Will debt trump Trump?
Opinions about the direction of economy after Donald Trump takes residence in the White House next month have lately been almost as divided as the contentious election itself. On the one hand, an increasing number of market pundits are predicting a new era of greater US growth. This camp postulates Trump will successfully spearhead a massive federal stimulus programme providing around $1 trillion in federal spending aimed at rebuilding roads, railways, airports and other infrastructure.
Government infrastructure spending coupled with large personal and corporate income tax cuts are expected to fuel the US economy well above its present ‘muddle through’ level of around 2 per cent real annual GDP growth to as much as 4 per cent for the remainder of the President’s first term in office.
The new world order under this paradigm stands in stark contrast to the previous two decades which were characterised by relatively innocuous fiscal policies, sluggish domestic growth, low inflation and falling bond yields.
Another group of economists is less sanguine. This camp believes the structural headwinds of a progressively ageing and over indebted America will ultimately be too much to overcome despite the best intentions of the new administration. The non-believers opine that fiscal initiatives will be challenged by still relatively poor productivity and the irreversible headwind of an ageing population.
For these reasons, the non-partisan Congressional Budget Office has forecasted America’s GDP growth potential at just 2 per cent for the foreseeable future. A fiscal stimulus plan may temporarily boost GDP but the long-term growth potential of the economy is unlikely to change.
Others have noted growth-restraining immigration and trade policies would likely be invoked faster than the stimulus measures which are not expected to produce results until at least 2018.
Given the relatively high importance of the US consumer to rest of the global economy, making America great again is absolutely great for the world.
However, America’s citizens are rapidly ageing. Baby boomers, a disproportionately large slice of the country’s population, are hitting their retirement years en masse. Older persons are generally less productive and tend to be savers rather than spenders.
Furthermore, retirees have been promised substantial benefits through Medicare and Social Security — two massively underfunded budgetary black holes. Plans to tackle the problem have been conveniently pushed to the back burner by all of Washington’s leaders.
On the liability side of the general ledger, fiscal spending might boost growth in the short run, but adding to the billowing US debt pile essentially just kicks the can down the road. Studies have shown that overleveraged economies ultimately tire of their own weight.
By definition, debt represents a reduction of future net disposable income. A car buyer taking a loan enjoys the benefit of driving a (perhaps otherwise unaffordable) car today by sacrificing future earnings in the form of car payments later on. But paying away future earnings eventually crimps the household budget and the same is true for the economy as a whole. Trump’s plan of lower taxes and bigger spending is said to add an additional $5 trillion onto the approximately $20 trillion existing debt.
Kenneth Rogoff, an economist at Harvard University argued in a 2010 research paper that GDP growth slows to a snail’s pace once a government’s debt level exceed 90 per cent of GDP. The US economy is fast approaching this level and Trump’s plans would get us there very quickly.
Unrestrained, the Trump plan would take America’s public debt, presently at about 75 per cent of GDP, to approximately 105 per cent. That’s well above the danger area, according to an analysis by the Tax Foundation, an independent agency.
Possible offsets may include infrastructure investment which could help improve productivity and reducing regulations which have been a significant drag on key sectors such as banking a healthcare. Of course, the notion that government can improve efficiencies runs a bit counter to what we have actually witnessed over many decades of malfeasance.
Remember, Republican party leader Ronald Reagan’s famous statement: “Government is not the solution to the problem, government is the problem!”
At the moment, financial markets are anticipating the reflation scenario. Bond prices have been falling as longer term interest rates have steadily climbed since election day. At the same time, US equity markets are up sharply, hitting new all-time highs across the board.
More ‘cyclical’ industries, or those closely tied to the performance of the economy, such as industrial, basic materials and financial companies have led the rally. Interestingly, stock markets outside of the US have not quite joined the “risk on” party.
Two possible outcomes are possible for 2017 and beyond. The first (and more likely in my opinion) is a less aggressive political agenda where tax cuts and increased fiscal spending end up being below expectations as conservative congressmen block the most extreme, debt-increasing measures. The second possibility involves Trump getting his way for the most part. In this case, aggressive tax cuts and a large fiscal spending plan would stoke the economy in the short run, but would also incur much higher debt levels and weaken the federal balance sheet considerably.
For the second scenario, the outcome may be similar to Warren Buffett’s famous discarded cigar butt story. In his early days, Buffett would sometimes encounter an investment which, like a used cigar stub found on the ground was short and soggy but good for one more puff. Similarly, an over indebted American economy, driven by populist demand for higher wages and growth in the number of unskilled labour jobs, lower taxes and protectionism at any cost could be good for a last puff. However, ultimately the borrowed funds must be paid back either through future fiscal austerity, less public entitlements, higher taxes or simply larger price inflation.
Under either scenario, investors should be at least somewhat wary of the current Trump stock market rally. Elevated political expectations leave little room for error. On pullbacks, considering adding to those sectors blessed by the GOP’s magic wand, but I recommend staying diversified which means also owning some presently unpopular sectors such as bonds, cash and defensive stocks. In the intermediate to longer term, these more defensive assets could be quite important for the rainy day when Government has a very small umbrella.
Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.
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