Mr Trump’s failure to reform US healthcare has raised doubts about his ability to pass pro-business legislation, including tax cuts and infrastructure investment. But we think investors have over-reacted: we still expect the corporate tax rate to be slashed and other business-friendly measures to be implemented this year. Moreover, the US economy is already in decent shape: consumer and business confidence is high, inflation is rising and the labour market is tightening rapidly. With the fed funds rate set to rise faster than investors anticipate, we think now is a good time to take long US dollar positions and short US Treasury positions.
Donald Trump’s failure to reform healthcare has raised doubts about his ability to enact the rest of his legislative agenda. Investors are particularly concerned that he may not cut taxes or increase spending on infrastructure, as hoped. The so-called Trump trade has partially unwound. Compared to a few weeks ago, equities are down, the US dollar has weakened and Treasury yields have fallen. But have investors over-reacted? We believe so.
First, by walking away from negotiations on healthcare, Donald Trump may have strengthened his hand. Obamacare is the law of the land for the foreseeable future and Mr Trump can point the finger at the Freedom Caucus. Growing pressure from the Republican Party establishment and Donald Trump’s base make the Freedom Caucus (and other potential rebels within the Republican party) more likely to support other aspects of Mr Trump’s agenda. Indeed, one member of the Freedom Caucus has already resigned over the group’s opposition to the healthcare plan.
Second, we do not expect tax cuts to be matched by spending cuts. Uncle Sam will pick up the tab! History has shown, after all, that Republicans have often loosened fiscal policy and left the Democrats to tidy up the state finances. The Laffer Curve argument – which contends that if tax cuts are properly targeted tax revenues may even rise – will probably convince sceptical Republicans to vote for tax cuts without offsetting spending cuts.
Republicans bought into this argument during Ronald Reagan’s presidency even though the budget deficit rose after the first round of Reagan’s tax cuts. More recently, following the botched healthcare reform, the leader of the Freedom Caucus has said that he would support a tax plan that is not revenue neutral.
Third, the economy is already in decent shape and the outlook is not completely dependent on tax cuts. Consumer and business confidence is high, inflation is rising and the labour market is tightening rapidly – all of these suggest that the economy is gaining momentum and points to a quicker pace of interest rate hikes than that implied by fed funds futures, fiscal stimulus or no fiscal stimulus.
Moreover, House Speaker Paul Ryan’s tax proposal includes a number of measures that would increase incentives for businesses to invest, such as subsidising research and development expenditures and allowing firms to immediately expense investment1. These measures should receive unanimous backing by Republicans (and possibly even some Democrats).
Admittedly, some aspects of Paul Ryan’s tax plan are complicated, controversial and unlikely to gain unanimous endorsement by the Republican Party. The most contentious issue is likely to be the so-called border adjustment tax that would subsidise US exporters and tax US imports. This measure would raise revenues as long as the US runs a current account deficit, but would probably fall foul of World Trade Organisation (WTO) laws and, if adopted, spark retaliation by US trading partners. This could tip the world into recession.
Finding a compromise on the complicated issue of tax reform is likely to take several months. In our view, the most likely outcome is that a watered-down version of Paul Ryan’s bill (which includes no border tax but large cuts to corporate tax and other incentives to boost investment) will be approved by Congress and passed into law in Q4 this year.
Admittedly, if tax reform is not passed until next year, business and investor confidence may suffer a setback, potentially knocking growth. But for now, we still expect US GDP growth to exceed 2.5% in 2017 and 3.0% in 2018. Uncertainty over fiscal policy could end the honeymoon period of Mr Trump’s presidency, but we do not envision a protracted downturn. In fact, the economic fundamentals warrant a faster pace of rate increases than investors currently anticipate. This, in our view, will put further upward pressure on the US dollar and US Treasury yields before long. As such, we think that now may be a good time to accumulate long positions in the US dollar and short positions in US Treasuries.
1 Current depreciation rules mean that firms recover the cost of investment over many years. Immediately writing-off (or “expensing”) investment would represent a zero percent marginal effective tax on new investment.
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