When will trump hit the wall ?

When will
hit the wall?

Pascal Blackburne & Luc Synaeghel 2017-02-10

The first weeks of the Trump term have been animated, to say the least.
Far from “rising to the function” as many were hoping, the new US President has kept to his Twitter style and set about running the country as if it were a company. We are convinced that institutions will eventually constrain him, be they the Congress (manifestly in no hurry to confirm the nomination of several Trump candidates), courts of law (as is occurring on the issue of immigration), the Federal Reserve or state governors. Pressure from the US corporate sector is also already evident. In domestic affairs, Donald Trump will thus have to start to compromise.

On the external front, a US president typically has greater leeway, although overly extreme behaviour could always trigger court procedures and some foreign “friends” may try to prod President Trump towards a more “politically correct” stance.
That said, the odds of seeing some form of taxes on imports be implemented appear high. This is one subject where the President and the Republican party are looking in the same direction. They may differ on the specifics, but they agree on the end goal – more on page 2.

Not surprisingly then, our main decision this month is to exit Chinese equities.
Beyond the fact that Chinese exports stand to be specifically targeted by US tax measures, we are also concerned about China’s shrinking foreign reserves. Roughly one quarter of the treasure chest has already been used to absorb capital outflows and stem yuan depreciation. Going forward, Chinese policymakers will have little choice but to continue depleting dollar reserves in the short term – halting the process would weaken the currency, accentuate capital outflows and further anger the US. But considering the speed at which reserves are declining, the People’s Bank of China will eventually be forced to reverse course, no doubt rattling currency markets.
The odds of seeing some form of taxes on imports be implemented appear high

And then there remain the structural issues of an overheating real estate market (especially since the latter half of 2016 saw Chinese policymakers urge banks to extend credit) and high debt. As we have written previously, the Chinese debt to GDP ratio of 280% is not a problem in and of itself, to the extent the debt is financed internally, courtesy of a massive domestic savings rate. The risk down the road though lies in a build-up of non-performing loans, since much of these savings have been channelled, via the banking system, to state-owned enterprises and capital misallocation has not necessarily been the exception...

As an alternative to Chinese equities, we did consider Russian equities, very attractively valued and potential beneficiaries of a lifting of US sanctions. The close correlation between the Russian stock market and the oil price deterred us from doing so. Our portfolios are already well exposed to the oil market recovery, in manners that we deem less geopolitically risky.


Towards some form of tax on US imports

We view the Mexican wall as an example of a rash – not properly thought out – electoral promise. It fails to recognise the labour shortage that already prevails in the construction sector across southern US states, with hourly wages that have spiralled to above USD 25. Building the wall will require a few thousand additional workers, even before considering that a quarter of existing construction workers are said to be illegal.

In contrast, President Trump’s promise to tax imports resonates with views that the Republican majority, particularly in the House of Representatives, has been espousing for some time – as part of a broader bid to revamp the US tax code. Rather than being termed “import tax”, which would run afoul of World Trade Organization rules, their concept bears the somewhat arcane name of “destination-based cash flow tax”. In short, such a system would introduce a border adjustment to corporate income taxes. Rather than paying taxes on their worldwide profits (worldwide revenues less worldwide costs), companies would pay taxes only on the difference between the revenues that they generate and the costs that they incur in the US. While this would have no bearing on purely domestic companies, importers would face a larger tax bill (since much of their cost base lies abroad, thus would no longer be deductible) while exporters would be advantaged (as part of their revenues come from outside of the US, thus would not be included in the computation of net US earnings).

Over time, these taxes on imports and subsidies on exports – which clearly boil down to a form of protectionism – would be mitigated by trade flow-driven US dollar appreciation.

That said, many other factors also influence the value of the US currency (notably central bank policies in and outside of the US) meaning that the dollar would probably not strengthen to the point of nullifying the new tax effect and thus bringing exporters’ and importers’ after-tax profits back to their original level.

President Trump would clearly prefer a straight-forward import tax, easier to target at specific countries/industries as well as being a useful political tool per se. But he could well be persuaded to work with Congress, as both share the same end goal, which raises the odds of seeing some form of taxes on imports be implemented during coming months.

Assuming this does indeed occur and that the US dollar consequently appreciates, China will find itself in an inextricable situation. If it does not allow its currency to depreciate alongside those of its neighbouring Asian countries, it will lose competitiveness – forcing a deflationary downward adjustment in domestic nominal wages, not to mention continued depletion of its foreign exchange reserves. If it does allow the yuan to depreciate, it will only increase the ire of President Trump and expose the country to further damaging trade measures...

Challenging european politics weighing on bond markets

Getting through this year without a political “accident” will be a challenge

Turning to Europe, recent developments have confirmed what we feared last month: 2017 stands to be a challenging year on the political front. The run-up to the French presidential elections is certainly proving unruly, leaving the outcome still very open. As for Italy, the Supreme court has just ruled that early elections can be held. It is up to the Italian President to actually call them, but given requests to that effect by both former country leader Matteo Renzi and Five Star founder Beppe Grillo, as well as the general resentment amid the Italian population about the ongoing string of “non-elected” prime ministers, elections appear likely before summer.

(source : Bloomberg)

At this point, we feel that getting through this year without a political “accident” will be a challenge. The disillusion of “ordinary” Europeans should not be underestimated – particularly given the amplifying effect of social media channels. It has already brought about Brexit and could propel Marine Le Pen to power in France (or indeed either of her “populist” peers in the Netherlands and Italy). Although European equity markets have been dull year-to-date, it is in sovereign bond markets that political uncertainty has been most damaging. Spreads have widened markedly in a number of countries, as illustrated by the following chart.

In this context, our switch last month from a (double) short on German Bunds to a (single) short on the larger Eurozone universe – with also a longer duration – paid off. Not only did the general (albeit slow) rise in interest rates work to its advantage, but it directly profited from the spread widening outside of Germany. With the short instrument’s country composition being determined by respective levels of debt with a 10+ year duration, Italy for instance has double the weighting of Germany and France roughly 1.7 times.