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WILL TRUMPFLATION TRUMP PROTECTIONISM?

February 2017

Multi asset views from RLAM

Royal London Asset Management manages £99.6 billion in life insurance, pensions and third party Funds*. We have launched six Global Multi Asset Portfolios (GMAPs) across the risk return spectrum with a full tactical asset allocation overlay.

*As at 31/12/2016

This month’s contributor

Ian Kernohan

Senior Economist

In the latest UK Inflation Report, the

Monetary Policy Committee (MPC) of the

Bank of England reduced their estimate of

the equilibrium unemployment rate, from

5% to 4.5%. This is an important change

and comes after a lengthy period when

MPC forecasts of a pick-up in wage growth

have consistently undershot. Given that

wage pressures in the UK remain subdued

(see chart opposite) and well below growth

rates seen prior to the financial crisis, we

think monetary policy settings will remain

very loose for some time. Even aside from

Brexit uncertainty, this will weigh on

sterling versus the dollar, at a time when

the Fed look set to tighten their policy

stance further.

The major market surprise of recent months is that the election of

Donald Trump as US President has acted as a positive catalyst for risk

appetites. Global economic data has also shown good signs of

improvement. Investors will need to see greater detail from the Trump administration on fiscal stimulus, tax reform and deregulation, if the

equity market rally is not to be undermined.

Summary

A key element of the “Trumpflation” trade is the anticipation of US corporate tax

reform. If these plans get bogged down in Congressional politicking, an important

plank of the post-election equity market rally will be undermined. We look at this

issue in greater detail. Ahead of any news on fiscal stimulus however, most

economic indicators in the US suggest a robust start to the year. We expect the US

Federal Reserve (Fed) to continue to tighten monetary policy.

A year ago, fears of China exporting deflation was a major market theme, however

twelve months on, the situation looks very different. Faster nominal GDP growth

in China has eased a revenue squeeze in the corporate sector, while the large

domestic savings pool, closed capital account and lack of foreign debt has reduced

the risk of a classic Emerging Market crisis. We are not complacent however, and

will maintain a close watch on economic indicators as we exit the New Year holiday

period.

Inflation is rising globally, even in the Eurozone, although most of this reflects the

diminishing drag from past falls in commodity prices, rather than a pick-up in

underlying inflation. Despite the fall in unemployment, wage growth has remained

muted, at just 1.4%yoy in Q4 2016, and we expect the ECB to maintain its dovish

stance, especially during a period of heightened political uncertainty.

UK GDP growth was 0.7% quarter-on-quarter (qoq) in the final three months of 2016, driven mainly by activity in the service sectors and indicating continued robust growth in household spending. Excluding the volatile oil & gas sector, GDP growth was even stronger, at +0.8%qoq. Looking ahead, growth is likely to be hampered by a squeeze on real household incomes, as inflation rises.

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ECONOMIC OUTLOOK

Global: momentum in the global economy has

improved, however reviving global trade will be

key to a sustained recovery

Growth in global trade has gone through several phases, and a

number of key developments since World War 2: the 1947

General Agreement on Tariffs and Trade (GATT) which

morphed into the World Trade Organisation (WTO) in 1995,

the rise of China post the 1978 market reforms (culminating in

joining WTO in 2001), the end of the Cold War in 1989, the

launch of the Single European Market in 1993, and the Great

Financial Crisis (GFC) of 2007/8.

The chart of world exports shows how far global trade has

slowed in the post-GFC period, with the five-year moving

average slipping towards zero. Reviving global trade will be

key to sustained economic recovery, which is why the

protectionist rhetoric of the new Trump administration has

raised so many concerns. A sustained contraction in global

trade would hit overall global GDP growth, and worsen the

growth/inflation trade off.

