Trump's Trade Policies Only Make the Dollar Stronger
Donald Trump is off to a controversial start as U.S. president, but for the most part financial markets have been fairly relaxed about American and global economic prospects despite the lack of any precise contours for the new administration's fiscal strategy.
In fact, the markets have barely discounted the risks of trade and currency conflicts. What they should prepare for is a significantly stronger U.S. dollar, and greater weakness in U.S. bonds, commodities and emerging markets. The implications for equities are more nuanced.
The president and several key nominees haven't sought to obfuscate how they think about trade. For them, it's a zero-sum game in which there can only be one winner, and in which the interests of U.S. suppliers of exports and labor take precedence over those of Americans as consumers of imports. Regional trade agreements such as the Trans-Pacific Partnership that are built around the establishment of rules and the economics of supply chains are out, while bilateral arrangements in which the U.S. can bring to bear its economic heft and leverage are in.
China and Mexico, both threatened with tariffs and other trade restraint measures, are the principal countries in the cross hairs of America’s new trade policy, though Germany has recently been sucked in, too. All countries, however, would be subject to the effects of the so-called destinations-based cash flow, or border-adjustment, tax as part of corporate tax reform.
Markets may be underestimating the likelihood that this tax will be enacted. The case for the defense is that it is economically defensible, and loosely compatible with other nations’ tax practices. Yet it is also a blatant form of protectionism because it will, in effect, tax imports and subsidize exports.
Since the overall policy objective will be a meaningful reduction in the annual $750 billion merchandise trade deficit, markets will have to take on board three major implications.
First, in its simplest form, a narrower trade deficit means less demand from the U.S. for foreign currencies to pay for imports. This should support a period of further dollar appreciation.
Second, since the U.S. provides dollar liquidity to the world through the trade account, a narrowing in the deficit will also lower the liquidity used to finance the bulk of transactions in trade, business investment and commodity markets. This will also push the dollar up, building on the gains since 2014 in the wake of less U.S. energy imports, and the very gradual shift to tighter Federal Reserve monetary policy.
Third, a drop in the external deficit will strengthen reported gross domestic product and, since the Fed regards the economy to have attained full employment, this will raise the risk of a bigger or faster tightening of monetary policy. In this context, the Fed will also be sensitive to fiscal stimulus measures and trade measures that lead to higher aggregate demand and inflation.
Pulling these ends together, we should expect to see another leg up in this U.S. dollar cycle, perhaps on the order of 10 percent to 15 percent, along with higher U.S. bond yields and wider yield spreads relative to other major markets. These trends, playing out over the next one to two years, should ordinarily have negative effects on commodity prices -- geopolitical angst notwithstanding -- and on emerging markets.
The latter will be especially vulnerable to the extent that they rely on U.S. consumption, and commodity exports. Those economies such as Chile, Turkey and Malaysia with significant external U.S. dollar liabilities would also be at risk. China would not normally qualify as being vulnerable on these criteria, but investors would still be advised to scrutinize developments closely, such is the sensitivity of the economy and financial system to capital flight and dollar appreciation.
For equity markets, the initial effects of a shallower trade deficit and expected fiscal measures should be positive for U.S. aggregate demand and corporate profits. Over time, though, that could be offset by the cumulative impact of dollar appreciation on earnings, the effects of tighter monetary policy, and ultimately the broader global consequences of trade compression or conflict.
Not even the U.S. can remain aloof for long. The tyranny of national income accounting means that if America's external deficit drops sharply, and the government’s fiscal imbalance widens, companies and households will save more, and invest less. That is a poor endgame for markets, but it is also a ways away. The trades for trade conflict have yet to be put on.
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