitative easing, not just in the US but outside the country as well. However, this will change now – first of all in the US, where a turnaround will occur from quantitative easing to quantitative tightening and interest rates will rise.

As for Europe, policy will shift from quantitative easing to neutral, rising long-term interest rates are envisaged this year and the ECB is expected to start hiking its rates by next year. A similar policy is envisaged for the rest of the world in the years to come. This therefore means that share prices were initially driven up to excessively high levels by massive monetary growth and artificially low interest rates, while they will now be faced with monetary tightening and higher interest rates to a far greater extent.

Chart 1: Negative effect of ageing on US government finances – rising health care expenditures – remain worrisome
Chart 1: Negative effect of ageing on US government finances – rising health care expenditures – remain worrisome

Source: Thomson Reuters Datastream/ECR Research

Such a transition normally occurs at a slow pace, but it will probably be faster now due to the US suddenly implementing far more fiscal stimulus than was foreseen – for a long time, it was believed the tax cuts would be offset by major cutbacks on expenditure. Germany seems to be heading in this direction too. Furthermore, growth in the rest of the world is better than expected as well, which has an accelerating impact on the process.

In combination with persistent high valuations, we certainly expect the above-mentioned turnaround in monetary policy to cause the S&P 500 index to decline towards 2,300 in the months or quarters ahead. However, as a decline below this mark would also affect US economic growth, this could moderate a further increase in interest rates.