US: business and consumer surveys suggest a

strong pick-up in economic growth

US GDP growth fell from 3.5% (annualised) in Q3 2016 to 1.9%

in Q4, as a one-off boost from net trade unwound. By contrast,

the more important payroll data showed employment growth

remained robust in the three months to January, and while the

unemployment rate has risen a little, this was due to a rise in

labour market participation. Despite the fall in unemployment

over recent years, growth in labour costs, as measured by the

Employment Cost Index, has remained modest, at just

2.3%year-on-year (yoy) in Q4 2016.

Our base case assumes GDP growth picks up in 2017, and the

most recent survey indicators of output growth, as well as

measures of consumer and business sentiment, tend to support

this.

Looking further ahead into 2018, growth should also be supported by a fiscal stimulus, although there is considerable

uncertainty over the scale, timing and composition of this.

Mr Trump’s inauguration speech was uncompromising in its

tone - “we’ve defended other nation’s borders while refusing

to defend our own”, “we will follow two simple rules: buy

American and hire American”. Protectionism, heightened

geo-political risk, and the new President’s general

unpredictability seem to be the greatest concerns for investors.

We expect the US Federal Reserve (Fed) to continue to raise

rates this year, although they will be wary of excessive dollar

appreciation, and the impact of higher bond yields on

mortgage rates. A further hike of the Fed Funds rate is likely in

Q2.

The long-term drivers of economic growth are workforce

growth, capital investment (technology, buildings etc.) and

how labour and capital combine to boost efficiency (Total

Factor Productivity (TFP), or Innovation). In the US, TFP grew by an average of 1.8% per annum from 1995-2004, but

has since slowed to around 0.5% per annum. One possible

explanation is that compared with previous decades, the most

recent technological innovations have been more focused on

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leisure than on businesses. At same time, labour force growth

has slowed, while educational attainment has plateaued.

Taken together, trend growth could be as low as 1.75% pa,

compared with 3-4%+ in most of the post-war period up to

2005, which was boosted by rising female and baby boomer

participation, at a time when productivity growth remained

close to 2% pa. Immigration reform and protectionism will

weigh on trend growth, while tax reductions and deregulation

will be offsetting factors. The Fed will have to weigh

“Trumpflation” against “Trumprotection” in assessing the pace

of interest rate hikes.

China: faster nominal GDP growth helps ease

China’s debt concerns (for now)

Real GDP growth has been stable in recent quarters, however

nominal GDP growth has risen. Survey indicators point to

continued robust growth in the near term. GDP grew by

6.8%yoy in Q4, led by the services sector. This sector now

accounts for more than half of economic activity, and there is

still scope for further growth in many areas, such as healthcare

and leisure, which are underdeveloped. The rise in nominal

GDP growth has eased revenue and debt servicing pressures in

the corporate sector. Thus, a mild pick up inflation has been a positive for China.

On the expenditure side, a rising share of GDP accounted for by consumption suggests continued rebalancing away from a

reliance on net trade. On the surface, this is a positive

development, however domestic demand growth has become

increasingly dependent on credit growth, which poses a risk to

the medium-term sustainability.

China’s non-financial sector debt to GDP ratio was estimated

by the Institute of International Finance (IIF) to be 255% in

Q316, around 100 percentage points higher than in 2008. On

the plus side, the debt burden has shifted in recent years, away

from more vulnerable areas such as local government and

corporate sectors, towards central government and the

household sector. Faster nominal GDP growth has eased a

revenue squeeze in the corporate sector, while the large

domestic savings pool, closed capital account and lack of

foreign debt, reduces classic EM crisis risk.

An acceleration in capital outflows is also a risk to domestic

demand. Over the past six months, the renminbi has fallen

against the dollar, despite intervention by the authorities. In

response, the authorities have placed restrictions on domestic

households’ and corporates’ overseas transfers and

investments.

House price inflation has slowed, and with housing by far the

largest share of household wealth, a large property crash

remains the biggest downside risk to the economy.

The People’s Bank of China (PBoC) want to curtail speculative

housing purchases, while avoiding any collapse in prices. They

have provided some support by reducing minimum down

payments for First Time Buyers from 30% to 25% in 2015 and

then to 20% in 2016, although these are still high by

international standards. On second homes, down payments

have been lowered to 30%, while mortgage rates have also

fallen.

