Market Views

Byron Wien: The Administration Now Faces the Hurdles of Reality

There has rarely been a new presidential administration in the history of the United States that has tried to get so much done in its first ten days as the current one.  Most elected presidents talk about the first 100 days, but Donald Trump seemed to be in an executive order sprint during his first 100 hours.  When you are trying to get your cabinet approved, organize your White House staff and issue several important executive orders all at the same time, a few missteps are likely.  He didn’t seem to reflect on the full implications of what he was doing or check with the appropriate agencies. 

The American political system prides itself on its checks and balances and the new president experienced that immediately with the reaction to his travel ban.  Putting his Chief Strategist Stephen Bannon on the National Security Council principals committee as a voting member also raised considerable controversy.  There is now talk of a shake-up in the White House staff.  Trump had three campaign chiefs during his march to the presidency, so he is no stranger to staff turnover.  An example of the need to create better discipline and organization within the White House team was demonstrated by the resignation of National Security Adviser Michael Flynn over his reported conversations with the Russian Ambassador to the United States and his failure to disclose the contents of those talks accurately to Vice President Michael Pence.  Because Trump acts spontaneously and unilaterally, others on the staff may have felt that they were operating within a culture of anarchy and could act independently.  That is dangerous and must be stopped. 

One of the forces that may result in calming down Donald Trump is the complexity of accomplishing anything in Washington.  All important legislation has to be sold to Congress, even within your own party.  Every executive order will have implications well beyond its original purpose and many require a rulemaking and a comment period.  Many items on the domestic agenda have international ramifications and it is important to seek the advice of regional experts.  Cultural differences within the United States and abroad often make it difficult to anticipate the reaction to various initiatives.  With many smart people in Washington, acting deliberately and drawing on them as a resource is a good idea.

So far the stock market and the economy seem to be taking the turbulence in Washington in stride.  Equities have risen about five percentage points since the beginning of the year as investors look forward to the implementation of Trump’s pro-growth agenda of tax cuts, dismantling regulation and infrastructure spending.  They are less concerned with the immigration issue, repeal and replacement of the Affordable Care Act, and the written opinions of the Supreme Court nominee.  On the face of it, the economic plan almost assures an increase in growth.  Cutting taxes for individuals and corporations will encourage more spending at the retail level and more capital investment.  Rolling back many of the regulations put in place during the last eight years in the post-recovery period will give American companies more flexibility and enable them to reduce the burden of compliance.  The economic cost of compliance amounted to billions and was particularly high for some financial and energy corporations. 

Spending public or private money on infrastructure where maintenance has been deferred for decades will create jobs, improve our quality of life and make the country more competitive.  Along with lower taxes and deregulation, investors recognize these positives and have been willing to buy equities in anticipation of improved corporate profits and stronger growth.  The assumption is the favorable effects will begin to show up in earnings this year but we may have to wait until 2018 to see the real benefit of the economic plan.  While the U.S. equity market has been rising almost every day, at some point the good news will be fully discounted and the market will be vulnerable to a correction.  Valuations are becoming extended.

One of the key tenets of Trump’s economic program is that it is supposed to be revenue neutral.  That will be hard to achieve while making significant cuts to corporate and individual income taxes.  Partly for that reason the tax cuts may be trimmed from the levels originally announced.  Limiting deductions was expected to provide some additional revenue to offset the reduction in rates but a key element of that plan was the elimination of the deductibility of interest costs by corporations.  As an offset to this aspect of the tax reform plan, corporations would be allowed to deduct the full cost of capital assets acquired in the year they were bought.  The problem here might be that companies would buy real estate or other assets to reduce their tax bill, bidding up prices to unrealistic levels.  The plan would also limit interest deductions by individuals, but this proposal has run into sharp resistance from the real estate industry.

Another initiative that gained considerable traction in the House is the border adjustment tax.  This idea would mitigate the revenue loss from lower rates and seemed totally consistent with Trump’s objective of encouraging manufacturing within the United States and discouraging imports.  Under the plan exporters would not pay an income tax on products shipped abroad and importers would not be allowed to deduct the cost of products manufactured abroad but sold in the United States.  In the absence of a stronger dollar to offset the loss of the deduction, this would put all retailers at a disadvantage and Congressional representatives in every state regardless of party affiliation are under pressure on this issue from their constituents.  The energy industry, which imports crude for its domestic refineries, is also opposed to the border tax.  In addition, the World Trade Organization and the European Union have objected to the plan.  China has also told the president that it views the border adjustment tax as a punitive measure likely to provoke retaliation.  The trade issue is clearly important to the administration.  Trump has spoken of modifying NAFTA and other multilateral agreements in addition to calling China a “currency manipulator.”  While international commerce may not be a “level playing field” given the application of the VAT in many countries as well as other bilateral imbalances, Trump does not want to start a trade war because that would impair his growth objectives.  Lately, he has softened his language on trade in conversations with Canadian, Chinese and Japanese leaders.

