Special Issue Focus - The Potential Economic Impact of Donald Trump
THE POTENTIAL ECONOMIC IMPACT OF DONALD TRUMP
Trump win promises policy shifts…
The victory of Donald Trump in the U.S. presidential election promises significant policy shifts. These shifts, and the expectation of them, are likely to have significant impacts on the world economy and financial markets over the next few years.
Indeed, financial asset prices have already shifted markedly. The big winners so far have been commodity prices, especially industrial commodities like metals, U.S. stocks (particularly financials) and the U.S. Dollar. The losers have been government bonds and emerging market assets, especially those in Mexico (see Chart 1).
…but much uncertainty remains
In our view, the moves in asset prices, so far, mainly reflect a belief that the incoming Trump administration will prioritize deregulation and bring in a large fiscal stimulus, including increased infrastructure spending. The latter would boost U.S. and global growth, and also lead to a faster pace of interest rate rises in the U.S., driving up global interest rates.
The latter impact might be exacerbated by the U.S. economy already being close to full employment, so that the fiscal stimulus could push up U.S. inflation. Notably, rising inflation expectations have been a key factor in the rise in U.S. bond yields since November 7th; The 10-year breakeven inflation rate derived from U.S. inflation-linked bond prices has risen 30 basis points since November 7th.
Meanwhile, high U.S. yields have diverted capital flows away from emerging markets, harming emerging market assets. Mexican assets have been particularly hard hit.
In our view, there remains great uncertainty about the precise policy mix that the Trump administration will implement. Much will depend on where the balance falls between growth-enhancing policies, like fiscal stimulus and deregulation, to more growth-damaging policies in areas like foreign trade and immigration reform.
For the most part, the market is taking an optimistic view for now, concentrating on the potential positives. But the possible negatives are not being wholly ignored; The weakness of Mexican assets suggests the threats of protectionism Trump leveled at Mexico before the election are being taken seriously. Overall, we see considerable downside risks to our baseline scenario.
Using the Oxford Global Economic Model, we have created three different scenarios for the U.S. and global economies, using varying assumptions about Trump’s policies:
Baseline scenario: In our baseline scenario, there is a fiscal stimulus worth $1.2 trillion (including extra infrastructure spending of $200 billion) offset partly by backloaded spending cuts. This scenario also features modest deregulation, a reduction in immigration of 600,000 per year and only limited protectionism. In this scenario, U.S. GDP growth improves from 1.6 percent last year to 2.3 percent in 2017 and 2.5 percent in 2018 (see Chart 2). World growth firms from 2.3 percent in 2016 to 2.6 percent in 2017 and 2.9 percent in 2018.
Upside scenario: In this scenario, there is a larger fiscal stimulus of $2.3 trillion (most of the extra being tax cuts), there are no changes to current trade policies and there is widespread deregulation. In this scenario, U.S. GDP growth rises above 3.0 percent by mid-2018 before retreating back towards baseline levels by 2020 as the stimulus wears off. The level of U.S. GDP is around 1.5 percent higher by 2019 than in the baseline, and world GDP is about 0.6 percent higher than in the baseline.
Downside scenario: In this scenario, Trump follows through with some of the more economically damaging aspects of the program outlined in the election campaign. Tariffs of 45.0 percent are brought in against China, 35.0 percent against Mexico and 20.0 percent against Korea and Taiwan. Immigration is cut by one million per year. Fiscal stimulus is also more limited, at $500 billion.
Growth outcomes are very negative with world trade badly disrupted as countries hit by tariffs retaliate. U.S. growth turns negative by end-2019, and the level of U.S. GDP is 4.0 percent below baseline by then, with the level of world GDP 2.0 percent below baseline.
Particularly hard-hit would be countries bearing the brunt of protectionist policies, such as Mexico (which exports more than 20.0 percent of its GDP to the U.S.) and China. But also hit would be other countries in Asia, which would suffer from lower U.S. demand and weaker growth in China, such as Korea, Singapore, Hong Kong and Vietnam (see Chart 3). Canada, a major U.S. trade partner, would also suffer.
Wide range of bond market outcomes
The wide range of GDP outcomes in our different scenarios also implies very different possible paths for bond markets. In our baseline scenario, the U.S. Federal Reserve raises interest rates twice this year and U.S. 10-year yields rise to 2.8 percent by end-2017 and 3.1 percent by end-2018. But in the upside scenario, higher U.S. growth and inflation means that the Fed would be more aggressive, so that U.S. 10-year yields would approach 4.0 percent by end-2018.
Meanwhile, in the downside scenario, although the tariff war would initially add to U.S. inflation, this effect would be swamped by weaker U.S. and global growth. As a result, the Fed would hold off from rate rises in 2017 and start cutting by 2018. U.S. 10-year yields would be 2.3 percent at end-2017, then slump back to 1.6 percent by end-2018 (see Chart 4).
This wide range of possible outcomes probably explains why the term premium (the compensation investors get for the risk that the path of short-term interest rates deviates from what they expect) embodied in U.S. 10-year bonds has risen significantly since November 7th, by around 30 basis points. As the policy picture becomes clearer, this effect might wane, though we would note the term premium remains low by historic standards.
Currently, we think the balance of risks across our scenarios is skewed slightly to the upside, i.e. towards higher growth and higher yields than in the baseline.
But this balance could shift quickly. A big question mark remains over how much fiscal stimulus the complex U.S. political system will allow. In addition, Trump’s recent rhetoric on trade and also some of his choices for cabinet postings, so far, suggest markets might still be underpricing the risk in areas like protectionism and immigration.
Some tax proposals being floated by Republicans could also have large effects; The proposed ‘border tax’ would amount to a large protectionist. Meanwhile, suggestions to alter the territorial basis of corporate taxation could also potentially shift substantial tax revenues to the U.S. from other countries, including in Europe.
This update was researched and written by Oxford Economics, 121 St. Aldates, Oxford, OX1 1HB, England, as of 24 January 2017.