Macro Signposts | 17 December 2024
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Will We See Bold Policy Choices in the U.S.?
November's U.S. election could be seen as a clear vote for change, delivering a Republican sweep of the White House and Congress. Yet relative to other major developed countries, the U.S. economy was likely the least in need of change. Since the pandemic, despite a roughly 20% price level adjustment, U.S. real standards of living (measured by per capita real GDP) have outperformed nearly all OECD countries, and this relative economic strength is reflected in buoyant U.S. equity markets. Other regions, including China, Europe, and the U.K., were more in need of change, at least according to their respective post-pandemic economic and equity performance (details in our 14 November 2024 Macro Signposts).
After winning on a campaign of change, what will President-elect Donald Trump and his administration look to achieve for the U.S. economy - and how?
Post-pandemic improvements in U.S. standards of living haven't accrued evenly to all. Signals from the incoming administration indicate a possible focus on policy pivots that they believe will result in a more equitable distribution of U.S. economic gains. Based on public remarks from Trump and individuals in the top economic policy positions, we believe these policy pivots could seek to address three long-term imbalances:
Correcting imbalances that have built over decades could be an economically painful transition, both domestically and outside the U.S. This raises an important question for Trump's second term: How much U.S. equity market underperformance is Trump willing to tolerate? Many investors believe the answer is "not much" - that U.S. stock markets are how the incoming president will gauge the success of his policies. Current market pricing suggests an overarching view that equities will be a constraint on any ambitions to meaningfully alter trade and fiscal deficits. Hence, a key question for 2025 is whether Trump will surprise with more aggressive policy actions.
Global trade imbalances: why they exist and how to correct them
Michael Pettis, a senior fellow at the Carnegie Endowment for International Peace, has explained1 how the U.S. trade deficit is the result of industrial policies elsewhere. China in particular, but also Germany, Japan, and others, have been able to run serial trade surpluses due to government policies that effectively subsidize their manufacturing sectors by driving up household savings. This process, which became the heart of China's export-led growth strategy, also created significant excess savings that needed to be reinvested. The relatively open and stable U.S. capital markets provided a place for these savings, contributing to asset bubbles over the years and a stronger U.S. dollar.
The glut of foreign excess savings also coincided with U.S. dissaving. A shrinking manufacturing sector and reduced labor bargaining power - economic developments that some Western economists (such as MIT's David Autor) have termed the "China shock"2 - meant that real wages stagnated, political polarization widened, and fiscal deficits swelled. Over time, these trends increased consumption's share of GDP and reduced domestic savings, while China's manufacturing share of GDP increased along with its savings rate.
Winners in this system have been foreign (mainly Chinese) industry, capital owners, and the U.S. consumer (through lower prices of goods). Losers have been non-U.S. households that have had to subsidize their respective domestic manufacturing sectors, U.S. manufacturing, and U.S. middle-class workers.
To correct these imbalances, trade surplus countries would need to rebalance their economies away from manufacturing, likely through economic reforms that reduce implicit manufacturing subsidies and targeted fiscal policies aimed at stimulating household consumption. Whether they would do this is an open question. For example, economic arguments in favor of a more balanced Chinese economy have been around for a while, with little apparent traction from Chinese central government officials. Since China is currently dealing with a large-scale, multi-year property sector bust - and in need of household stimulus to counter deflationary trends - China's and the U.S.'s interests appear more aligned now than at any time in recent memory, and yet central government officials still appear reluctant to directly stimulate their household sector. Meanwhile, self-imposed debt constraints within the eurozone - the German debt brake is a prime example - may limit adjustments there.
If trade surplus countries are not willing or able to make these adjustments, the U.S. is left to try to implement policies that effectively force these adjustments. Such policies could include implementing a higher universal tariff (not a tariff just on China or other specific regions), or a foreign investment tax, while maintaining the ability to limit further offsetting dollar appreciation. In other words, the U.S. would need to orchestrate an effective devaluation of the dollar to force these adjustments. At the same time that the U.S. implements policies to limit foreign savings entering U.S. markets, it would also have to boost domestic saving - most likely via a material reduction the U.S. government deficit.
Market implications of these hypothetical adjustments
If these major policy and market pivots came to pass, then we would likely see steeper interest rate curves in those regions with serial trade surplus markets versus the U.S. Higher U.S. prices - whether driven by tariffs or a weaker dollar - could slow the pace of Federal Reserve rate cuts (although we believe rate hikes remain unlikely), while a negative relative price adjustment in other regions could speed up central bank cuts elsewhere.
Improvements in the U.S. fiscal deficit relative to some expansion in the trade surplus countries could result in long-end U.S. rates outperforming rates in those countries. (As we discussed in our 27 November Macro Signposts, while the longer-term U.S. debt trajectory continues to point higher, we do see signs of potential fiscal constraints that could at least limit additional costs of extending the current tax cuts.)
If Washington policy constraints - remember Republicans have very slim majorities in Congress - limit the extent to which the U.S. fiscal deficit can shrink at the same time the government is discouraging the inflow of foreign excess savings, then higher bond yields and a steeper U.S. Treasury yield curve would likely coincide with the higher private savings (or lower investment) needed to offset the foreign capital inflows. In other words, this adjustment could push the U.S. economy into a recession.
For equity markets, the implications of these potential policy shifts aren't likely to be good. Indeed, some outperformance in long-term bonds would likely be offset by wider equity risk premiums (i.e., the yield above the "risk-free" rate equity investors demand to take on the risk). A higher U.S. labor share of income will tend to erode margins and earnings, while a sharp reduction or elimination of foreign excess savings flows into U.S. capital markets could increase the cost of capital.
The challenge of forecasting the Trump administration's policy
Herein lies the complication of predicting Trump's policies. Making tough adjustments will most likely result in poor equity performance, at least during the transition phase. If Trump's tolerance for any equity drawdown is low, then his tariff, trade, and deficit policies are likely to be more limited, symbolic, and economically manageable. However, if he is willing to be bold, then more equitable long-term U.S. growth may be possible, although it would most likely involve lower returns for holders of capital.
1 Michael Pettis and Erica Hogan, "Trade Intervention for Freer Trade," paper published online by the Carnegie Endowment for International Peace, 3 October 2024
2 "Q&A: David Autor on the long afterlife of the 'China shock,'" MIT News, 6 December 2021
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