The optimism that has followed the election of Donald Trump
has pushed the Dow Jones Industrial Average to the threshold of 20,000, a
level that will be both a nominal record and a symbolic milestone.
Although this is not the way most observers had predicted that 2016
would play out, most on Wall Street have become extremely reluctant to
look a gift horse in the mouth…or to even look at him at all. The
impulse is to jump on and ride, and only ask questions if it pulls up
lame. But if this year has proven one thing, it is that predictions made by the consensus should not be trusted.
Back in the earlier part of 2016 the mood was decidedly darker. At
that point most people believed that the Federal Reserve would be
raising rates throughout the course of the year. While such hikes had
been anticipated (and delayed) for years, most took comfort in the
belief that the economy would be expanding nicely by the time the Fed
actually pulled the trigger. But in late 2015, the already tepid GDP
growth seen in the prior two years seemed to be decelerating. Investors
also concluded that Hilary Clinton was a lock to win the election,
thereby assuring that the anti-growth policies of the Obama
years would continue. Many looked at these developments and concluded
that the sins of the past decade, in which the Government and the
Federal Reserve had used unprecedented levels of fiscal and monetary
stimulus to prop up the economy and the stock market, had finally caught
up with us. As a result, the Dow Jones shed more than seven per cent in
the first two weeks of the year, its worst start on record.
But the year comes to an end amid a cloud of Trump-fueled
bullishness. The markets fully embrace an unapologetic capitalist, and
his team of billionaires, who promises to cut taxes, rewrite trade deals
in America’s favor, take a machete to anti-growth regulations, repeal
Obamacare, and return America to its former industrial might. Many are making parallels to the Reagan Revolution
in which a maverick anti-establishment Republican took charge in
Washington and ignited an economic boom, a stock market rally and a
surge in the dollar. But to make this comparison, boosters must
jump over a more telling comparison to the last Republican president
elected, George W. Bush.
The parallels to W. are striking. Both lost the
popular vote, and will have taken office following the tenure of a
two-term Democrat who had presided over a furious stock market bubble
and a surging dollar. In the 4 years prior to Bush’s election, the Dow
Jones had surged approximately 60% and the dollar index had risen
approximately 19% (1/2/97 to 12/29/2000). For Trump, the numbers are 48%
and 24% (1/2/13 to 12/21/16). Then, as now, the U.S. was seen by
investors as the only game in town. Clinton’s second term was rife with
global crises that both created safe-haven flows into the dollar and
caused the Fed to backstop U.S. financial markets with cheap money (at
least cheap by the standard that existed at the time). Both will have
come into office promising tax cuts and regulatory relief following
eight years of Democratic reign. As a result, the market gains of the
Clinton and Obama years were expected to continue under their Republican
successors.
But the optimists did not anticipate that the big, fat, ugly bubble
that inflated during Clinton’s second term, would burst early in Bush’s
first term (although the air started coming out of that bubble while
Clinton was still in office). Given the ensuing recession of 2001, it
can be argued that the only reason Bush was reelected in 2004 was that
the Fed was able to inflate an even bigger, fatter, and uglier bubble in
housing that postponed the pain until the financial crisis of 2008.
That is where the similarities will likely end, as Trump will likely not
be that lucky.
One of the pillars of dollar strength under Clinton was eight straight years of deficit reductions,
culminating with a massive $236 billion budget surplus in 2000
(Congressional Budget Office). While the surplus did require some
accounting smoke and mirrors and a stock market bubble to create, it
nonetheless marked a significant achievement. At that point, many
economists had assumed that the U.S. debt problem had largely been
solved and that the country would ride a wave of permanent surplus. The
only problem most could envision was a shortage of Treasury bonds once
the national debt was fully repaid. No one is to worried about that
“problem” now.
Similarly, Trump is taking charge at a time when official budget
deficits have fallen consistently since 2009 (albeit from astronomically
high levels). But 2016 is projected to be the first year since 2009 in
which the deficit will have risen, significantly, from the prior year.
