Back to the grindstone

8 min read

Anyone who had expected anything special from President Donald Trump’s address to the joint houses of Congress yesterday has either not been listening to him for the past 18 months or was smoking something for which most of us would get banged up.

The tone was different but it would have to have been, given that he was not talking to people who will be expected to vote for him but who will be asked to vote for his legislative programme. Will the real Donald Trump please stand up? My guess is that the Trump we saw yesterday was not the real one but the performing one in his finest “Let me butter up Capitol Hill” guise.

While Republicans, heaven known only why, fêted him like a long lost son, the Democrats sat stony-faced, even when he presented them with spending and investment plans that should have had them carrying him out on their shoulders. My sense is that the childish partisanship that has emasculated Congress for the best part of the past two decades and which has turned it into a global laughing stock is not yet ready to be set aside.

True, the speech was little more than a rehash of everything Trump has been telling us since he first began his presidential campaign and also true that it was severely short of detail but, to be frank, I’d have been more sceptical of the sincerity of finely worked out details so shortly after election and inauguration than I am of the ongoing conceptual vagueness. In either case, now we begin to get to the meat of the Trump presidency, where is the money going to come from?

The national debt is knocking on the door of US$20trn, more than half of which has been run up in the past decade since the dawning of the global financial crisis, a period which has also been marked by historically and unsustainably low interest rates and hence fairly stable nominal debt servicing costs. Trumponomics seems to blithely assume that pushing economic growth from 1% to 3% - don‘t ask - will yield enough supplementary fiscal revenue to cover the cost of increased spending and lower taxation at both the corporate and household level. Winston Spencer Churchill, the provider of the best one-liners, suggested that trying to spend your way out of debt is like standing in a bucket and trying to lift yourself up by its handle, Fiscally conservative Republicans were mightily unimpressed when a Democrat president did this; how can it be that they are now so enthusiastic about an even more concentrated, deficit-financed, government-funded growth programme? Answers on a tweet, please. It is quite staggering how disingenuous politicians can be, isn’t it?

Let’s look at the economic and fiscal reality and where the monetary authorities fit into the picture.

During my three weeks on my little Caribbean island I generally stayed away from markets although I was struck by a few realities which made a far greater impact when not swamped by the white noise created by day-to-day trading. The first and most obvious one of these concerns the next FOMC meeting. From a distance, the members of the committee, Madame Yellen included, seem to have made it quite clear that the plan is to begin the 2017 tightening programme on March 15 and yet, as at last Thursday, the futures market was only pricing a 37% probability of a rate rise. I think that by this morning that figure should have risen above 50% but I would have sold the living daylights out of 37%, had it been my job to do so.

There is, however, a conundrum and this is something that requires some blue-sky thinking. The issue concerns the influence a rise in short-term rates will have on the rest of the yield curve and impact this will have on debt servicing charges as a percentage of GDP.

Let us assume that ultimately, for argument’s sake, one-third of every dollar earned in the economy ends up being paid in tax. Let us also assume that, in the case of the US, debt to GDP is at 100%. That also means that if the cost of refinancing the entire debt stock rises by 1% then 3% GDP growth is required just to stand still. An increase in servicing cost of 1% doesn’t of course just happen overnight – it might take eight or 10 years for a northward shift in the yield curve to permeate through the entire debt pile but happen it will. An extra trillion dollars or so will not show up in any significance in the short term, even if the Fed were to tighten by 100bp or even 200bp by the end of next year, and that would be assuming a free market in long-term interest rates.

When I learnt my trade, the wisdom was that central banks could manipulate rates out to 12 months at best but from then on it was the market that took over. Now, through the means of QE or whatever sobriquet one might want to ascribe to market-manipulating bond purchasing programmes for which we would go to jail, the long end of the curve is in the hands of the monetary authorities in the same way as regular money market rates. As most central banks are joint-stock companies, which have to publish their accounts and show capital adequacy, a sharp and sustained rise in long-term rates would probably see them blow up just like LTCM did in 1998 as a result of irresponsible leverage and the mistaken belief that Fischer Black and Myron Scholes had cracked the risk thing once and for all.

The difference is that central banks – the BoE and the ECB included - will both be able to and need to keep the illusion alive that all is well in the garden. Thus they will push front-end rates higher citing it as being their response to a normal and cyclically recovering economy while faking the living daylights out of the long end and thus bringing about a flattening of and eventually inverting of the yield curve against all the laws of nature. Conclusion: growth or no growth, the long end is a safer place to be.

While away, I also saw that a Bloomberg poll of asset managers had revealed that until bond yields comfortably exceeded 3.5%-4%, there would be no significant shift in asset allocation from equities back into bonds. I have been arguing this as common sense for a long time and didn’t need Bloomberg to tell me what should have been blindingly obvious to anybody responsible for managing other people’s money. What it does confirm, however, given the above argument for persistently low long-term rates, is that equities, irrespective of how expensive they may look on traditional valuations, are still the only game in town.

A lot of other thoughts have passed through my head in the weeks I’ve been away and I shall be airing some of these in the future. The problem is that bringing all of them into line makes finding the unifying theory between Newtonian physics and quantum mechanics look like a walk in the park.

I would love to say that it’s good to be back and that I’ve missed the markets but, with all due respect, I think I’d do best to plead the Fifth Amendment on that one.

Happy March.