The U.S. election putting the Presidency, Senate and House of Representatives under Republican Party control ushers in an era of legislative activity and policy initiatives – effectively ending nearly a decade of gridlock in Washington. Macro-economics, top down analysis, big picture policy issues, rise of fiscal policy, less accommodative monetary policy, shift in trade policies, etc. are all going to impact markets. Our objective is to frame the critical challenges for markets, so we provide here our summary of nine key items, many of which have already moved markets – perhaps not enough, perhaps too far if expectations are readjusted.
1) Infrastructure Spending. There is a general consensus that an infrastructure spending bill will pass Congress in 2017, leading to significant economic stimulus in 2018 and beyond. Industrial metals, such as copper and iron ore, have reflected this expectation, as have various stock market sectors involved in materials and construction. It is not clear, however, if any U.S. infrastructure spending can meet the level of expectations which have been built into market prices for industrial metals, especially if economic growth in China, the main consumer of such metals, continues to slow. Moreover, some infrastructure proposals have relied heavily on private funding and the implied private ownership may not pass muster for what are essentially public assets, such as roads and bridges, etc.
2) Tax Reform. Again, there is a general consensus that a tax reform act will pass Congress in 2017. On the personal side, tax reform may include some significant income tax cuts and possibly the abolition of the estate tax. For corporations, a reduction in corporate tax rates is highly likely as well as changes in the foreign earnings repatriation rules. Bond markets have moved yields higher, reflecting the combination of more spending and lower taxes leading to larger budget deficits, more government bond supply, and potential upward pressure on inflation expectations. The technology sector has been especially impacted by speculation over how foreign earnings might be taxed, given the highly visible nature of technology companies’ overseas earnings and cash holdings.
3) Debt Ceiling and Impact on Fiscal Policy. As noted above, the net result of the likely infrastructure spending and tax cuts would be to greatly expand the budget deficit and increase the issuance of federal government debt. This expectation collides with the debt ceiling. The current debt limit was temporarily suspended in late 2015 to avoid any Congressional vote and potential threat of a federal government shutdown during the election year of 2016. Notably, the debt ceiling law is set to go back into effect on 16 March, 2017. Based on our estimates, the United States will be immediately in violation of the debt ceiling.
We do not have a good read on what compromises among the different factions of Republican might be needed to pass debt ceiling legislation. There are some Republican lawmakers who have never ever in their careers voted in favor of raising the debt ceiling. The rural populism that was at the core of the Republican victory in the election embeds a strong theme of smaller government. This means navigating the debt ceiling challenge may be the first real challenge of the Republican-controlled Congress.
More than likely, the Democrats will make the Republicans "own" the decision to raise the debt ceiling. For their part, the Republicans will need to confront the implications of the spending plans and tax cuts. Or, the Republicans could just move to abolish the debt ceiling law (not that likely, just an interesting scenario). And, does debt ceiling legislation, assuming a version does pass, portend that future spending (i.e., infrastructure) will have to be paid for with cuts in other parts of the budget? This scenario is difficult to imagine since there just is not enough discretionary and non-military spending to go around. More likely, due to a debt ceiling compromise, an infrastructure spending plan with a large “headline” number might be stretched out over 10 years or so, reducing the immediate impact of the spending on the deficit and, of course, on the economy, too.
The implications for equity and bond markets are huge. The post-election rally and Treasury bond sell-off were based on expectations of a highly expansionary fiscal policy. Any debt ceiling compromise among the different factions within the Republican Party could very well roil both equity and bond markets. This is a classic example of the utility of options as a risk management tool around event risk uncertainty. And, we note that March 16, 2017 (when the debt ceiling law is reactivated), is a Thursday, so one has a choice to use Wednesday or Friday expiring equity options (or both), depending on one’s volatility and timing scenarios.
4) Dodd-Frank. A lighter touch to financial market regulation is expected. However, what form this takes is unclear. Repealing the Dodd–Frank Wall Street Reform and Consumer Protection Act (July 2010) with it 3,000 pages of legislation and 15,000 pages of agency rules and regulations is no easy task. Replacing Dodd-Frank is not likely to be quick work, no matter how fast the new Administration pushes. The devil will be in the details. Still, we expect a dismantling of the Consumer Financial Protection Bureau (CFPB), and a rollback of the Volcker Rule impacting proprietary trading of financial institutions, among other items. However, we do not expect a re-introduction of the Glass-Steagall Act separating commercial banking (lending) from investment banking (capital raising and equity/bond trading) which was repealed under President Clinton in the late 1990s. So far, financial sector stocks have rallied strongly although the rebound owes at least as much to expectations of higher interest rates as it does to a reduced regulatory burden.
