Markets for risky assets and confidence indicators have been very strong in recent months. Many commentators credit Donald Trump for this. And many of them then go on to say that the new US administration is likely to under deliver leading to disappointment further down the road. This may well be true, who knows? What bothers me about this line of thinking is that it does not quite add up in my view.
Given how widespread and strong the improvement in business sentiment is, I simply cannot imagine that output growth will not accelerate materially in the period ahead. Fasten your seat belt!
Han de Jong Chief Economist
Admitted, we also believe that the Trump economic policies will provide a boost to economic growth in the US, though potentially at the expense of a larger budget deficit, rising income inequality, deteriorating climate conditions and future financial stability. Despite these negatives, this prospect could explain strong sentiment reflected in strong performance of risky assets and general confidence indicators.
We cannot all be winners in a zero-sum game
But I cannot see why that optimism should spread around the world. It seems to me that Donald Trump's view on the economy is a 'zero-sum game'. 'America First' suggests that Trump sees the economy as a competition in which some win and others lose. An important part of his rhetoric is also about how the US used to win everything, but has stopped doing that. He has vowed to make the US a winner again. That implies others must lose.
Trump's rhetoric on international trade is distinctly mercantilist, which is based on the view of the zero-sum economy. We think that Trump's policies will not be as protectionist as he sounds. But we cannot be sure of that. The US system contains all sorts of checks and balances, but the President has far-reaching powers in trade policies.
Colbert (1619-1682) was wrong; Ricardo (1772-1823) was right
My training as a modern economist tells me that the mercantilist view of the world, as first expressed and exercised by French economist Jean-Baptiste Colbert, is wrong. Economists have been taught that his is so since Ricardo's book in 1817. We also believe that mercantilist policies don't work, or rather, they are a disaster for the world as a whole in the medium term. The problem is that these sort of policies may have noticeable positive short-term effects for a country that takes them.
The logical conclusion is that Trump's policies may be good for US growth, but they may not be so good for other countries. So it does not make a lot of sense for confidence indicators everywhere in the world to strengthen because of Trump, in my humble view.
Either I am wrong, others are wrong, or something else
That leaves three possibilities open. First, I may be wrong and perhaps the whole world will benefit from Trump policies. Second, markets and economic agents may realise their optimism is based on a delusion and a sharp correction becomes inevitable. Or third, it is not (only) expectations about the effects of Trump's policies that are driving markets and general confidence. I strongly believe that the third option is the key. There is something else driving risky assets and general confidence. It is the profit cycle, stupid!
I have repeatedly written about the improvement in global trade and logistics towards the latter part of last year. The graph on Japanese trade shows that the positive trend has rolled in to 2017. Korean trade data show the same for February.
The first graph shows the S&P500 index and US aggregate corporate profits, in dollar terms, taken from the national accounts. This graph leads to a couple of important observations. Many commentators are arguing that the stock market has been boosted in recent years by aggressive monetary policy. And that is undoubtedly part of the story. Very low interest rates should push up equity valuations as they are the discount factor for calculating the net present value of future cash flows. Indeed, we know for a fact that equity valuations have risen and are relatively high compared to their history.
Equities take their direction from profits
However, the graph clearly shows there is a strong correlation between profits and equities with the profit cycle actually leading the stock market. The graph suggests that the direction of the stock market is determined by the profit cycle. The degree of the response of the equity market to the change in profits is influenced by what happens to interest rates. (Note that the two scales of the graph differ.) As the profit cycle has turned in the course of 2016, so has the stock market.
The next question then is what will happen to corporate profits under Trump. Most commentators focus on tax plans, economic growth, inflation etcetera and conclude that Trump will be good for corporate profits. That is fine, but there is also a macroeconomic way of looking at this.
Some accounting principles
The economy can be divided into the public sector, the private sector and the international sector. The savings surpluses or deficits of these three must add up by definition. It is a simple accounting rule. If the US government runs a budget deficit and the US private sector also has a savings deficit, the US must be running a deficit on the current account of its balance of payments. As things currently stand, the US government is running a deficit, the private sector is running a small surplus and this adds up to an external deficit that is a little smaller than the budget deficit.
