Latest macromarket note from KBRA. Happy holiday -- Chris
“It was the best of times, it was the worst of times,
it was the age of wisdom, it was the age of foolishness,
it was the epoch of belief, it was the epoch of incredulity”
A Tale of Two Cities
Charles Dickens (1859)
As 2016 comes to an end, one of the last details of the year involves awaiting the decision by the Federal Open Market Committee (FOMC) whether or not to raise short-term interest rates by a whole quarter of a point. But in many respects, the November election that has brought President-elect Donald Trump to the verge of the American Presidency also rendered the deliberations of the FOMC irrelevant. Since the last week of October, the U.S. central bank has gone from leading the markets to following a remarkable change in economic narrative that has seen benchmark interest rates rise more than a point and equity market valuations soar. Indeed, a mere quarter point move at this late date by the FOMC will hardly generate notice, much less a market reaction.
And yet, it is worth asking whether the renewed exuberance coursing through the veins of Wall Street is really due to the prospect of tax cuts and public spending promised by Trump, or rather the cumulative effect of eight years of extraordinary monetary policy actions. While Kroll Bond Rating Agency (KBRA) has long believed that the positive effects of zero interest rates and trillions of dollars in open market purchases of debt were ebbing, in many respects the benefits were cumulative and seem to have become fully manifest just as the U.S. central bank is trying to normalize policy. The economic malaise that carried Trump to the White House has seemed to subside as Inauguration Day approaches.
With valuations for asset classes such as residential homes and commercial real estate at record levels, and credit expansion in the U.S. banking system showing signs of marked deceleration, it seems appropriate to ask whether the best of times, to paraphrase Dickens, are behind us. After spending eight long years on the economic equivalent of a ventilator, the U.S. economy has gotten up and run at an annualized GDP growth rate of about 3%, a figure that only a decade ago would have generated contempt from most economists. Indeed, the comments by St. Louis Fed President James Bullard that 50 basis points may be the limit of FOMC rate hikes to allow continued growth may be correct.
So while some members of the Trump team may believe that even higher growth is possible given tax cuts, deregulation of the financial sector, and an increase in government spending – a strange mixture of supply side and demand side policies – KBRA wonders whether such initiatives may be needed to merely maintain current levels of growth and job creation into 2017 and beyond. Looking at the swoon in auto sales for example, after years of torrid growth, as well as weakness in other industrial sectors, makes us wonder if our friend Gary Shilling isn’t right when he predicts continued deflation and lower interest rates in 2017, this combined with a soaring dollar.
Donald Trump is scheduled to take the oath of office for the Presidency of the United States on January 20th and some fear will almost immediately begin a trade war with China, which he has branded a “currency manipulator.” But we think it is interesting to note the sage wisdom of Randall Forsyth of Barron’s, who writes that China has been spending its foreign currency reserves to “brake the depreciation of the yuan – contrary to assertions that it’s trying to drive its currency lower.” Many of Trump’s supporters view China’s sales of U.S. Treasury bonds – some $1 trillion since 2014 – as part of a nefarious plot to drive up interest rates and thereby weaken the United States. But in fact China remains the largest holder of U.S. Treasury debt and Chinese citizens have been spending the dollars provided by the Bank of China to purchase real estate and other assets in the U.S.
Hopefully at some point the impressive collection of business moguls and financial titans surrounding President-elect Trump will refocus U.S. policy pronouncements on the basic tenants of global economics, especially the concept of “recycling” dollar trade surpluses. Just as capital inflows from China helped to stoke the housing boom of the 2000s, ending with financial disaster in 2008, inflows from China more recently have helped to reflate sagging asset prices and then some, and arguably complemented the Fed’s actions in this regard.
Instead of attacking China as a currency manipulator, perhaps Trump ought to extend holiday greetings to Chinese Communist Party General Secretary Xi Jin Ping and maybe even thank him for adding another trillion in stimulus to the extraordinary monetary actions of the FOMC since 2008. In many respects, the decision by Xi to allow Chinese nationals to have access to dollars and to spend these funds freely offshore may be at least partly responsible for the strong economic situation that now greets the new U.S. leader. Indeed, what Trump ought to worry about is the day when “Uncle Xi,” as he is known in China, shuts the currency door and ends the flow of Chinese direct investment coming into the U.S.