5) Health Care System. Ditto for health care on complexity and timing.; The Patient Protection and Affordable Care Act (March 2010) is now embedded in the health care system. Outright repeal would cause tremendous uncertainty. So, again, repeal is unlikely and replacement is favored; some parts will survive and others will die, and it will probably be too complex to get done in the first 100 days, although possibly by the end of 2017. Replacing the Affordable Care Act and agreeing to all the details of a new plan has the potential to divide many factions within the Republican Party. Many of the relatively poor and rural Republican voters oppose the Affordable Care Act and yet use it or benefit from certain aspects of it. Already the President-Elect has embraced two key tenants of the law: 1) the ban on insurance companies discriminating on the basis of pre-existing conditions, and 2) allowing young people to remain on their parent’s plans until they turn 26. Acceptance of other provisions may follow. This is going to be very tricky.
6) Trade Protectionism. Sweeping trade protectionism in the form of higher tariffs would revive memories of the Smoot-Hawley Tariff Act of 1930, which played a material role in turning the recession of 1929 into the Great Depression of the 1930s (with a big assist from the Federal Reserve which decided to close thousands of banks instead of serving as a lender of last resort). Moreover, tariffs are a two-way street and invite retaliation. And, many goods are not easy to categorize. The parts of a product may be made in one country, assembled in another, and sold in many places. Still, various trade deals will get considerable scrutiny, no new ones will be approved, and some old ones will be renegotiated. The growth of world trade will be constrained, and without growth in trade, economic growth typically suffers. Sectors in the limelight will include metals, energy, and agriculture, not just foreign exchange. If movement on trade protectionism fades, then a rally in emerging market currencies is quite possible, even with higher U.S. interest rates. A global trade war, complete with retaliation, could send emerging market currencies sharply lower.
7) Energy and Environmental Regulation. Since the election, oil prices have fallen, perhaps in part due to the idea that easing environmental regulations will increase future U.S. supply. This notion is dubious in the short-run although potentially impactful in 5-10 years.
The main reason why U.S. supply fell in 2016 was because of lower oil prices, which are constraining output by driving higher-cost producers out of the market. When oil does move into the $45-$50/barrel range, as happened in Q3/2016, we saw US producers adding rigs and capacity. In the short-run, price is going to be the driver of US supply rather than changes in regulation. That said, a lighter touch on energy regulation and opening up more land for drilling will likely increase supply over 5 to 10 years, suggesting that crude oil may find it difficult to breach the $50-ish/barrel price level for any extended period of time to the detriment of oil suppliers such as Saudi Arabia and Russia.
Likewise, easing environmental regulations will not by itself boost coal production. The fate of coal mines in West Virginia and elsewhere in the country depends in large part on the price of natural gas, which may continue to rise as output falls and demand soars, especially from electrical power generation.
In terms of corn and ethanol, a great deal will depend on Congressional legislation and rule- making by government agencies. This is one to watch closely in the coming months.
8) European Union. The demonstrated rise of populism and nationalism displayed in the U.K. Brexit referendum and the U.S. election materially raises the probability of further follow-through in Europe.
On 4 December, 2016, Italian voters may reject the establishment’s constitutional reforms, triggering the resignation of the Prime Minister.
In March 2017, the Dutch voters may give anti-European Union parties a much greater voice in their parliament.
On 23 April & 7 May, 2017, French voters are highly likely to give Marine Le Pen and her National Front Party approximately 30% of the vote or more in round one of the Presidential election on 23 April, with the other 70% or so split amongst a dozen or so “establishment” candidates. It is not clear who might emerge to oppose Le Pen in round two, except that there is only a 1% chance it would be the very unpopular incumbent, President Francois Hollande. The two more likely candidates are former President Nicolas Sarkozy and former Prime Minister Alain Juppe. In round two, Le Pen will probably lag behind her opposition in the opinion polls but so did Donald Trump and the “leave” camp in Brexit, so be forewarned: her likelihood of becoming Madame Presidente, might be higher than one expects. And, even if Le Pen loses in round two, the new president would have been sent a very strong message that Brussels and the EU must be reformed.
