Four weeks into 2018 and the S&P’s 500 index of leading US stocks was already up 7.5 per cent. Since 1949, the average increase in the US equity market over a calendar year is almost exactly the same amount. But a year’s gain in less than a month! What lies behind this stellar performance?
There are no prizes for guessing what answer the current US administration would give to that question. The credit should go to Trumponomics, and in particular the Tax Cuts and Jobs Act (TCJA), passed finally by the US Congress on 20 December 2017.
It is not a completely unreasonable claim. All other things being equal, tax cuts do mean more money in companies’ treasuries and individuals’ pockets. At least some of this will be spent, rather than saved. Hence bipartisan and independent analyses estimating that the TCJA will boost US GDP by between 0.4 and 1.1 per cent over the next decade. Maybe the stock market is indeed just acclimatising to this new reality.
Yet markets are not stupid. They know that all else may not be equal. The biggest unanswered question is how the tax cuts will be financed. The aforementioned forecasts assume that there will be no offsetting reduction in government spending, since none has yet been put into law. However, this is not the administration’s stated plan. Donald Trump’s draft 2018 budget includes more than $2trn of spending cuts over the next decade – more than enough to counteract the $1-1.5trn of revenue forecast to be lost by the treasury on account of the TCJA.
If austerity cancels out the tax cuts in this way, there won’t be any direct boost to demand after all. The overall level of spending will stay the same – it’s just that it’ll be the private sector, rather than the government, doing it. No doubt there is a hard core of investors who are glad on principle to see such a shift in the composition, if not the level, of aggregate demand. It seems a stretch to think this could account for January’s spectacular stock market gains, however. Markets may not be stupid, but they aren’t typically quite that subtle, either.
What if austerity does not materialise? Then the tax cuts will be “unfunded”. There will be no offsetting reduction in government spending, and as a result the budget deficit will increase and the US will continue to add to its already considerable level of debt. The numbers involved are not small. In this scenario, the Congressional Budget Office forecasts that the US’s annual fiscal deficit would breach 5 per cent of GDP by 2021, and that its national debt would spiral to more than 120 per cent of GDP by 2027.
On the face of it, such statistics hardly look like great news for investors in shares. Can the stock market really be celebrating the transformation of the US into the Italy of the western hemisphere? For an answer to that question, it is worth checking the readings on that other great barometer of US economic health: the value of the dollar. For the greenback is sending out quite a different signal to the equity market: not that investors are welcoming Trumponomics as the greatest innovation since Ronald Reagan, but – paradoxically enough – that it represents the greatest risk to the long-term prosperity of the US since Richard Nixon.
You might have thought that with the US stock market up nearly 20 per cent last year, and more than a third of that again in January, the US dollar would be heading for the moon as foreign capital floods in to jump on board the rally. Not a bit of it. The US dollar lost 12 per cent of its value against the euro in 2017. At the time of writing, it is down another 3.5 per cent since New Year’s Day – and the same amount against the Japanese yen. Even much-maligned sterling is back to its pre-Brexit vote level against the dollar. This collapse in the value of the US currency affords a different perspective on the equity market’s tremendous run. Sure, the White House is correct to boast that the S&P 500 is up by a third since Trump’s election. But from the perspective of a pension fund in London or Frankfurt – including the effect of the tumbling dollar – the actual increase has been barely half of that. The reality is that a large part of the Trump bump in US share prices has simply been required to compensate international investors for the dramatic slump in the dollar.
The real question is not why the stock jocks have been cheering Trumponomics so wildly over the past month, but why currency traders have shown themselves so consistently unimpressed by the direction of US policy over the past 13.
The simplest explanation is not comforting. When it comes to the government budget, experts reason that cutting taxes is the easy part; taking the axe to spending will be much more difficult. Meanwhile, the other mainstay of US economic policy – the Federal Reserve – is in limbo, with a newly appointed chairman whose acumen and independence is untested. The path of least resistance is clear. Trumponomics is about to pour the lighter fuel of bigger deficits on to the fire of still ultra-loose monetary policy.
It all reminds the foreign exchange markets less of Reagan’s 1981 tax cuts – when Paul Volcker was at the Federal Reserve and interest rates were in double digits – and more of Nixon’s pre-election splurge a decade earlier, boosted by the pliant Fed chairman Arthur Burns, who was threatened with negative press if he dared tighten monetary policy. That infamous experiment with running unproductive deficits, even as the economy stagnated, gave the world a new concept: stagflation. The dollar? It lost a third of its value.
Don’t let the US stock market fool you. The currency markets are an order of magnitude larger and more liquid. They fear that another Republican president is repeating the mistakes of the past.
Felix Martin is a macroeconomist, bond trader and the author of “Money: The Unauthorised Biography” (Vintage)
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This article appears in the 31 Jan 2018 issue of the New Statesman, The Great Migration