Increased trade friction with the US is also a downside risk for

China, though to date there have been some signs of

rapprochement here, with Mr Trump acknowledging the “One

China”1 policy.

This year will be critical for President Xi Jinping, as he

prepares for a leadership transition, which will determine

whether he will be able to push through difficult economic

reforms during his second term. While the impact of the

2015/16 stimulus will wane, we would not expect growth to

weaken materially during 2017. Over the longer term however,

the pace of economic growth will slow further, due to

demographic factors and a slowdown in productivity gains. At

some point the official GDP growth target will be reduced to a

range below 6%, to take into account shift to services and peak

in working population size.

Eurozone: stronger global growth will provide

support, however the boost from cheaper energy

is waning

Eurozone GDP growth was 0.4% in Q4 2016, the same as in

Q3. Employment growth has picked up, while the

1 This refers to a diplomatic understanding by which the US does not

challenge China’s claim over Taiwan.

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unemployment rate has fallen from 12% three years ago, to less

than 10% now.

Headline Consumer Price Index (CPI) has risen sharply, to

1.8% in January, although this reflects the diminishing drag

from past falls in commodity prices, rather than a pick-up in

underlying inflation. Despite the fall in unemployment, wage

growth has remained muted, at just 1.4%yoy in Q4 2016.

We expect activity to be supported by loose monetary policy, a

more expansionary fiscal stance, and stronger global demand,

however rising longer-term interest rates and the cost of

energy will offset this to some extent. In contrast to the US,

which will see a stabilisation in energy investment, the boost

from cheaper energy in the eurozone (a large net energy

importer) is now waning, with headline inflation set to rise,

squeezing still modest nominal income growth and consumer

demand.

The European Central Bank (ECB) has given notice that it will

extend its asset purchase scheme to December 2017, albeit

with the rate of purchases reduced from €80 billion per month

to €60 billion per month from April. The ECB remains a major

support for sovereign bond markets, ahead of a series of key elections.

Longer term, we think the current arrangements for the euro

remain sub-optimal, in the absence of greater fiscal and

political union. A monetary union without political and fiscal

union (or something very close), or a convergence in unit

labour costs is flawed. Brexit may open up an opportunity to

create such a union, however even among euro member

countries, there will be differences of view on the right

direction to take.

With large variations in Unit Labour Costs (competitiveness), a

one-size-fits-all monetary policy will mean some economies

run “hot” and some run “cold”. As an example, Germany runs

a large current account surplus, driven up the by one-size-fits-

all euro, and a constitutional balanced budget rule, which stops

German public sector from running a deficit. The size of this

surplus has attracted the ire of the new Trump administration,

however Mrs Merkel has replied that this is an inevitable

consequence of Germany’s membership of the Euro.

UK: the Bank of England sends a dovish signal in

the latest Inflation Report

GDP growth was 0.7% quarter-on-quarter (qoq) in the final

three months of 2016, driven mainly by activity in the service

sectors and indicating continued robust growth in household

spending. Excluding the volatile oil & gas sector, GDP growth

was even stronger, at +0.8%qoq.

What accounts for the strength in consumer spending?

Nominal wage growth has been subdued, however rising

employment levels have pushed up aggregate income, while

very low inflation has supported real incomes. Consumption

has risen faster than incomes, so the saving ratio has fallen.

If households expect any slowdown in real income growth to be

temporary, they may choose to reduce their saving rate further,

and maintain spending growth. Our base case is more

pessimistic however, and we expect consumption growth to

slow, as rising inflation impacts purchasing power.

The official estimate of business investment showed a decline

in Q4, although early estimates are volatile and prone to

significant revision. We believe that the impact of Brexit

uncertainty may take some time to show up in actual

investment, given the lead times involved, although some

investment to satisfy short-term demand may be unaffected.

