Thoughts after Trump’s Speech: "Show me the Money?"
Trump reiterates tax reform, deregulation and infrastructure spend, however, little new detail for markets. Federal Reserve recalibration of rate hike probabilities is the main news.
Markets are moving quickly to re-price Federal Reserve rate expectations as four Fed Governors spoke about March 2017 being a live meeting, increasing the expectation of a March rate hike to 90%. Hence, the upcoming economic data on non-farm payrolls will be key to whether the rate hike will happen in March, April or June. There is a window for the Federal Reserve to act given the robust economy. A rate rise in the next three months seems to be extremely likely.
Post President Trump’s budget speech, the key question is how all of the fiscal policies will be funded. This is a political process where the Administration will have to work with the Congress for passage. The Republicans have a slim majority in the Senate (52 to 48), hence broad consensus would likely be required to pass legislation. Going forward the narrative will move to firstly, how quickly health-care reform occurs followed by tax reform. The agenda looks ambitious in timing as Treasury Secretary Mnuchin stated he wants tax reform completed by August. The sequencing is important and timelines could slip on tax reform to late 2017 or early 2018.
The key question is how does the administration create ample budget headroom for bold cuts (not moderate) in taxes while at the same time funding increases in fiscal spending. This could then impact our US dollar, interest rate, and equity market targets.
The situation remains fluid. President Trump highlighted in the speech he wants to keep the most expensive parts of Obama care including citizens with pre-existing medical conditions. Some in his own party want to cut expensive add-ons and build efficiency via national insurance policy. Democrats are firmly against repeal and will not support any major changes. Hence, it is hard to see how significant savings can be achieved and the timing of any breakthrough could take longer than expected.
Base case: Is it a tweak to the existing program with modest budget savings?
Trump promised a big cut in taxes and "massive tax relief" for the middle class in his speech but no figures were referenced (see Chart 1 below). The biggest potential source for budget savings is the border tax which could increase tax revenue (up to $1.2 trillion over the next decade). However, there was no mention of this in his speech. Paul Ryan the House Republican House leader, is a strong supporter of border tax albeit, some of his own party are firmly against. President Trump is lukewarm on border tax due to its complexity. Importers and selected multinationals are likely to lobby against the proposed legislation.
Base case: Hence, border tax probability is well below 50%. If a major breakthrough happens here, then there could be larger tax cuts as well as a greater amount of infrastructure spending, boosting the economy. Otherwise, expect moderate tax cuts.
President Trump reiterated a $1 trillion dollar infrastructure spend via pubic AND private means. The key is it will be difficult to fund this amount solely via public means given the budget reality. Keep in mind this is an area more favored by Democrats than Republicans.
Hence, the last way to reduce the impact on the budget deficit (only at -3.1% of GDP currently) would be to incorporate the higher GDP growth generated by these policies resulting in higher long-term tax revenues. However, it would take heroic assumptions to get the corporate tax rate to 15 or 20% and large personal tax cuts. The issue once again is how strong the appetite from a section of Republicans is for a potentially higher budget deficit.
Finally, there was nothing new on trade policy and currency views. President Trump kept pressure for trade reciprocity and fair trade, but wants a level playing field. Still, there are a great many unknowns on how this can be achieved.
Therefore, the base case is remains modest tax cuts and infrastructure spend, coupled with de-regulation which is positive for the economy but not entirely a game changer. However, it is a political process and we will have to see how events unfold. In fact, a modest fiscal boost given the US is already at full employment and with wage inflation rising, may be just what the doctor ordered. The current situation reminds me of a Rolling Stones song, "You can't always get what you want. But if you try sometimes well you might find. You get what you need."
In that regard, a large fiscal package right now could over-stimulate the robust economy, leading to greater than expected interest rate hikes and eventually an economic slowdown. Modest stimulus may turn out to be better for an economy already in a long expansion, extending it into 2018.