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The Trump Shock

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Patrick Kelliher

I write this just after the second presidential debate between Donal Trump and Hilary Clinton. With sordid details emerging of Trump’s attitude to women, his odds of winning have drifted out from 6/4 to 4/1 [1]. However, I don’t think Trump is out of the race yet. I think we will see more revelations about Hilary Clinton’s private e-mails which could yet turn the race on its head. I also think polls understate his vote as he is more popular with elderly voters who are more likely to vote on the 8th November. We could still see a shock win for Trump.

I have therefore been trying to think what risks President Trump may trigger. It is probably fair to say that his election will lead to increased US protectionism. TTIP and TPP will be dead in the water (if they are not already!). NAFTA could be scrapped, with adverse consequences for Mexico and Canada – as well as the US. As it takes a tougher stance on trade, there is a real risk of retaliatory tariffs and other measures, possibly leading to a breakdown in the global trading system. The parallels with the protectionism of the 1930s which exacerbated the depression are uncomfortable.

This would be just one example of Trump’s “America first, devil may care” attitude. His equivocation over whether he would come to the aid of NATO allies [2] could undermine confidence in the alliance. It may encourage Russian adventurism in the Baltic states for example, where there are large Russian minorities coupled with unhappy memories of Soviet annexation. Europe is weak enough as it is without the risk of conflict to its East.

One particular risk I see stems from Trump’s ambitious plan to cut taxes. He has been less forthcoming over where he might cut spending, other than ruling out major cuts to Social Security (pensions) and defence. His hope is that tax cuts will boost the economy, offsetting the effect of rate cuts, but that seems fanciful. I believe it is more likely that, like Reagan, he may be quite happy to let the national debt balloon [3]. 

This would have a number of consequences. Unless the Fed expands QE, it would probably lead to higher Treasury Bond (“T-Bond”) yields. I do not think this is necessarily a disaster as it would have a positive impact on pension scheme deficits and may help bank balance sheets, but it would lead to higher mortgage rates for US borrowers [4]. It might also fall foul of the “Tea Party” element in his own Republican party and lead to conflict with their caucus in Congress.

My fear is that Trump may seek to cut the “Gordian knot” of tax cuts versus deficits by imposing losses on America’s external creditors. This would probably not come as a formal default such as a “haircut” imposed on T-Bonds. More likely, the Trump administration might remove the existing “portfolio interest” exemption from withholding tax for overseas investors [5], effectively cutting interest payments by the withholding tax rate of 30%.

This could be viewed a pseudo-default by the US on its obligations, and it is not without precedent. In August 1971, Richard Nixon stunned financial markets by suspending the convertibility of the dollar into gold. This “Nixon Shock” ultimately lead to the breakdown of the Bretton Woods system of fixed exchange rates and contributed to rampant inflation in the 1970s [6].

So we might call the imposition of withholding taxes for overseas investors the “Trump Shock”. As well as cutting the net cost of US T-Bond coupons, the withholding tax would also apply to corporate bond interest payments previously exempt, adding to tax revenues. The consequences of such an action is likely to be a sell off of US bonds by overseas investors, pushing up US bond yields, though the Fed may intervene with QE to limit the rise in yields and mortgage rates.

Markets could be spooked by the pseudo-default of T-Bonds which are supposed to be one of the safest asset classes. Money typically flows into T-Bonds during market crisis, but where might it flow if T-Bonds themselves that are causing the crisis ? Investors are still likely to be in “risk off” mode, selling equities and other risky assets, but they may invest more in UK Gilts and other highly rated sovereign bonds as an alternative to T-Bonds. This could push UK bond yields down further, exacerbating pension scheme deficits [7].

There would be diplomatic consequences as well, as China is the largest external investor in US T-Bonds and might suffer the most from a tax raid. It is likely to come on top of fraught relations over the US trade deficit with China and currency rates. It may also exacerbate tensions around China’s claims in the South China Sea and China’s stand-off with Japan over the Senkaku/Diaoyu islands. While I view it as unlikely that China will engage in a massive sell off of its T-Bonds – this would push down the US$, making it harder for China’s exporters – this cannot be ruled out in the situation where diplomatic relations are fraying amid Trump’s aggressive stance on trade. A large scale sell off could overwhelm QE by the Fed and lead to a sharp jump in US T-Bond yields and a fall in the US$. This could turn the sell-off of T-Bonds into a rout and lead to a wider collapse in markets.

So if Donald Trump get elected, investors should be prepared for a Trump shock which could undermine the tax-efficiency and status of T-Bonds, pushing up T-Bond yields but possibly pushing down Gilt and other highly rated sovereign bond yields. It would spook markets leading to a sell off of equities and other risky assets. This would happen among wider trade and other diplomatic tensions which could spiral out of control, leading to a market crash.

Note that even if he doesn’t get elected, there is still a variant on the T-Bond shock scenario involving a budget clash between President Clinton and a Republican Congress. There have been a number of such confrontations in recent times, with both sides just backing down before it reaches the stage where the US government might need to skip bond payments, triggering a technical default on its debt. In an increasingly partisan political environment, there is always the risk that neither side backs down in a game of “chicken” with disastrous consequences: even a technical default could have severe implications for derivatives and other markets where T-Bonds are heavily used as collateral. This could make Lehmans look like a walk in the park…

On top of Brexit, ongoing tensions in the Eurozone, and the risk of a credit bust in China [8], the next year looks like it’s going to be a bumpy ride for investors…

[1] Source: Paddy Power – odds of 4/1 as at 12th October 2016.

[2] See for instance: http://www.bbc.co.uk/news/world-us-canada-36852805  

[3] In Reagan’s term in office, the US national debt increased from US$997bn to US$2.85trn as the US went from being the world’s largest creditor nation to its largest debtor.

[4] Unlike the UK, but like continental Europe, mortgage rates are fixed over the term of the mortgage, so the rates for new mortgages will be driven by long-term bonds yields and the yields on T-Bonds in particular.

[5] For more details on US taxation of Treasury Bonds and other assets held by non-residents, see: http://crossborderalliance.com/Resources/NRA%20Tax%20guide.pdf  

[6] See https://en.wikipedia.org/wiki/Nixon_shock . In retrospect, perhaps the shocking thing about this “Nixon shock” is that it was a shock at all. The US was running persistent deficits to finance its war in Vietnam and there was a steadily accruing pool of dollars building up overseas against a finite reserve of gold. One could argue the writing was on the wall when De Gaulle insisted on converting France’s dollar reserves into gold in 1965, but I digress… 

[7] See my previous blog on QE: http://www.crystalriskconsulting.co.uk/qe-ndash-fuelling-the-downturn-10.html  

[8] The Bank of International Settlements recently estimated that China’s debt : GDP ratio is 30% above trend, against a warning level of 10% they monitor against – see http://www.bbc.co.uk/news/business-37403363?intlink_from_url=http://www.bbc.co.uk/news/topics/41b5bb04-b97c-4705-bb42-fb7438aba2cb/china-economy&link_location=live-reporting-story

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