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Sunday, 17 December 2017

Trump, the risk even central banks can’t backstop

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  • James Saft - June 2014

If Brexit didn’t scare financial markets confident in the support of central banks, maybe the prospect of President Donald Trump will.

That Brexit, which will slow global growth and imperil the European Union, led to a rally in riskier assets is testament to investors’ mastery of the lesson of the past eight years: if rain threatens, central banks will put up tents.

Yet in Trump, just now enjoying a post-Republican convention bump in the polls, we may have found a factor too negative – and specifically too inflationary – for even central banks to make better.

The basic post-Brexit analysis was this: the US economy is passable and developments elsewhere will pin the Fed down, leaving it unable to hike rates as it might otherwise wish. Other central banks, meanwhile, will be disposed to ease, driving money into riskier investments. So far, so good for risky assets like stocks and high-yield bonds.

Trump, however, seems determined to enact policies which would be both bad for growth but, partly by stoppering up free trade and inciting trade wars, highly inflationary. In other words, stagflation.

Trump, of course, may well not win and may not have the votes in Congress to advance his policies if he does, but a Trump able to actually make policy will all but force the Federal Reserve to ultimately move to higher rates to head off inflation.

“The populist overhaul scenario may cause a risk-off fixed income move,” analysts at HSBC wrote in a note to clients citing the potential for 4-to-5% inflation as a result of a Trump win.

“Increased economic policy uncertainty is typical during an election season, but potentially greater this time given the unconventional nature of the Trump candidacy and high levels of global policy uncertainty.”

While the tax cuts Trump is calling for might be stimulative in the short term, the far more important impact could be from much higher prices, both as a result of tariffs and trade wars or the repatriation under pressure of production to the U.S. by global corporations.

So far, markets do not seem too bothered. But a rash of post-convention polls all showed Trump with a lead on Hillary Clinton, prompting the FiveThirtyEight forecasting blog to give him a 54.5% chance of winning an election if held July 25.

If we see those sorts of numbers in a month, after the Democrats get their convention bump, expects investors to become much more worried.

Extraordinary policies and the madness of crowds

We can’t know if Trump would, or could, govern as he has run, but he certainly is doubling down in his campaign on a set of extraordinarily economically negative policies.

In an interview on Sunday, Trump said the US might need to leave the World Trade Organization and backed hitting companies which moved production out of the US with a punitive tax.

Asked about a hypothetical in which a US company moved a plant to Mexico and then seeks to import air conditioners, Trump said a tax would be imposed.

“It could be 25%. It could be 35%. It could be 15%. I haven’t determined. And it could be different for different companies.”

Remember too, that while a divided Congress can block a president’s legislation, considerable powers have been transferred to the executive branch in recent years to impose tariffs and trade sanctions and negotiate trade agreements.

Trump is the kind of problem central banks can’t kiss and make better.

Consider too what it might do to the risk premia imposed by investors on US assets. If you think there is a global shortage of safe assets now, wait until investors confront the genuine possibility of a US president who has openly mulled defaulting on sovereign debt as a negotiating tactic. Interest rates might rise not just to account for higher inflation but also for the potential for unpredictable policy or outright bad faith by the US.

None of this is likely. Trump may lose, may change his stripes or may be effectively blocked by Congress or the courts if he doesn’t.

Yet the psychology of financial markets in the aftermath of the great financial crisis is the result of low growth, low inflation and faith in central banks. Thus we have all-time highs in leading equity indices despite mediocre fundamentals.

Introduce a change in which inflation looks to head up while growth goes down and the Fed will rapidly change from a reason to buy risk to a reason to sell.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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