The Trump Trade

There have been two trends since toward the end of 2016. The election of Donald Trump as president of the United States in large part due to his promises to boost economic growth and bring jobs back to the country and the turning of the corner by the Chinese economy returning it to consuming once again the world’s natural resources for its infrastructure and manufacturing sectors. Both of these trends have lifted the global economy out of deflationary pressures by reflating while investors in the financial markets are carefully watching their sustainability.

Trump’s election brought into focus the U.S. personal and corporate tax regimes, burdensome business regulations, deteriorating infrastructure and America’s trade policies that have proven to be detrimental to its economy. Promised reforms to all these determinants of the health of the U.S. economy greatly encouraged the equity markets on Wall Street which are eager for the expected reforms to become law. The president’s ongoing difficulty with members of his own political party in negotiating health care reform to end Obamacare is raising doubts about his ability to pass major economic reforms into law. If he cannot deliver, the markets could be deeply disappointed which could lead to a 10% drop or a correction in the major equity indices.

As China – the world’s largest economy by purchasing power parity (PPP) and the second largest in nominal terms – navigates the stabilization of its economy at a lower level of growth, transitioning, according to conventional wisdom, to a services and consumption-based economy from a manufacturing and exports-based model in its attempt to move up the economic value chain, a closer examination of China reveals that it wants to strengthen all four – manufacturing, services, consumption and exports. It is climbing up the manufacturing ladder to more innovative and higher-end manufacturing from simply being an assembler of imported components, building up the services sector, raising domestic consumption, and aggressively seeking and building markets for its exports with initiatives such as “One Belt, One Road.”

China intends to primarily import natural resources and food it is deficient in, make in China using Chinese producers for the Chinese market and for export. It is not a country that is open to foreign firms who wish to make in China for Chinese consumption even as it is beginning to expand the global footprint of its own corporations to produce for the consumption of others within their countries. When faced for some time – nearly four decades – with such globalization that takes advantage of the current global free trade regime not only by China, but by other aggressive exporters such as Germany and Japan, the United States cannot stand still without adjusting its global trade posture of playing the unsustainable consumer of global exports which is costing America jobs. This makes the sustainability of the Trump Trade all the more critical – an imperative. The president must succeed in passing economic reforms in America.

Any future success of the expected reforms in the United States will have a significant impact on the world. Lowering personal income taxes for the middle class while expanding the tax base with taxes on consumption (as India is doing) would economically strengthen the society. Cutting corporate taxes and facilitating repatriation of foreign profits of American firms at a low tax rate will increase business investment in the U.S. Streamlining regulations and making regulations smart will reduce the cost of compliance of firms, create a business-friendly environment and increase the ease of doing business while reducing the chances of events such as financial crises. Investing in infrastructure reduces business inefficiencies. Most importantly, a local, global and sustainable model of international trade which encourages local production by multinational corporations and local companies for sustainable local consumption while importing only natural resources and food items a country is deficient in will lead to global economic development by creating and developing local markets and political and economic institutions. All these reforms will be emulated by other countries once they become operational in the United States, pushing less open countries such as China and Japan to become reciprocally more open.

The American president may be lending his name to real estate projects around world but he may not have anticipated branding the global economy. The Trump Trade signals a paradigm shift in the structure of the world economy. It not happening will be a costly disappointment.

Expectations and Monetary Policy

Monetary policy has been in unchartered territory since the global financial crisis of 2007-2008. Interest rates in the Group of Seven (G7) countries have been cut by the central banks to zero or near zero since 2008 and have remained at that level until now. Besides the lowest level of interest rates, G7 central banks have engaged in massive financial asset and government bond purchases to continue to increase money supply at the zero bound while rescuing financial institutions which were impacted adversely by the crisis.

New regulations have been put into place with the intent of preventing future such crises and to ensure the solvency of financial institutions should a crisis occur again. Stress tests of systemically important financial institutions have concluded that the financial institutions are better prepared for any future crisis.

In spite of extraordinarily accommodative monetary policy and new regulatory regimes to contain the possibility of crises again, economic recovery has been slow and gross domestic product (GDP) growth rates have been, at best, moderate and, at worst, modest with low potential growth rates.

The Japanese economy remains mired in low or recessionary growth, continuing to be in an economic condition that began with the lost decade of the 1990s when its real estate bubble burst. It is now feared that, absent unconventional monetary policies, looking forward, the other G7 countries could face the same fate as Japan.

