The new US administration has had an eventful first month in office, although amongst the turbulence, one theme has remained consistent. That is, the US financial markets have enjoyed an incredible run. The Dow Jones Industrial Average, S&P 500 and NASDAQ have all climbed to record highs, rising 13%, 10.6% and 12.5% respectively, at the time of writing, from the election to date. This is equivalent to the creation of over $2.2trn.
The Immediate Effects
There are a number of different factors responsible for the rise, although they mostly centre on the expectations of the new government’s fiscal policy. The US president, aided by a pro-business cabinet, is expected to carry out his campaign promise and pursue a lower tax, lower regulatory business environment. It is also expected that Trump will reverse the fiscal policy of his recent predecessors, and unveil a substantial infrastructure spending package.
This will certainly boost inflation and, as a result, force the hand of the Federal Reserve in accelerating their interest rate hiking timetable. The lower tax will likely result in a sharper rise of company earnings growth, with an increased cost of borrowing caused by higher interest rates also aiding the revenue of financial stocks. It is no surprise then that it is the financial sector that has enjoyed the greatest outperformance from November to date, with the S&P Financial index up 23%.
Quick to Change?
The current problem, however, is that the market has already taken a big gamble when predicting the extent of these reforms. The aforementioned percentage increases reflect investor optimism for the degree of both tax and regulatory cuts, as well as the expected speed at which the Fed will increase interest rates.
Any announcement that hints at a watered-down fiscal policy is likely to cause disappointment, and in that case, sentiment may quickly turn bearish. With this in mind, how long will we have to wait to find out what the Trump administration is planning? The answer is: not long.
President Trump is set to publish more details of his so-called “phenomenal tax plan”. If in line with his campaign promise, this will see corporation tax cut to 15%, a simplification of the business tax code, as well as a tax reduction for the middle class.
Last week Steven Mnuchin, the new US Treasury Secretary, announced a time frame of six months before the passing of the first “significant tax reform”. This is ambitious schedule. To pass such a reform will require the full support of Congress, although members of the House remain divided over what this plan should look like.
House Speaker Paul Ryan has previously called for corporation tax to be cut to 20%, dependent upon a change in the ‘Border Adjustment Tax’, while other Republicans believe in a different strategy altogether. Trump has also stated that a plan should only be passed following the complete repeal and replacement of the ‘Affordable Care Act’. A critical facet of government policy that, despite causing despair amongst conservatives, is difficult to replace without a clear alternative.
While we may hear more details of this tax reform sooner rather than later, the authorisation of a plan that meets market expectations is unlikely given this time frame and these divisions. If this pessimism is justified, then there will be a retaliation in the currency and equity markets.
Predicting the Dollar Response
The dollar has enjoyed healthy gains in anticipation of the tax reform announcement and hit near thirteen-year highs following the election. On the 9th February, the spot index rose 1% on the news that Trump would release details “within the next few weeks”.
Last week, the dollar weakened over concern about the timing and lack of details regarding the fiscal plan, resulting in dovish comments from Fed Chair Janet Yellen who cited concern over an “uncertain fiscal policy outlook”.
Investors are looking for indications that interest rates will rise at a faster rate, which will surely occur should fiscal policy spark the levels of inflation that the market is expecting. If the policies included in the reform package do result in higher inflation, then expect a stronger dollar as investors seek higher returns on dollar-denominated assets, as a result of higher interest rates.
An area of the reform package that will have the greatest influence on the US currency is the Border Adjustment Tax (BAT). This proposal will tax US imports at the corporate income tax rate while exempting income earned from exports. Roughly speaking, an implementation of this policy would be equivalent to a 15% one-off devaluation of the dollar, resulting in the cost of imports rising by 20%, with the cost of exports dropping by approximately 12%.
The reason this policy will drive up the value of the dollar is that, in its nature, it would spark a rise in inflation. The price of exports does not affect US consumption, and therefore has no influence over the Consumer Price Index (CPI), while a 20% increase of import cost would be equivalent to a 5% rise in CPI.
On the other hand, fears persist over speculation that Trump’s administration will abandon the long-standing ‘strong dollar’ policy, alluded to on the campaign trail by the US President, who announced back in January that “[US] companies can’t compete with them [Chinese companies] now because our currency is too strong. And it’s killing us”.
The market should remain very cautious and, for now, focus on policy details instead of rhetoric.
The Stock Market Response
As mentioned above, the markets have already enjoyed a bullish streak since the election. Investors have been dreaming about expected tax cuts and light-touch regulation that will heavily benefit domestic US businesses, especially in the financial and industrial sectors.
Although in the mid to long term, this pattern is likely to reverse. Heavy inflows into the US markets have been premature, attempting to second guess the extent of these policy details. The strong market response to date shows that investors are predicting comprehensive reforms.
In a research note published by Capital Economics, chief market economist John Higgins stated:
“A reduction in the tax businesses can reclaim for borrowed funds and further repatriation tax on any earnings gained overseas, means that businesses are unlikely to see the increased funds markets had initially anticipated.”
Divisions over the direction of the tax reform may also hamper the extent of these changes, resulting in a feared ‘tax reform light’ package, which will see the market lose some of its gains. The potential downside remains considerably higher than any possible upside, given how far the market has already moved to price in these changes.
Simply put, given the timescale and political divisions, the market is likely to get something less than it expected. If this occurs, there will be a correction that will see an equity sell-off. Nonetheless, regulatory and tax changes will still benefit US corporations in the long run, and even a short-term downside is unlikely to result in losses that exceed the gains of the past four months.
The First Trump Card
The policies announced this week will likely dictate price movements for months to come. US Treasury Secretary Steven Mnuchin warmed everybody up with some hints last week, and now the attention will turn to Trump’s speech to Congress on Tuesday. After this, the markets will have just three days to digest the information, before the focus shifts back to the Fed.
Yellen’s speech on Friday will be the first indicator as to the sensitivity of the Fed’s monetary policy to the fiscal policy direction of the Trump administration. Any rhetoric hinting at uncertainty, or a slower rate of interest rate hikes, will likely see the major indices climb down from their all-time highs. The stage is set for the first Trump card.