Certainly, some survey indicators of investment intentions

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stabilised in Q4, but still suggest that investment growth will

remain subdued, especially in the service sector. The most

recent Deloitte CFO Survey indicates that levels of uncertainty

remains elevated.

By contrast, we expect the large depreciation in sterling since

November 2015 to support net trade, by reducing domestic

demand for imports and supporting UK exports in a stronger

global growth environment. Net trade was a significant

contributor to GDP growth in Q4. Overall though, our base

case is for growth to be slower in 2017 than 2016, as household

real income growth weakens and corporate investment is

impacted by uncertainty over future trading arrangements

with the EU.

Despite a decline in the unemployment rate from 8.5% to

4.8%, wage growth has stabilised at rates below those seen

during the pre-crisis period. Poor productivity growth and very low headline inflation are key factors here, however

beyond that, the relationship between pay pressures and the

rate of unemployment appears to have altered, suggesting a

decline in the equilibrium unemployment rate. In their latest

inflation report, the BOE reduced their estimate of equilibrium

unemployment to 4.5% from 5%. This equilibrium rate cannot

be measured directly. Instead, the BOE look at a range of

indicators and wage growth in particular, in order to deduce

any signs of change. The reduction is an important decision,

and reflects persistent undershoot of BOE wage forecasts. If

on the other hand, wage pressures recovery more quickly than

the MPC expect, it will be a clear sign that policy is likely to be

tightened.

There are risks to our base case on both sides: we may have

exaggerated the impact of Brexit on corporate investment, in

which case growth should hold up. A combination of cheaper

sterling and stronger global growth could offset any squeeze on

real incomes, via a stronger trade performance. If, however, households respond to the squeeze in real incomes and rise in

uncertainty by raising their savings rate, then the hit to

consumption and economic growth could be greater than we

are assuming. Since we expect global growth to hold up well in

2017, this should limit the downside to UK, as a medium sized

open economy with a cheaper currency. Thus we have

assumed weaker growth, rather than recession, as a base case.

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SPECIAL TOPIC - US

corporate tax reform

A key element of the current “Trumpflation” trade is the anticipation of US corporate tax reform. If these plans get bogged down in Congressional politicking, an important plank of the post-election equity market rally will be undermined. Fortunately, with Republicans controlling both the White House and Congress, the chances of major tax reform in the US are the highest they have been for many years, however the scale and mix of measures is still open for debate. President Trump has placed tax reductions high on his list of priorities, with the explicit aim of “encouraging” US firms not to move production overseas. House Republicans have also argued for tax reform. With some of the highest corporate tax rates in the G20, there is a long-standing complaint that current global tax arrangements are biased against the US.

The main points of House Republican Corporate Tax Plan are:

A steep cut in corporation tax from its current rate of 35%

A Border Adjustment Tax of 20%, which would “tax” imports implicitly, by removing the ability to deduct the cost of imported goods from taxable profits, while exempting export revenue from tax

An end to taxation of the foreign profits of US companies (ie tax only US based earnings), with a one-off tax on repatriating offshore cash. This reduction in the incentive to hold cash overseas would be a major blow to global tax havens.

Companies allowed to write off capex in the year it takes place, rather than over a number of years

An end to the deduction of interest payments from taxable profits, as this is thought to encourage over indebted capital structures

Supporters of reform argue that any new plan should be based on the very simple proposition that if something is consumed in the US, it should be taxed at an equal rate. World Trade Organisation (WTO) rules allow countries with VAT based tax systems to offer rebates on exports, however the US system relies much less on taxing consumption. Many countries levy VAT on imports, but not on exports. The most controversial element of the House Republican Plan

is the Border Adjustment Tax (BAT), which has polarised

opinion in the corporate sector. Consumer orientated

companies (eg. retailers) tend to be large importers, and are

very much against a new BAT. They view such a measure as an

inflationary tax on households, the very same low income

households that Mr Trump says he is trying to help. By

contrast, large industrial exporters are in favour of such a tax,

since it would end the current situation, where there are lower

taxes on imports than on US made goods.