Two crucial assumptions
I must now make two important assumptions about what will happen next. First, I am assuming that the US budget deficit will widen under Trump. My second assumption is that due to Trump's protectionist leanings and, for example the Republican plan to change the corporate tax system and introduce a border tax, the US external position will improve, or at least not deteriorate at the same rate as the budget deficit. If both assumptions are correct, then the accounting principle implies that the savings balance of the private sector must improve.
Profits the key beneficiary
The private sector can be broken down into households and corporates. If their combined savings surplus improves, how is that improvement broken down? The household sector has successfully delivered in recent years. Between 2000 and 2007, the personal savings rate averaged 4.0%. From 2008 until now it has averaged 5.8% and it currently stands at 5.5%. Household debt ratios have fallen significantly. I cannot see any reason for households to raise their savings rate further in the period ahead. So savings in the household sector may go up in dollar terms, but not in relation to GDP. As a result, the improvement in the private sector savings balance will show up largely on the corporate side. The way this will be expressed is in higher corporate profits.
So my conclusion is that if I am right thinking that Trump's policies will lead to a larger budget deficit and a smaller external deficit, corporate profits will get a very significant boost. And if the external deficit does not improve, but deteriorates, profits can still get a push as long as the deterioration of the external deficit is smaller than that of the budget deficit. If I am right thinking that corporate profits will rise under the Trump presidency, then so will the stock market. A rise in interest rates can only affect the degree of the movement, not the direction as long as the rise in interest rates does not cause a recession.
Recent indicators confirming familiar trend
Confidence indicators, already at high levels, have generally risen further in February. The eurozone's economic confidence indicator managed to inch higher, reaching 108.0 in February against a long-term average of close to 100. Spain produced some remarkably positive data. Its composite Markit PMI rose sharply in February, reaching 57.0, versus 54.7 in January on the back of a strong improvement in services.
Confidence indices in the US are showing a rosy picture too, though the Markit PMI for the manufacturing sector eased from 55.0 in January to 54.2 in February. But a range of other confidence indicators moved higher. The manufacturing ISM moved up from 56.0 to 57.7, the Dallas Fed index from 22.1 to 24.5, the Chicago PMI from 50.3 to 57.4 and the Richmond Fed index from 12 to 17.
The picture in Asia is a little more mixed with some countries registering a decline in their PMIs. This was the case in Taiwan (54.5 versus 55.6). But business confidence rose in Korea: 49.2 versus 49.0. Chinese business confidence improved in manufacturing but eased a little in services. The national manufacturing PMI rose from 51.3 to 51.6 and the Caixin PMI moved from 51.0 in January to 51.7 in February.
Harder data was generally satisfactory, but some areas of weakness remain. US personal spending and income rose at a decent clip and Korean exports and imports continue to be very buoyant. Export growth accelerated to 20.2% yoy in February, from 11.2% in January, while imports were up 23.3% yoy, against 18.6% in January. The latter numbers suggest that world trade growth continues to improve. The gap between US industrial production growth and business sentiment in the sector remains remarkable. As I have said before, this cannot last. Given how widespread and strong the improvement in business sentiment is, I simply cannot imagine that output growth will not accelerate materially in the period ahead. Fasten your seat belt!
Inflation continues to rise in Europe and the US. Eurozone inflation accelerated to 2.0% yoy in February, up from 1.8% in January, the highest since 2012. The so called PCE deflator in the US rose from 1.6% yoy in December to 1.9% in January, also the highest since 2012. However, core inflation is much better behaved. Core inflation in the eurozone was stable at 0.9% and core PCE in the US was stable at 1.7%. These numbers suggest that the rise in inflation is all in energy and not triggering a meaningful inflationary process around the economy.
Change in Fed call
As the economy is doing better than expected, there is every reason for the US Fed to hike rates further. Until recently, we thought the Fed would hold fire in March and hike in June. Recent comments by Fed officials, however, suggest that a March rate hike has become more likely. The financial markets have taken this message on board and are now pricing in a high change of a rate hike on 15 March. In our view, there are good arguments for the Fed to move rates up and as they have now been successful in convincing the market, they may as well do it. So we now believe they will raise rates in March. We have not adjusted our expectation that 2017 will see a total of three hikes, but we think the chance of four hikes in total has increased.