Published in the Nikkei Asian Review 11/1/2017
In a matter of days, Donald Trump will be sworn in as the 45th President of the United States. His distinctive personality and political style loom large in media coverage and the new administration’s proposals will be the subject of intense debate. Yet Trump did not create the deeper forces that swept him to power. He merely responded to them better than his rivals.
For investors, the big picture is much more important than policy details. Across the developed world a turning point has been reached in the multi-decade political cycle. A transition in the long cycle of inflation and deflation is likely to follow, with enormous implications for key asset classes.
To recap the extraordinary events of the presidential race, Trump was a political neophyte. He was outspent, out-organized, and out-debated by his opponent, lambasted by the mainstream media, indeed by the leaders of his own party, and ridiculed by social elites. Yet he won, by a comfortable margin of electoral college votes – and saw off two of the U.S.’s most powerful political families, the Bushes and the Clintons.
Trump’s message was improvised rather than thought out, but the essence was a repudiation of the long-held tenets of pro-business Republicans and moderate Democrats – free trade, fiscal hawkishness, toleration of mass immigration, a general presumption that the market delivers the best outcomes, focus on the supply side of the economic equation and willingness to put key areas of policy in the hands of supposedly neutral technocrats, like central bankers.
In most spheres of human activity what works gets imitated. Trump’s message worked and politicians everywhere will have sat up and taken notice. In some countries, the Trump phenomenon may be repeated as populists move into government; in fact half-a-dozen European countries already have populist parties in government, either via coalitions or on a standalone basis. Elsewhere mainstream parties are likely to incorporate populist themes into their programmes in order to remain viable.
In the UK this happened last year, with stunning speed. Prime Minister Theresa May supported “Remain” during Britain’s EU referendum campaign, as did then-Prime Minister David Cameron and most of the ruling Conservative Party and business lobbying groups. She is now strongly committed to leaving the EU, which makes electoral sense since two thirds of the public wants to proceed with Brexit, but has alienated big business and other usually Conservative-friendly groups.
May’s volte face is not restricted to the UK’s membership of the EU. Just as Trump rejects the intellectual legacy of his Republican predecessors, so May is turning her back on the small government, anti-egalitarian principles of the UK’s first female prime minister, Margaret Thatcher.
In the mid 1980s Thatcher was quoted as saying “there is no such thing as society.” In stark contrast, May recently declared “there is more to life than individualism and self-interest. The social and cultural unions represented by families, communities, towns, cities, counties and nations are the things that define us… And it is the job of government [my emphasis] to encourage and nurture these relationships and institutions where it can and to correct the injustice and unfairness that divides us.”
Like Trump, May has criticized central bank policies, thus busting a taboo of the current orthodoxy, and is willing to intervene in private sector decisions, as evidenced by her persuasion of Nissan to keep its operations in the UK. Just as Trump identified an important new demographic of discontented voters in the American heartlands, so May is pitching for the support of the “JAMs” (people who are “just about managing”) and the working class.
In political terms, her new approach has produced results. The support rating of May’s Conservative Party has risen to levels rarely seen in the last 30 years.
BACK TO THE FUTURE
The Reagan and Thatcher era was born at a time of seemingly unmanageable inflation, poisonous labour relations and double digit interest rates. The solution – an intense, recession-inducing monetary squeeze – inflicted severe social and economic damage, but was nonetheless supported by large sections of the electorate who had seen their savings devastated by inflation. Deregulation, tax cuts to increase incentives, privatization, confrontation with militant unions and other supply side reforms became important parts of the policy mix. Over time many other countries followed suit.
That seems like ancient history – and it is. The issues pre-occupying voters today could hardly be more different – stagnant wages, declining job quality and fraying of the social fabric. The economic background is of weak nominal GDP growth, the lowest interest rates in centuries and the extraordinary wealth accumulated by “the 1%” and the quasi-monopolies of the New Economy.
Radically different problems require radically different solutions. Almost by definition, successful treatment of these ills must involve higher nominal GDP growth, higher wages and flatter income distribution. Instead of freeing up the supply side, the political impetus will be towards tightening it – less trade, less off-shoring, less immigration, higher minimum wages, public interest restrictions on M&A, tax raids on unpopular sectors and activities, increasing regulation and perhaps even break-ups of the New Economy giants.
As in the early 1980s nobody knows what will produce the desired results. The process will be one of trial-and-error and it will be many years in the future before a successful policy mix gets crowned with a title like Reaganomics or Thatcherism. If Trump and May fail, others will appear to take up the challenge. A return to business as usual is unlikely.
WINNERS AND LOSERS
The message for investors is that the current extraordinarily low level of bond yields is part of the problem and therefore higher bond yields must be part of the solution. Successful reflation must bring a decisive end to the 35 year bull market in bonds. Equity markets usually do well when inflation is in the 1-4% band, but in some countries the upper limit will be breached. Furthermore, today’s historically high profit margins would be unlikely to survive the political rebalancing, with labour-intensive industries particularly vulnerable.
In terms of national markets, the return of inflation would create unexpected winners and losers. Just as the U.K, which had the worst inflation profile in the 1970s, was the greatest beneficiary of the disinflation of the subsequent three decades, so the countries currently suffering the most from deflation could benefit the most in the next cycle. That would mean Japan, Taiwan, perhaps even the countries of southern Europe if they were able to leave the Euro.
On the other hand, some of today’s emerging economies might drop into a spiral of high inflation and political crisis and consequently disappear from the list of investable locations. Others, including some of the largest, may seek to protect themselves by raising barriers to capital inflows and outflows – thus reversing the financial liberalization that has been the dominant trend for so long. Populism thrives under deflationary conditions, as in Japan and Germany in 1928-33, but populism in power often brings high inflation as in Japan after 1935 and in Argentina for most of its history.
None of this will happen immediately. Judging by historical precedent, such transitions take years to complete, rather than months. And as Trump and May will soon find out, the beneficiaries of the previous disinflationary dispensation will fight tooth and nail — just as militant unions did in the early 1980s. Meanwhile a U.S. recession is overdue and financial crises and geopolitical jolts could occur at any time. In such cases, the policy responses are likely to become ever more aggressive. Once the direction of travel is set it cannot be easily reversed. That is why turning points are called turning points and long cycles are long.
The ascendancy of Donald Trump has destroyed conventional wisdom in the political world. The challenge to long-held assumptions in the world of investment is yet to come.