Not Just Another Recession
Why the Global Economy May Never Be the Same
World financial markets have had an unusual reaction to the unexpected U.S. presidential election victory of Donald Trump: they remained relatively calm and, some might say, even responded positively. Unlike the British pound after the Brexit vote, which tumbled rapidly shortly after, the U.S. dollar, after Trump’s election, actually strengthened modestly against foreign currencies such as the yen, the euro, and the yuan. Interest rates in the U.S. treasury bond market have increased, in both nominal and real terms. Inflation is also expected to increase modestly.
The reaction of global equity markets was perhaps the most surprising of all. U.S. stock futures fell as much as five percent on Tuesday evening, as it became apparent that Trump had all but secured a victory. The behavior was consistent with the pre-election pattern. Whenever polls showed an increased chance of a Trump win, stocks tended to dip (as they did following reports that FBI Director James Comey would be reopening an investigation into Secretary Hillary Clinton's emails). But a few hours after Tuesday’s decline, stocks beat expectations and crept back up. By the end of the next trading day, the market was above pre-election levels.
It is not clear why stock investors responded in this way. Some suggest that Trump’s conciliatory victory speech on Wednesday eased investor concerns. Prior to the election, stock investors were worried about the populist aspects of Trump’s campaign. After the election, investors seemed to anticipate possible supply-side reforms, such as tax reform and deregulation for important industries, perhaps reflecting the fact that the GOP was (also rather unexpectedly) able to maintain control of both the House and the Senate.
It is important, however, not to read too much into these initial market reactions. To a greater extent than usual, investors are unsure as to exactly what the president-elect will do. Whatever one thinks of Trump, he is clearly not a normal politician. In addition, although the various shifts in the market were sizable for a single day, they did not dramatically change asset prices, such as bonds or stocks. The U.S. Treasury yield, or the interest rates that the government pays on new debt, is a bit higher than before, but overall, we still live in a very low interest rate environment. And since markets are forward-looking, these asset prices don't just reflect the current reality, they also reflect the impact that Trump’s policies are expected to have on future asset prices. This means that the market consensus does not, at this time, anticipate that Trump’s election will significantly affect the government’s ability to repay its debt or for U.S. companies to generate profits, for example.
Nonetheless, a few patterns seem apparent. Banking and biotech stocks did particularly well over the last few days, presumably due to the expected loosening of regulations after the election. The previous administration imposed some very costly rules on the banking sector, and Trump’s opponent, Hillary Clinton, had promised much tighter controls on drug prices, which would have put added pressure on the biotech industry. Sectors linked to possible spending increases on weapon systems and infrastructure also did well.
Looking forward, the biggest question is whether Trump will follow through on his populist promises or follow a more traditionally conservative supply-sider path. If Trump follows through on his campaign promises, such as undoing the North American Free Trade Agreement (NAFTA) and scrapping the Trans-Pacific Partnership (TPP), he will likely impose trade barriers on foreign countries, which might explain the weakness in currencies such as the Mexican peso. However, investors seem to be anticipating that Trump will focus more on supply-side policies such as tax reform and deregulation. These sorts of reforms would modestly increase economic growth in the United States, and that probably explains both the post-election increase in real interest rates (the nominal interest rate adjusted for inflation) and the strengthening in the U.S. dollar.
There has also been a lot of speculation that Trump, who has promised to fix the country’s roads and bridges, will roll out a big infrastructure program. Some pundits have said that such an initiative would boost economic growth. That likely overstates the impact of fiscal stimulus. Trump once promised a $1 trillion investment in infrastructure. Even if he spends less, he is very likely to increase the budget deficit over the next few years, and this may put modest upward pressure on interest rates. But recall that long-term bond markets, such as ten-year U.S. Treasuries, are already incorporating any future impact on interest rates. This means that at this time, long-term bond markets do not anticipate dramatic change to monetary policy under a Trump administration.
More important, in a world in which two percent inflation is considered the standard target, fiscal stimulus has little or no impact on either inflation or total public and private spending or GDP because the Fed will simply raise interest rates more quickly to prevent any jump in inflation. Conceivably, fiscal stimulus might increase real GDP without increased inflation, if the infrastructure projects improve the supply side of the economy. But the productive potential of a $20 trillion economy is not going to be greatly improved in the short run by investments in airports and roads. Major growth would take decades. If real economic growth does increase in the near term, it will come from deregulation and tax reform, if those policies are in fact enacted. But that’s a big if. Major policy changes are not easy to get through Congress, even when one party controls both the executive and legislative branches, and Trump will be under real pressure to reward his populist supporters with anti-growth policies such as protectionism and reduced immigration.
Asset markets will do much better if Trump avoids a sharp crackdown on immigration and international trade, and stock investors are hoping, in particular, that Trump emphasizes tax reform and deregulation. But that all depends on whether the populist Trump or supply-sider Trump shows up next year.