In September or October 2017, German voters may rebuke Chancellor Angela Merkel and the Christian Democratic Union (CDU) which she leads alongside their Bavarian sister party, the Christian Social Union (CSU). The CDU/CSU came to power when they won 35.2% of the vote in 2005, and 226 of 614 seats in the Bundestag, allowing them to govern with minority party assistance. In 2009, they repeated this outcome, winning 33.8% of the vote and actually picking up a few seats to win 239 of 622 seats but still needing minority party help to govern. In 2013, the CDU/CSU made bigger gains, winning 41.5% of the popular vote and 311 of 630 seats, picking up 72 new seats, but still needed some minority party help to govern. This time around, public opinion polling suggests a decline in the popular vote for the CDU/CSU to around 32.5% and a loss of 80 or more seats, and it could easily be worse for the CDU/CSU. Whether Merkel would resign as Chancellor after such an electoral setback is not clear, but is a distinct possibility. And, putting together a governing coalition might be much harder, if not impossible. We put the odds at 60% that Merkel will not be Chancellor of Germany in 2018.
These French and German election scenarios have major consequences for the European Union (EU), for the EU-UK Brexit negotiations, and for the path of the euro relative to the U.S. dollar.
If there is new leadership in France and Germany responding to strong anti-EU sentiment from the voters, then the critical question in 2018 may well be whether the EU survives in the current form or whether major changes are coming to how the EU is structured and run. In this scenario, Brexit would be collateral damage, and all negotiations for U.K.’s exit would be at a complete and utter standstill.
Moreover, if the elections in France and Germany swing toward an anti-EU bent, the euro versus the U.S. dollar could move through parity on the back of increased political fragmentation and uncertainty set against rising rates and inflation pressure in the United States.
These developments will put a spotlight on European Central Bank (ECB) policies. The ECB has committed itself to massive asset purchases and negative rates. The asset purchases have damaged the liquidity of European sovereign and corporate bond markets, and when credit markets do not function well, economies typically do not grow as fast as their potential. And, while negative rates were intended to loosen monetary policy, they may appear to have had the unintended consequence of boosting savings rates, weakening the health of the banking sector, and decreasing lending, thereby working as a tightening of policy and further constraining economic growth. The ECB, of course, would vigorously dispute this assessment of how their policies have worked. Nevertheless, we would see the rise of anti-EU sentiment in the electorates across Europe leading to a behind-the-scene re-think of monetary policy.
9) Federal Reserve.& Janet Yellen’s term as Chair expires early in 2018, and we do not expect her to be reappointed. The Securities and Exchange Commission (SEC) will get a new Chairman in 2017, as will the Commodity Futures Trading Commission (CFTC). The leadership shifts in these three key financial regulators will accentuate the move to lighter touch regulation.
In the meantime, the Fed’s Federal Open Market Committee (FOMC) has a two-day meeting ending on Wednesday, 14 December, 2016. The prospects of fiscal stimulus have raised the odds, as calculated from CME federal funds futures, to 90% for a rate hike in December and possibly three or four more in 2017. The Eurodollar deposit maturity curve has moved sharply steeper to reflect these changes in rate hike probabilities, and Treasury note and bond yields have risen. And, we note again, a higher U.S. federal funds rate might push the U.S. dollar upward against the euro and Japanese yen. The fate of emerging market currencies is much more influenced by how trade policies develop and that was covered above in item #6.
Higher rates call into question other Fed policies.The Fed is challenged with how to influence short-term rates, given the over $2 trillion in excess reserves. Currently, the Fed enforces a higher target range for the federal funds rate by increasing the rate of interest it pays on required and excess reserves. This rate of interest is essentially a part of the cost of funding the Fed’s massive portfolio of Treasuries and mortgage-backed securities. With the rate paid on excess reserve heading upward, the earnings of the Fed will shrink. Fed earnings are largely turned over to the U.S. Treasury, so a decline in Fed earning will raise the budget deficit. And, if one includes the impact of capital losses within the portfolio from higher bond yields, the Fed’s recent contributions to the U.S. Treasury of around $80-$90 billion per year could shrink to zero by 2020.
Shrinking earnings may well impact policy. Currently, the Fed re-invests all interest and principal payments received from its massive portfolio of Treasuries and mortgage-backed securities. This policy is likely to be changed, allowing the portfolio to shrink slowly – with no sales of securities, but no more reinvestment either. Still, it may take until 2030 to materially shrink the Fed’s balance sheet.
Also, with new financial regulations coming as the Dodd-Frank Act is replaced, the Fed may rethink the role of repo activities in how it manages short-term rates. We may see the Fed move to support and revitalize the repo market.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
View more reports from Blu Putnam, Managing Director and Chief Economist of CME Group.