If you want to see how financial markets react to a political crisis, look at Brazil. Last Thursday, the Bovespa stock market index plunged 10 per cent as new developments in the corruption scandal around President Michel Temer increased the odds of his impeachment.
Apropos impeachment, the US S&P 500 index also had a wobble last Wednesday, falling by 1.8 per cent as Deputy Attorney General Rod Rosenstein announced a special counsel to take over the investigation into Russian interference in US politics.
But by Friday, the US market was barely lower than it had been before. The trade-weighted US dollar index, up 6 per cent early this year, is now back to where it was at the election. Does this suggest that the Trump trade—radical tax cuts and changes in tax reform, deregulation and infrastructure spending—might be toast?
What spooks financial markets is discontinuity. This is why they have come through many political shocks, such as 9/11, that had few enduring economic consequences.
But while the allegations against Donald Trump and his team, and the investigations, make for lively political coverage, will they lead to impeachment proceedings? And, in the meantime, will Washington be so preoccupied with the allegations and investigations that the legislative functions of the government are impaired—at least as far as the key planks of economic policy are concerned?
Comparisons with Watergate
Understandably, last week led many people to recall Watergate, when Washington was consumed by scandal and impeachment proceedings against Richard Nixon that ended with his resignation. During those years, the US stock market went through a brutal bear phase with the S&P index falling 50 per cent between the start of 1973 and Nixon’s resignation in August 1974.But any lessons for today are highly tenuous. This was also a time that saw the quadrupling of oil prices, a deep recession in 1973-4 that pushed unemployment up to 9 per cent, and a surge in inflation from 3.6 per cent in January 1973 to 12 per cent by the end of 1974.
Today’s economic environment is much more benign, though the equity market is at an expensive level. Even though the economy grew by just 0.7 per cent at an annual rate in the first quarter, the “nowcasts,” or real-time GDP forecasts produced by the Atlanta and New York Federal Reserve Banks, suggest that growth in the second quarter is shaping up at around 4.1 and 1.9 per cent, respectively.
The underlying rate, given that there seems to be a seasonal adjustment issue with first quarter numbers, is probably around 2-2.5 per cent—pretty much where it has been since the expansion started in 2009. Inflation is subdued. And even though markets are expecting the Federal Reserve to raise interest rates three times—some expect four—over the coming year, they have also been buoyed by a sharp turnaround in corporate earnings. After a five-quarter earnings recession that finished in the third quarter 2016, they were up around 14 per cent in the first quarter of 2017.
For the moment, then, the economy looks to be in reasonable shape, and markets are optimistic about corporate profits.
The business of government
Moreover, the business of government goes on, at least as far as it matters to the economy and to financial markets. Last week, the administration announced that renegotiation of NAFTA, the North American Free Trade Association comprising the US, Canada and Mexico, would commence with a view to completion by the end of the year. The House of Representatives began hearings on proposals related to tax reform.The government may yet try kick off discussions about infrastructure soon. On Tuesday, the US government will present budget proposals to Congress that aim to balance the budget by 2027. It is expected to provide for a 10 per cent rise in defence spending in 2018, and for over $50bn in federal spending cuts on social programmes, education, foreign aid, housing and the environment. The Office of Management and Budget will claim tax reform and deregulation will boost growth and be self-financing.
I have argued before that this is fantasy. Look out for fanciful and unrealistic assumptions about economic growth and interest rates in the administration’s pitch.
Two outcomes
There are basically two outcomes for markets.The government could certainly do with some good news. With the appointment of a special counsel, Congress might find space to go for the tax cuts, tax reform and infrastructure agenda. That said, very few programmes command broad Congressional support, and many such as tax cuts for the better off and large spending cuts are not popular in the country.
In that case, the biggest risk to the Trump trade, and the credibility of the administration’s tax and spending claims, is that the economy drops into a recession in 2018-9. This expansion will be 96 months old next month, a month more than the average of three expansions since 1990, and nearly twice as long as all expansions going back to the 1950s.
As the economy eats up diminished capacity, and the Federal Reserve raises interest rates, we should expect the markets to start discounting a cyclical about-turn in the not too distant future.
Politics could cut short the wait. Tax reform expectations may end up punctured because they are too difficult to deliver. Enough Republicans may come to feel that it would be better to keep a distance from the White House ahead of next year’s mid-term elections.
Special Counsel Robert Mueller’s investigations will be thorough and take time. Congressional committees will continue to hear evidence and probe witnesses. The White House will be batting charges and defences back and forth, and the president may lash out at home or abroad, and also be unable to forge a consensus to pass economic legislation.
If the chances of a bigger political crisis increase, fear of discontinuity will shred the Trump trade and end the bull market. Faites vos jeux.
