After the healthcare reform failure
The Republican drive to repeal and replace Obamacare failed ignominiously on Friday. Together, President Donald Trump and House Speaker Paul Ryan were unable to muster enough support to pass the new health care bill through the House of Representatives. Bowing to reality, they pulled the vote. If there is a positive element to this failure, it is that both the administration and Congress will now shift their focus to tax reform. However, the setback on health care— the new administration’s first big legislative test—has badly damaged the confidence of US households and businesses in Trump’s ability to push his reform agenda through Congress. Investors’ already dwindling belief in the sustainability of the Trump trade is only likely to diminish further as a result.
The obstacles to tax reform are at least as great as those that blocked the health care bill. For one thing, without the projected fiscal savings from replacing Obamacare, the backers of tax reform will have an even bigger fiscal hole to fill when they table their bill. For another, the White House view of the border adjustment taxes proposed by the House Republicans remains unclear. With US retailers lobbying aggressively against the idea and a sizable number of Republican Senators publicly expressing concerns about the potential impact, the headwinds are stiff. As a result, it is now abundantly clear that fiscal and regulatory reforms are going to take a lot longer to accomplish than many investors previously hoped.
That means the post-election optimism on US growth prospects is likely to moderate further. Granted, the hard data, such as industrial production, have shown a modest improvement lately. But, the rebound has been less strong than indicated by soft data, such as sentiment indexes. If the soft data now eases, hopes for a strong cyclical upturn in growth will dissipate.
That will further dampen enthusiasm for the Trumpflation trade, which has waned lately as expectations for higher nominal growth have eased. The diminishing base effect from last year’s rebound in oil prices and slowing bank credit growth both point to moderating US inflation. In response, the US break-even inflation rate has started to fall, the yield curve is flattening, the outperformance of bank shares is reversing, and the US dollar has weakened from December’s highs. Friday’s blow to the administration’s reform agenda only increases the odds of a further reversal in the Trump trade.
That’s clearly a headwind for US risk assets. However, it also means that both structural and cyclical forces in the US now increasingly favor the outperformance of emerging market assets. With the near term prospect of stimulative US reforms much reduced, the chances of a steeper monetary tightening path from the Federal Reserve are also diminished. As a result, the risks of a higher long bond yield and a stronger US dollar—both major concerns for emerging market investors—have receded.
On top of that, the US current account deficit is widening. The US trade deficit came in at US$48.5bn in January, the biggest gap since March 2012. With US consumers buying more overseas goods and services, this is a clear sign that additional US dollar liquidity is flowing abroad. For two reasons, this is likely to mark the beginning of a new downward trend in the US current account:
1) The US dollar is overvalued. In relative terms, that makes non-US goods and services cheaper and US products expensive, leading global consumers to favor non-US goods and services.
2) Real yields are now higher in the US than in America’s major trading partners. This makes sense; the US economy is now approaching full capacity, while other major economies, notably in Europe, are still in the early stages of recovery. In the past this dynamic has been highly supportive of capital flows into the US, encouraging a widening of the current account deficit (see chart).
The caveat here is that a wider current account deficit would conflict with Trump’s policy goals. The risk, therefore, is that the administration could pursue disruptive measures to prevent the current account deficit from blowing out, such as coordinated currency intervention or outright import tariffs. However, with the focus of the White House now turning to domestic tax reform, a unilateral attempt by the administration to constrain the current account deficit remains a distant prospect, at least for now. Given the strong pick-up in international demand, and the cyclical dynamic in the US, investors should look beyond US shores for investment opportunities.