The inauguration of the 45th US President is finally upon us. The scrabble to decipher what this administration will mean for the economy and markets hopefully now enters a new, less speculative, phase. Here we examine some of the key tenets of the incoming administration's proposed economic policies.
They say if you want to become President, it's better to do so at the bottom of an economic cycle. President Trump is perhaps unlucky here. There are indications that the economic cycle is ageing, if not yet showing the signs of eccentricity that would tell us that the end is imminent. Household compensation is picking up across all categories amidst diminishing labour supply and the consumer is even starting to re-lever relative to GDP, confounding those who expected a much longer period of contrition. Onto this reasonably fully-employed, functional economy, the incoming administration plans to drop a mix of tax cuts, deregulation and deficit spending.
There have obviously been plenty of studies on the effects of tax changes on economic growth over the years. However, from the Kennedy Revenue Acts of 1962 and 1964 through to the Jobs and Growth Tax Relief Reconciliation Act of 2003, the evidence for a clear impact on trend growth is best described as elusive.
Looking further back - the US had no personal tax and total tax revenues were just 3% of GDP between 1870 and 1912. Wind forward to the period between 1947 and 2000 and the highest marginal tax rate averages 66% and federal tax revenues average close to 20% of GDP. However, throughout this period, characterised by wildly different tax regimes, trend growth in per capita output is almost identical at around 2%. The data inevitably become significantly more questionable the further back you go, however investors would be wise to assume that while tax changes may temporarily boost consumption and corporate earnings, there will be no material changes to healthy existing trends.
One of the more controversial proposals currently championed by elements of the Republican Party concerns border taxes. At its very simplest, this would raise the cost of imports and slash the cost of exports. In theory, these 'border adjustments' would initially make imports less competitive and US exports more competitive, reducing demand for imports and increasing demand for exports. Theory suggests that this should result in US dollar appreciation, which in turn should help mitigate the initial effect on competitiveness and trade flows.
However, the assumption that real exchange rates would adjust quickly and perfectly to the tax changes may well work better on paper than in the real world. The US conducts a large proportion of its trade with emerging economies, not all of which will have a free-floating exchange rate and some of them will obviously be keen to use their FX reserves to limit the pace of currency depreciation against a surging US dollar.
This and various other real world frictions suggest that a potentially disruptive surge in the world's reserve currency, with all its associated side effects, may not occur as advertised. However, the inherent Catch 22 in this policy proposal is that without this sharp correction in the dollar, US prices (and interest rates) will have to bear the brunt of the adjustment. This unappetising trade off is likely to make this proposal a hard sell as the incoming President's recent comments on the subject would suggest.
Finally, infrastructure spending - surely a much less questionable positive for all? Again, history teaches us some caution here. Between 1991 and late 2008, Japan spent some $6.3trn on new infrastructure. This staggering sum undeniably left the country with some engineering marvels, it likely kept some people working too, but it is hard to argue that it meaningfully changed the country's trend growth rate. For his part, the Nobel laureate economist Robert Fogel famously pointed out that while the opening of the Erie Canal in 1821 brought enormous value because the inland transportation options in the US were so poor at the time, the very existence of these canals significantly reduced the benefits of the later rail system.
The wider point is really that greater infrastructure alone wouldn't necessarily lead to higher sustainable growth. In order to generate a return over and above invested capital, infrastructure spending needs to be targeted in areas where the economic activity will be when the project is finished - a difficult trick to pull off.
These are unsettling times for investors. On the one hand, we have a world economy that looks increasingly capable of rewarding our continuing tactical faith in its ability to generate adequate growth and inflation. On the other, an incoming US administration promising both activist economics and protectionism. Congress, even one mildly Republican in hue, will remain a constraint domestically. Internationally, we are left relying on economic self-interest and the policing role often played by markets. Those improving prospects for growth and inflation still win with regards to our asset allocation, but our composure is surely going to be tested.