Trumpflation - A Special Report

The two major price activity themes of the post-election rally, even strengthening across regions and sectors as well as broad day-on-day, evenly timed gains, collectively point to healthier, trend-bound movement. As opposed to exuberant price activity that would likely serve to fuel a balancing sell-off in the future, the particular movement currently seen is indicative more of stability and consistent growth. A new year, a new market perhaps? 

Although the supporting evidence behind the current wave of bullish ideation remains fundamentally and logically consistent, the journal emphasizes that risk factors that have caused previous sell-offs still remain and would like to take time out of next few journal editions to discuss particular issues and scenarios we see as pertinent for the year ahead. In this edition, we’ll discuss the impact of higher interest rates and the particular implications on foreign-exchange risk and debt sustainability.” 

A primary focus of the recent post-election rally has been the potential effects of a business-orientated Trump administration on future interest- rate policy both in the United States and internationally. The so-called “Trumpflation” theme, although enabling a significant breakout rally in stocks, has rattled bond markets as market participants adjust risk premiums in a rapidly changing marketplace. 

For those unfamiliar, business-friendly policies that would incentivize investments into higher net production of goods along with new economic innovations that would boost productivity rates together would both boost economic growth. As a result, monetary policy authorities, like the Federal Reserve, would need to adjust interest rate levels to better reflect a growing or “hotter” economy such that the conditions necessary to receive credit are more restricted. This is done to prevent “overheating”, in which case inflation would rise to unhealthy levels while at the same time growth falters following a wave of irrational exuberance (“Stagflation”). Under the most preferable scenario, investment- inducing policies would extend the current post-financial crisis business cycle while also forcing adjustments in interest-rate policy that would make the process of obtaining credit that much more difficult and expensive. 

However, the situation as it stands today is substantially different from the past scenarios central banks faced. For one, the global economy, not just in the United States, continues to expand at some of the lowest growth levels seen historically. This is reflected in the current interest-rate environment, in which now, quite ironically, the market provides some of the easiest credit conditions in history following what was largely believed to be a credit bubble-induced recession. Much of the new financial support provided by central banks, such as quantitative easing, has eased credit conditions even further, questioning the true integrity of the current economic expansion. Many economists question the feasibility of raising interest-rates further as such hikes may induce another recession if the economy is not fundamentally strong enough to sustain itself without abnormally low interest rate policy (ZIRP or near ZIRP). Some investors remain concerned about the existence of “zombie companies” that can only exist profitably in an artificially low interest rate environment. Once interest rate levels are forced to normalize following a wave of inflation, the companies unable to survive without external support would fade into obscurity, potentially along with millions of jobs and the billions of dollars those jobs provided in relation to spending power. The question of fundamental, structural strength in the post-financial crisis expansion needs to be further investigated before any serious changes in the credit environment can be made. 

Two, a higher interest rate environment would limit future government spending and threaten the government’s general financial standing. Just as tighter credit markets negatively influence the ability of companies to receive credit, it also disrupts the public sector’s access to credit. Higher interest rates would make the Trump administration’s plans for investments into infrastructure as well as border security far more expensive given that they would likely expand the United States’ spending deficit. Additionally, such a new credit environment would also increase the costs for servicing debt both domestically and globally. Many developing economies have assumed debt denominated in US dollars. As the value of the dollar rises against other currencies whose monetary policy authorities continue to practice quantitative easing and low-interest rate policies, the value of the debt owed increases, significantly compromising the financial positioning of many developing countries. 

Three, higher interest rates may negatively impact the incoming administration’s political popularity, making the issue of central bank policy that much more politically important. In the past, the Federal Reserve and presidential administrations have had conflicts, most notably during the Nixon administration whereas the Federal Reserve was goaded into holding interest-rate policy at abnormally low levels for a rapidly expanding US economy. This conflict rapidly evolved into a national inflation crisis, showcasing the potential for dangerous political involvement inside monetary policy bodies. Higher interest-rates will make it more difficult for families to buy homes, take out credit for consumption, etc. Without underlying economic strength, such policies would dramatically threaten the Trump administration’s political existence. However, if any influence was to be held, necessary policy decisions could be thrown off course in favor of short-term political gain. Politics will become increasingly more important as the landscape becomes more divisive and political support for the new establishment becomes threatened. 

There are many ways in which higher interest-rate policy can throw both domestic and international economic prospects off course. Economic fundamentals must be investigated and analyzed further by investors in all markets so that the proper hedging decisions can be made against a rapidly-changing, volatile marketplace. If we learn anything from this, it ought to be the realization that our capital is always at significant risk.