At the beginning of the year, I had hoped the new president would move away from his extreme positions on many issues, but he seemed somewhat extreme during his first several weeks in office.  Perhaps now, with the Flynn resignation, the forced (by Xi Jinping) adoption of the “One China” policy, and the court ruling precluding the travel ban, he will take more care in his statements and decisions.  The executive order on travel ran into opposition from the start because the seven countries named had not produced a terrorist responsible for the death of a single American.  Pakistan, Egypt and Saudi Arabia were countries of origin for terrorists who were responsible for the loss of American lives and they were excluded from the ban, presumably for political purposes.  The ban was also ruled likely to violate constitutional provisions.

One of the reasons Donald Trump was elected was his promise to get the economy growing at a rate that would put more people to work at better wages.  Bringing manufacturing back to the United States was one way he proposed to do it, but over the past two decades many jobs have been lost to robotics and not China or Mexico.  Since the last recession ended in 2009, growth has been less than 2% on an annual basis, with occasional quarters approaching or exceeding 3%.  Trump promised growth of 4%, but that may be hard to achieve.  The unemployment rate has come down from 10% during the recession to 4.8% now.  While the participation rate has dropped to 63% from 66%, not all of that 3% are potential candidates for the work force.  I have done some analysis on how many more workers would be required to add even 1% to the current level of U.S. growth.  Strategas Research estimates that 120,000 additional workers monthly would be required over and above the 150,000 that are currently coming into the work force.  That might be difficult to achieve considering the current low level of unemployment. 

In any case, higher wages may have to be offered to lure part-time or idle workers back into full-time jobs, and that would create some inflationary pressure that would ultimately be reflected in higher interest rates.  I am hoping that an increase in growth to the 3% level also results in an improvement in productivity, a problem in the current recovery.  Productivity has only increased at a .5% annual rate and we really need 1% to expand profits and see a rise in our standard of living.  Faster growth is conducive to higher levels of productivity because companies are slow to hire workers to meet the increased demand.  I know there are many critics of the way we measure productivity but I believe the data is reasonably accurate.  We have seen few innovations that have improved output in the last decade.

Both short-term and long-term interest rates could become an impediment for economic growth.  Even with low rates, growth has been slow.  As rates move up, companies may be less willing to borrow for building inventory and capital projects.  If the Trump economic plan were not revenue neutral and government borrowing starts to rise significantly, we are likely to see yields on U.S. Treasurys rise.  U.S. government debt has increased from $6 trillion in 2000 to something approaching $20 trillion today, but the cost of servicing the debt has risen only modestly.  The blended interest rate in 2000 was 6%, so debt service was about $360 billion.  Today, with the accumulated debt having tripled, the debt service is only slightly higher at about $380 because the blended interest rate is only a little over 2% as a result of the ample liquidity searching for yield around the world.  If the budget deficit increase were to push interest rates up by 1%, that would add $200 billion, or equivalent to about 40% of the current level of the annual deficit.  The deficit would still be below 5% of GDP, which is a manageable number.  I believe we would need to see rates above 3% on the 10-year Treasury for the cost of borrowing to become a problem and we are below that level now.

All of this is happening while the U.S. economy is developing a natural momentum of its own.  Initial unemployment claims are at a 30-year low.  Sentiment is improving at every level.  Consumers, farmers and CEOs are growing more positive because they believe Donald Trump will deliver on his economic promises.  The favorable economic outlook is spreading throughout the world.  The European Purchasing Managers’ Index is rising and growth in Europe is expected to approach 2%.  The implementation of Brexit may change that negatively, but hopefully bilateral trade agreements will soften the impact. Chinese nominal growth is running above 10% and conditions in Japan are improving.  The global wind is at Trump’s back as he begins to put his economic plan in place.  The new president is not an ideologue.  Let’s hope his pragmatism dominates his behavior and he behaves less impetuously going forward.  Investors are behind him even if they didn’t vote for him.  Nobody expects him to get his entire program enacted, but his economic efforts will be viewed as a success if even half is put in place and growth increases 1% with only modest inflation and a minor increase in the budget deficit.  That’s what the stock market is telling us is going to happen, and let’s hope the stock market is right.

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