Winter is coming: what’s next for US markets after a tense political summer?
Stéphane Monier Chief Investment Officer, Lombard Odier Private Bank

Winter is coming: what’s next for US markets after a tense political summer?

After a summer of political chaos in Washington, we ask whether the Republican reform agenda – once lauded by the market – will prove the ultimate casualty of the turmoil on Capitol Hill.

On the election of President Trump, risk assets rallied on the prospect of corporate tax cuts, deregulation and a trillion dollars of infrastructure spending. Within six weeks of Trump’s victory, US equities had hit the first of many highs, while the dollar strengthened and US treasury yields rose. Across the sectors, the parts of the markets deemed most likely to benefit from reform, including deregulation (banks), infrastructure spending (manufacturing / construction), earnings repatriation (tech) and corporate tax cuts (small caps) enjoyed the lion share of the upside.

With the Trump trade having long evaporated, markets were further disappointed by clear signs that Donald Trump was losing the confidence of the business community. As we move into a new season, we believe the market will imminently refocus its attention away from the turmoil of the past month towards a year-end agenda that is itself fraught with political flashpoints.

A quieter Autumn?

In light of the increasingly combative relationship between the White House and the rest of the Republican party, it is unlikely that Trump’s policy agenda will pass through Congress unscathed. The first big legislative test will come in the form of the debt-ceiling negotiations next month. Following the failure to pass key healthcare reform and Trump’s recent threat to ‘shut down government’ should he fail to get the necessary funding to build a wall on the Mexican border, we are braced for some market jitters in the run-up to the 29 September 2017 deadline for agreeing a new borrowing limit.

As Congress returns from its summer recess, it has been greeted with White House efforts to reinvigorate the reform agenda., Markets, meanwhile, are still awaiting solid detail on the infrastructure building plan, or indeed any other area of reform.

Although, as investors, we maintain a clear distinction between politics and our positioning, we share the concern that any worsening of the political climate in Washington could be a tangible threat to economic policy. As this fact dawns on the market, we may see business and consumer confidence ease in the coming months. But what ultimately tempers the importance of the political turmoil of the summer and the tangible loss of confidence in Trump, are the fundamentals of the US economy.

The economy can stand on its own two feet

After eight years of expansion, continued falling unemployment and no clear sign of recession, we would argue that the US needs neither tax reform nor a pro-business agenda. The economy is doing relatively well on its own: Q2 economic data and forward-looking indicators1 suggest continued strength for Q3. Service activity remains solid and, going forward, none of the economic and market measures that we monitor[1] are sending signals of an imminent slowdown in growth.

On fiscal reform more specifically, Trump’s proposals to cut corporation tax from 35% to as low as 15% is unlikely to come to pass in the near term. Despite the market’s initial enthusiasm for this policy, deeper analysis of the US tax regime suggest that most companies pay an average of 26% corporate tax and any reform is likely to take the average down to a level of 23%. Meanwhile, history tells us that tax cuts are most effectively used for counter-cyclical purposes during the end stages of an economic cycle.

Looking now to the Fed, minutes from the July meeting documented the debate among policymakers over the effect that rate hikes would have on inflation. Some committee members argued that the board “could afford to be patient, under current circumstances, in deciding when to increase the federal funds rate further.”2

Unless inflation picks up, we think the Fed will be forced to slow down the pace of interest rate rises as it enters the 1.5-2.0% range. The standard ‘Taylor rule’, which links the path of interest rates to developments in price growth and labour markets, implies rates should be curbed around 2%.

In our view, US fiscal authorities may do well to follow the Fed in keeping its powder dry, and saving its stimulus for such a time as the economy might need it.

After eight years of expansion, the US has arguably overrun its growth cycle. But with, for now, few signs that the economy is overheating, we believe the administration would be wise to hold fire, allowing economic – as opposed to political – forces to dictate the timing of its stimulus.

[1] Q2 indicators: ISM Manufacturing Index +1%; Retail Sales -0.1%; Industrial Production Index +1.3%; S&P 500 Index +2.57%. Source: Bloomberg, 01 August 2017$

[2] US Federal Reserve Publications, 16 August 2017

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