In a historic upset, Donald Trump won the American presidential election last night. All ears and eyes will now be focused on his words and actions over the next few weeks. To quell the uncertainty that his surprise victory is casting over the economy and the markets, early indications of what President Trump intends to do over the next few years will be crucial to avoiding a recession or a financial crisis.
Investment needs to grow and credit to flow in order for the economy to prosper both in the U.S. and globally. This is not difficult to figure out; more difficult will be to identify what a credible path of actions should be to keep the confidence of consumers, businesses and investors. The U.S. equity markets, after dropping more than 5% last night, recovered this morning in the hope that Mr. Trump will prove more reasonable and structured than anticipated.
Observers may expect that Donald Trump will back down from some of his wild promises and that Congress won’t let President Trump act on some of them. However, we are of the contrarian view that Donald Trump would lose credibility and that his presidency would be less effective if he does not stick to his guns. However, this does not necessarily mean that this is negative for the markets in the short-run.
Donald Trump’s emphasis on the need to rebuild American infrastructure in his victory speech implies that Republican leaders in Congress will have to accept large fiscal deficits for the foreseeable future. In particular, Paul Ryan who could remain the House leader, as Republicans retained control of both Chambers of Congress last night, will have to sit with the President and accept that Donald Trump’s economic program will trump Republican ideology of small government and balanced budgets.
If the Republican controlled Congress cannot accommodate Mr. Trump, the President won’t hesitate to replace Mr. Ryan or find allies across the aisle. Reforming Obamacare, as opposed to repealing it, will also be a Trump priority.
Combined with promised tax cuts, the federal deficit will thus likely remain substantial, therefore increasing upward pressures on long-term U.S. and global interest rates. The renewed uncertainty caused by the U.S. elections outcome has however immediately diminished the odds of a modest increase in the Federal Reserve’s policy rate before year-end, increasing the steepness of the yield curve.
This being said, if uncertainty settles relatively quickly, the Federal Reserve may still find it appropriate to raise rates at its December 14th meeting. Moreover, market expectations of a higher path for the U.S. policy rate may also arise if the combination of tax cuts and infrastructure spending is effective at boosting the outlook for growth and inflation in 2017 and beyond.
The question of climate change will be trickier to tackle as Mr. Trump’s pro-business stance may conflict with the harsh reality that the risks related to the climate are increasingly being recognised as being real and that backtracking on the process could be too costly on the international scene. We believe that President Trump will push for the Keystone pipeline and drag his feet on the issue of green-house gas emissions in order to help oil and coal producers.
Keeping his elections promises while not definitely and totally back-out of recent international climate agreements will require some juggling, at which he has shown ability. Elsewhere, promises of deregulation, especially in the financial sector, cutting waste in government spending and tax reforms may also bring benefits if they can be achieved. This is a big question mark given the need for lengthy negotiations in Congress and Mr. Trump’s distaste for details.
On the wall with Mexico, we suspect that Donald Trump will insist that Mexican authorities efficiently patrol their boarder at their own expenses to prevent Mexicans from crossing illegally into the United States. Mr. Trump will use the leverage of the NAFTA agreement to extract this concession and then move on. For Canada, the threat of NAFTA renegotiations will probably have insignificant effects as there is no real ground to renegotiate the agreement with Canada.
Our exports to the U.S. being 30% commodity related, higher U.S. tariffs on Canadian goods would only make American businesses less competitive. Moreover, the threat of retaliation of Canadian tariffs should be enough to convince Mr. Trump to limit his rhetoric. Tariffs on softwood lumber may be the price Canadians will pay to save appearances. We expect the Canadian dollar to retract in the short-run and regain some footing if Mr. Trump is able to convince Congress to accept large fiscal deficits which in the end would benefit Canadian exports.
On the question of illegal immigration, we think that the process of deportation is actually going to take place. But it will happen over a long period of time in exchange for a quicker path to citizenship or temporary legal residency for these illegal aliens; a compromise that everyone has been trying to achieve for years.