The Congressional Budget Office sees a return to perpetual $1 trillion
plus annual deficits in the early part of the next decade (The Budget
and Economic Outlook: 2016 to 2026 report, January 2016), even if we
have no tax cuts, spending increases or recessions over that entire
time. Under the Trump presidency, we are likely to get all three.
If a recession comes early in Trump’s presidency, it will be no more his fault than the 2001 recession can be blamed on Bush.
A sharp pullback has been years in the making. Firstly, there is simply
the issue of timing. On average, the U.S. has experienced a recession
every 60 months or so since WW II (based on data from National Bureau of
Economic Research and Bureau of Labor Statistics). The current
expansion is already 90 months old, or 50% longer than average. Sooner,
rather than later, it will have an end date. Recessions completely
reshuffle the budgetary deck, causing government outlays to rise and
revenues to fall simultaneously. The swings can be dramatic. The
1981-1982 recession resulted in a 61% increase in Federal red ink. The
recession of 2001 turned a $236 billion surplus in 2000 into a $377
billion deficit in 2003 (then a record). The Great Recession of
2008-2009 caused the $458 billion deficit in 2008 to more than triple to
$1.4 trillion in 2009. Rest assured, the next recession can cause a
similar catastrophe to the government’s finances.
Trump’s election was predicated on his intention to buck traditional Republican policy of fiscal restraint.
He has promised tax cuts for people and corporations and massive $1
trillion plus spending binges on infrastructure and the military. Of
course the argument goes that these moves will stimulate growth thereby
raising tax revenue to pay for both the cuts and the spending. The same
arguments were made by George W. Bush in 2001 when he cut taxes,
increased spending, and pushed through a temporary tax holiday to
encourage corporations to repatriate money held overseas. Deficits
soared anyway. The only real question is will the recession arrive before or after Trump’s fiscal policies kick in. If the events happen simultaneously, the budgetary implications will be hard to fathom.
Investors who are basking in the Trump victory should take a hard
look at what happened to the markets during the Bush presidency. In
mid-2008 (just a few months before the financial crisis sent stocks
plummeting), the S&P 500 was just 17% above the level when Bush was
elected nearly eight years earlier. The dollar, in particular, took a
beating under Bush. In August 2008 (right before the dollar rallied
temporarily as a result of the panic), the dollar index had fallen by
19% since his election. The opposite occurred in gold. In November of
2000, gold was at about $370 per ounce, close to a 20 plus year low. In
August 2008, it was more than $920, down significantly from it’s high of
almost $1,100 hit earlier that year.
Also, for all the optimism about the U.S. stock market and
pessimism abroad, it was foreign markets that delivered for investors.
From Bush’s election to mid-2008, just before the global financial
crisis sent stocks reeling around the globe, developed foreign markets
were up 80% (priced in U.S. dollars) while emerging markets were up a
staggering 300% (priced in U.S. dollars). Even if you include the huge
losses in the back half of 2008, by the time Obama was sworn in,
developed markets were down less than 3% from the time of Bush’s
election, and emerging markets were still up about 80%. (In contrast,
the S&P 500 was down almost 27%).
The 2001 Recession, which was triggered by the bursting of the
dotcom bubble and the September 11 attacks, came very early in Bush’s
first term. Fortunately for W., the Federal Reserve was able to support
the economy by bringing rates down from more than 6% to just 1% (Federal
Reserve Bank of St. Louis) (which helps explain the swift collapse of
the dollar). As a result, the 2001 recession was the shortest and
mildest on record. In doing so, however, the Fed blew up an even bigger
bubble in real estate, the bursting of which created a far bigger
recession in 2008, propelling Obama into the White House.
But can the Fed ride to the rescue this time around? Given that
rates are practically zero and the Fed is choking on trillions of
dollars of assets that are permanently held on its balance sheet, the
answer is clearly no. All the Fed will be able to do is launch the
mother of all QE programs, perhaps in the form of a massive helicopter
drop. But the bad news for Trump fans is that the result will not be a
housing bubble like the one that bailed out Bush, but a wave of
stagflation that will make Trump a one-termer. The nightmare
scenario is that once again tax cuts and deregulation take the blame,
allowing Bernie Sanders or a socialist candidate to ride another
populist wave, only this one headed far left, into the White House o
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