It has been argued that the interest rate sensitivity of G7 economies has gone down because of the large service sectors in G7 countries which are less sensitive to interest rate changes compared to agricultural and industrial sectors. It is unclear if the G7 economies are more sensitive to interest rates when interest rates are on the rise during monetary tightening than they are during monetary easing. In the United States consumer spending on durable goods and on residential fixed investment after the crisis has also been found to have become less sensitive to decreasing interest rates because consumers have withheld spending to make their debt-to-income ratios better. The question arises, however, as to why ever lower interest rates are being expected by market participants before investment and consumer spending can fully recover? Expectations could provide an answer.

Though the conduct of monetary policy has been discounted as a reason for muted interest rate sensitivity of the economy since 1984 in the United States, it must be remembered that the expectation of preemptive easing before economic downturns and especially during crises and preemptive tightening to avert higher levels of inflation has become the norm since the coming of the Greenspan Fed in 1987. Market participants expect the central bank to keep cutting interest rates until recovery indicators surface and, therefore, consumers hold back spending on big ticket items such as durable goods and residential fixed investment, and businesses hold back on capital spending waiting for lower interest rates. Likewise, as inflation begins to rise, with the expectation that the central bank will raise interest rates, market participants will borrow and spend before rates rise further.

Monetary policy response and, in particular, central bank signaling of the health of the economy, therefore, plays a critical role in setting and managing the expectations of consumers and businesses.

Responsible Investment

International trade, climate change and the 2007-2008 financial crisis are forever changing the landscape of investing. As advocated by free market economists such as Milton Friedman, the notion that the purpose of the firm is to maximize profit – its bottom line, irrespective of any negative impacts of the firm’s activities on the environment and society – has come under severe scrutiny over the past decade.

Negative externalities in the operation of a firm, which are many, have not thus far been factored into the cost of production of goods and services and hence into their prices. Impacts such as pollution, climate change, exploitation of labor in the global supply chain, and adverse consequences of a firm’s operations to employee and people’s health and safety have largely been dealt with in the judicial system, with the cost of such litigation eventually finding its way into prices.

There have been no attempts until the turn of the century to prevent the harmful consequences of the activities of the firm, to deal with them ex ante rather than ex post through the legal process, because the financial markets did not punish such behavior. In fact, risky financial market behavior in investing was encouraged by the government in the name of not interfering with financial innovation leading to the housing crisis in the United States and the consequent Great Recession that is still reverberating around the world. The financial crisis has put the spotlight on corporate governance and on the ability of financial institutions to weather economic downturns and any crises caused by their actions so that tax payers do not foot the bill of rescuing systemically important financial institutions and real sector corporations while also enduring loss of livelihoods, homes and jobs as a result of such crises.

The systemic negative consequences of the activities of the firm have spurred change to take the approach of strengthening the triple bottom line rather than merely the single bottom line of profit: corporate sustainability is now beginning to mean operating at the intersection of the economy, environment and society. Now more corporations are publishing annual corporate citizenship or sustainability reports along with their annual financial reports. The movement is toward publishing integrated annual reports of corporate finance and sustainability because the ability of public corporations to raise capital in the financial markets is increasingly becoming dependent on the triple bottom line. Moreover, the triple bottom line will determine the market capitalization of firms.

Investing in firms, public and private, is beginning to incorporate the medium and long term sustainability (or Environment, Society, Governance – ESG) performance of corporations along with the short term because of the financial materiality of ESG issues in strategic planning. Some examples are the financial impacts of the Deep Water Horizon Spill on BP and the Libor scandal on Barclays. “Responsible investment,” says the United Nations supported Principles for Responsible Investment (UNPRI), “requires investors and companies to take a wider view, taking into account the full spectrum of risks and opportunities facing them, in order to allocate capital in a manner that is aligned with the short and long-term interests of their clients and beneficiaries. This analysis should inform asset allocation, stock selection, portfolio construction, shareholder engagement and voting.”

The six UNPRI principles for responsible investment that UNPRI signatories adopt are:

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Widespread adoption of responsible investing is a first step toward financial and corporate sustainability to achieve the Quadruple Bottom Line (QBL) of incorporating the future vis-a-vis the environment, social and governance actions in the present.