Supporters of the BAT proposition argue that it would not have a long lasting impact on global trade, since “according to economic theory”, the dollar would appreciate to offset its impact, making imports cheaper and exports more expensive. Many are sceptical of this dollar view, especially since many economic models assume free-floating exchange rates, which is true for the euro and yen, but not China’s renmimbi. Whether President Trump would be happy to see a soaring dollar is also a moot point. On paper at least, the BAT would raise substantial revenue (a 20% tax is assumed to generate $1trn over 10 years) and help fund a much larger cut in corporation tax than would otherwise be possible. This has obvious attractions, however the position of the Trump administration is unclear. The BAT idea was not part of his campaign manifesto, originating instead from the House Republican Plan. Some voices in the White House, notably Peter Navarro head of the Trade Council, have said that BAT is just one of several options being looked at (higher import tariffs are the main alternative), rather than a central plank of policy. Senate Republicans also appear less keen on the BAT idea, especially if it would breach WTO rules, and help trigger an unravelling of the global trading system - a “beggar thy neighbour” dead end, where everyone loses. Already there are rumblings about a legal challenge by the European Union to the WTO, which does permit tax rebates linked to specific products, but not rebates to overall income. The EU will argue that BAT is not the same as VAT, since the latter does not impact a decision to source from domestic versus overseas. One major concern is that radical reform of US corporation tax, as part of the “America First” agenda, could feed the growing protectionist sentiment seen in recent years, and discourage or even reverse the globalisation process. A trend which has seen many large companies set up global rather than national supply chains. This would represent yet another example of the tensions created when a globalised economic system meets a political system still very much rooted in nation states. We assume some compromise on the overall Trump fiscal

stimulus, with tax and spending plans totalling 1-1.5% of GDP,

rather than the 3%+ outlined during the election campaign.

Mr Trump’s pre-election proposals also included a GDP growth

target of 3.5%, and a pledge to create 25m new jobs over 10

years. This would be more than three times the rate of job

creation since 2006. Since the global financial crisis, potential

GDP growth has slowed, as boomers retire and labour

productivity has weakened. Immigration has added around

0.4 percentage points per annum to population growth, so any

severe restrictions would also hit trend growth.

What happens next?

President Trump is due to address Congress on 28 February. The White House has also said that tax reform and other plans will be made public at or around this time.

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Republicans hold a narrow majority of 52-48 in The Senate. To avoid filibuster2, they will need 60 votes to pass legislation. There is the option to pass a “Budget Reconciliation” by a simple majority, but only if the proposed tax legislation is deficit neutral over a 10 year period.

Markets will be keen to see that any legislation is passed by the summer recess. Any signs of serious delay and a key plank of the post-election equity market rally will be undermined.

2 The filibuster is a device used in the Senate, which means that

most major legislation (apart from budgets) requires a 60% vote to bring a bill or nomination to the floor for a vote.

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CHARTWATCH

1. Measures of US business and consumer confidence have risen sharply since the November election.

2. In the UK, the number of long term unemployment has fallen, suggesting that this group may have become less “unemployable”, and thus are helping to curtail upward pressure on wages. Surveys of recruitment difficulties have remained close to or below their pre-crisis averages, despite falls in the unemployment rate, which also suggests some remaining slack in the labour market.

3. The Bank of England expects the labour market participation rate in the UK to remain broadly flat. An ageing population will tend to depress the aggregate participation rate, as older workers tend to work fewer hours, however the participation rate among older people has been rising, helping to offset this.

4. Eurozone employment growth has recovered, however wage growth remains weak. This will keep the ECB cautious, and we expect quantitative easing to continue.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.

Issued by Royal London Asset Management February 2017. Information correct at that date unless otherwise stated. The views expressed are the author’s own and do not

constitute investment advice. Royal London Asset Management Limited, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited,

registered in England and Wales number 2372439. RLUM Limited, registered in England and Wales number 2369965. All of these companies are authorised and

regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and

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