In brief – no change in the US’ aggressive trade stance and fiscal policy gridlock. The possibility of a softer US dollar looms as well.
" There is plenty of evidence to suggest the [US] cycle is approaching maturity.”
The Democratic Party took back control of the US House of Representatives and the Republicans tightened their grip on the Senate. The finer makeup of Congress aside, the result was broadly in line with pre-election polling and financial markets also responded in line with expectations.
The implications of the result will be felt into the long term, particularly in the context of the economic and financial backdrop in the US. Indeed, the US business cycle appears to be approaching its end, the equity bull market is ageing and a Presidential election is now only two years away.
At ANZ Wealth, we think there are several implications from the election result:
• further fiscal expansion seems unlikely;
• the US Federal Reserve (Fed)’s political independence is being compromised and this will probably intensify, particularly if the economy slows and fiscal levers are out of play; and
• the $US could be targeted by White House rhetoric in the absence of fiscal expansion.
Leading macroeconomic indicators all suggest it’s premature to expect a near-term US recession but there is plenty of evidence to suggest the cycle is approaching maturity.
The latest US payroll data show jobs growth is strong, the unemployment rate is at its lowest level since the 1960s and inflation and wages growth are picking up.
All of this means the US Federal Reserve is likely to keep nudging up interest rates until some cracks in the economic landscape begin to appear.
One analogy is it’s like the Fed is tiptoeing out on a frozen lake to see how far it can go. If the Fed goes too far, once the cracks in the ice start appearing then the economy will fall into recession. If the Fed can see the cracks and nimbly stop moving - or even backtrack - then a slip into recession is avoided.
Here the track record of the Fed is not comforting. It has managed only once in the past 40 years (the mid-1990s) to avoid a plunge into icy water.
Trade policy unlikely to change
A key issue markets have been grappling with over the past month or so is how to price an earnings slowdown in a late-cycle environment with natural cost and inflationary pressures amplified by White House trade policy.
On this important issue, the midterm election results provided no resolution and we expect the US to maintain its aggressive approach to trade with China, for three key reasons:
• it wants to deliver on pre-election promises;
• the Administration doesn’t need the support of Congress to act; and
• there is now even bipartisan support to reign in Chinese access to US markets and investment practices.
The only near-term chance further escalation can be avoided is when China President Xi Jinping and his US counterpart Donald Trump come together at the G20 meeting in Buenos Aires later this month. Either way, the meeting should provide more visibility on the outlook for trade tariffs and trade protectionism.
Fiscal policy gridlock
Previously announced fiscal spending is likely to peak in the first half of 2019, although Trump has indicated he would like further tax cuts for low and middle-income earners.
The Democrats would likely provide conditional support for this provided it has no net effect on the budget position by taxing higher income earners. A deal seems unlikely.
Trump has delivered many of his election promises but infrastructure spending is one notable exception. Democrats support more infrastructure spending but disagree with Republicans about how and where the funding should be deployed.
A meaningful deal would seem unlikely given the gridlock in Congress. However it shouldn’t be completely ruled out given both sides support the idea of more investment in infrastructure.
The Fed has been leaning against the fiscal expansion this year to meet its dual mandate objectives and this has not flown under the radar of the White House, with Trump publically criticising recent policy moves.
Political interference in Fed policy was last seen only two months ahead of the 1980 Presidential election as a Volcker-led Fed raised the Fed funds rate from 10 per cent to 11 per cent. Then-President Jimmy Carter complained Fed policies were “ill-advised”.
ANZ Wealth thinks there is a high risk Trump intensifies his sabre rattling in the face of the Fed as it deals with late cycle inflationary pressures and he attempts to get re-elected in 2020. It would become more likely if a Democrat-controlled House takes away any chance of another fiscal splurge.
This political interference leaves the Fed in a difficult position. If economic fundamentals dictate higher interest rates it places itself on a collision course with the President. If economic fundamentals dictate the Fed should stop raising rates it will be perceived as being under Presidential control.
Either way it is being compromised. Trump sees the strong economy as a key re-election platform and a Fed intent on taking away the punchbowl is undermining his second term prospects. Watch this space.
$US likely to soften
The other lever Trump could pull is to jawbone the $US. Dollar strength has gone hand-in-hand with the strong economy and higher interest rates.
However if the economy starts to underperform and the unemployment rate rises then a lower currency would be a desirable objective that would improve financial conditions.
Trump could intervene by suggesting the Fed will begin cutting the Fed Funds rate. Of course fundamental forces will also be at play and the $US may depreciate anyway but it would seem likely in this situation Trump would jump on board as well.
Mark Rider is Chief Investment Officer & Shane Lee is Asset Allocation Strategist at ANZ