Yet, the undoing of Mr. Trump could be caused by his unpredictable and feisty character. This might not be visible for a while. Overtime, however, as Mr. Trump loses interest in building bridges with his allies and increasingly responds to the provocations of his enemies, things may get complicated for his presidency. This will be particularly true in Congress but also on the international scene where his anti-trade positions are today negatively affecting the equity valuation of companies involved in international trade.
His temptation to bend China to his will on trade, for example, may provoke the Chinese to seek other alliances – with Russia for instance - and compromise American geopolitical influence globally. To win this battle may prove harder than to beat Hillary Clinton last night.
Although we wish Mr. Trump the best of luck and certainly hope that he will succeed, our impression, until we can be convinced otherwise, remains that his apparent lack of knowledge and competence and his inability to listen to sound advice will likely prove to be a disaster in the long run for the US economy and for the world. The presidency of Mr. Trump could thus mark the end of the world as we know it and spell the decline of the U.S. dominance in the world.
A risk-off event to global financial markets
Donald Trump’s surprise win last night should lead to heightened uncertainties over future U.S. economic policies and result in rising market volatility in the near-term. The key question now for investors is if this rising uncertainty will also lead to a tightening in financial conditions and hurt both consumer and business confidence. First, a tightening in financial conditions would be detrimental to global equities and result in a contraction of valuation multiples, hence putting downside pressure on stocks over the near term (see the chart below).
According to the October 2016 Senior Loan Officer Opinion Survey, a positive net percentage of banks continued to tighten lending standards for commercial and industrial loans to large and medium-size firms during the third quarter, albeit at a lesser degree than during the previous four quarters. A renewed acceleration in the tightening pace of lending standards for C&I loans could lead to downside risks to the global economy.
Moreover, rising expectations for a large and permanent increase in future U.S. fiscal deficit and the threat of increasing trade barriers - such as imposing a 45% tariff on goods from China - already pushed inflation expectations and bond yields higher this morning (see the chart below). A rapid rise in bond yields could choke economic growth considering the already elevated level of federal and corporate debt, hence adding further downside pressure on price multiples and earnings expectations. All in all, this is a risk-off event to global financial markets.
For investors bearish on the long-term prospects of the American economy given the rather unorthodox policies of Mr. Trump, the relief rally of this morning might constitute an opportunity to exit the market and wait for a better entry-point if the uncertainty concerning his intentions and his plan of action abates later this year or early next year.
Canada: potential short-term aftershock and long-term threat to economic growth
In the short-run, the increased level of uncertainty triggered by the Trump presidential victory could restrain investments by Canadian companies –notably exporters– and push consumers to delay major purchases. Ultimately, a hit to Canadian consumer and business confidence is more likely to occur due to the Trump Victory than in the aftermath of the Brexit given our strong trade ties with the U.S. Consequently, a Trump-induced anxiety at home has the potentially to weigh heavily on Canadian economic activity in the coming months (real GDP growth was already expected to be soft under the hypothesis of a Clinton victory).
Also, it remains to be seen if the U.S. elections outcome will have negative repercussions on Canadian financial conditions. During the last few hours, long-term Canadian interest rates have moved up in lockstep with the U.S. rates. If this trend continues, this would become an unwelcomed headwind to our highly-leveraged Canadian economy. Under such a negative scenario, the Bank of Canada would likely respond with a bold move that could include more than a simple policy rate cut.
In the long-run, a Trump administration has the potential to alter the way bilateral trade is done between both countries (Canada sends three-quarters of its exports to the U.S.). Clarifications on how the new U.S. President intends to renegotiate NAFTA will be key, as it will determine to what extent the current 1.5% potential growth rate of the Canadian economy could be altered. Under the worst case scenario of a broad-based tariff plan on all U.S. imports or a reinforcement of Buy American policies, Canadian exports would fall significantly and several workers would lose their jobs.
The good news is that most of Donald Trump’s protectionism remarks are oriented towards Mexico and China, not Canada. Also, Trump favours the construction of the Keystone pipeline from Alberta, a favourable development for the Canadian oil sector looking for a much needed access to the global oil markets. Furthermore, Canadian companies involved in the commodities, machinery and transportation sectors could reap some benefits from the Trump’s plan to spend $500B more on infrastructure.
