The last 18 months have seen a rejection of the status quo in multiple elections, from the Brexit vote to the U.S. presidential election to the recent Catalonia vote. Last week, we saw the U.S. and U.K. continue to work through the changes stemming from their elections – and we saw one key region buck this trend and embrace the status quo as the way to move forward.
Below, I discuss four key themes from the headlines last week.
1. Embracing the status quo while moving forward
Japanese citizens voted emphatically for the status quo with Prime Minister (PM) Shinzo Abe. PM Abe’s decision to call snap elections in October brought back memories of U.K. Prime Minister Theresa May’s ill-fated decision to hold elections last spring. However, the outcome in Japan could not have been more different than the one in the U.K. – PM Abe won a resounding victory, which translates into a mandate for his agenda going forward. And that agenda is an ambitious one, largely focused on the economy. It would mean a continuation of ultra-accommodative monetary policy. In addition, PM Abe intends to implement a consumption tax but, rather than use the proceeds for debt reduction as originally had been planned, he would like to use some of the revenue to support education and elder care. He also wants to expand Japan’s military capabilities. Recall that after World War II, Japan was forced to relinquish its traditional military and instead rely on its allies. But today, when allies such as the U.S. might be less reliable, that arrangement presents a difficult situation for Japan – particularly given growing aggression from North Korea. It makes sense for Japan to want to build its military – particularly nuclear capabilities. We could see a similar reaction from South Korea. However, such moves will likely be opposed by China, which would like to maintain the status quo militarily in Asia.
In related news, the 19th National Congress of the Communist Party in China opened last week and, as expected, there were important developments for China. First and foremost, President Xi Jinping hinted that he would like to continue as the leader of China beyond the end of his term. He is clearly consolidating power. So in terms of leadership, the status quo may last longer than expected – but that doesn’t mean that President Xi will be looking backward. In fact, he plans to embark on a period of change for China – a “new era” that will achieve the “Chinese dream.” In echoes of Maslow’s hierarchy of needs, where the most basic needs are satisfied then humans move on to higher-minded needs, China is focusing on higher-minded needs such as fairness, justice, security and the environment now that basic economic needs have been met. President Xi shared a two-stage development plan for the future. By the end of the first stage, expected to last from 2020 to 2035, China plans to have a strong rule of law in place as well as global influence – and is expected to be a global leader in innovation. In the second stage, China is expected to become more prosperous and culturally advanced – and an even more powerful force in the world.
The key takeaway from the Congress is that China’s economy is in transition; specifically, it is moving from a “fast growth” economy to a more mature economy focused on “high-quality development.” This means that China must ensure its economic structure is adapting and its growth drivers are changing. That means more emphasis on high-end manufacturing industries as well as internet technology, big data, artificial intelligence, green energy and other “new economy” industries. In addition to a variety of economic reforms, China has a strategy for increasing its influence in the world; part of that plan involves a stronger and more modern army. The implications of a maturing economy include, of course, lower growth.
2. Geopolitical uncertainty continues
Negotiations over the future of the North American Free Trade Agreement (NAFTA) remained acrimonious, with little progress being made. As a result, they were extended into the first quarter of 2018 in the hopes of resolving differences and keeping NAFTA alive. NAFTA is a critical trade policy, and uncertainty over whether or not it will continue to exist should be of concern for the U.S., Canadian and Mexican economies. In particular, I am worried about certain demands recently raised by the U.S., especially the demand that the trade agreement automatically end in five years unless all three governments agree to keep it. In my view, it doesn’t seem prudent to create more economic uncertainty, which could deter corporate investment.
Great uncertainty remains over Brexit negotiations as well. In a surprise decision, even though the cost of the “divorce bill” has not been locked down, the European Union has agreed to begin the second phase of Brexit negotiations with the United Kingdom, which is certainly a positive. However, there remains a great deal of uncertainty about what Brexit will ultimately look like – and whether the negotiations and ratification of an agreement can indeed be completed by March 2019 – a very tight deadline. As a result, I wouldn’t expect British businesses to spend more than they need to in the next year given the great economic uncertainty the U.K. faces.
Similarly, we continue to have uncertainty around escalating tensions with North Korea, while worry increases about what will happen if the U.S. imposes sanctions on Iran and walks away from their nuclear deal. As I travel and present around the country, I continue to get asked why it is the stock market has shrugged off the North Korea threat. I think investors have become somewhat immune to geopolitical risks, since we’ve experienced them before and the stock market has always rebounded relatively quickly. However, what the market is not prepared for is an event that goes beyond the war of words to an outlier event – also known as a black swan event – such as the potential for North Korea to hack into critical U.S. systems or detonate an electromagnetic pulse bomb. We need to be vigilant about those outlier risks that do have the potential to be disruptive.
3. Monetary policy question marks
In the U.S., a very public job interview process for the Federal Open Market Committee chair is underway. Virtually every day a new favorite candidate emerges. It was reported that President Donald Trump was particularly impressed by his interview with Stanford professor John Taylor, the creator of the “Taylor Rule” and an advocate of a more “rules-based” approach to monetary policy – although he has somewhat softened his stance in recent years on the use of a formula to determine monetary policy. Most recently, President Trump spoke favorably about incumbent Janet Yellen. In other words, as of this writing, the next person to hold one of the most important jobs in the world – at a crucial time as we navigate balance sheet normalization – is undecided.
And this coming Thursday, European Central Bank (ECB) President Mario Draghi is expected to announce whether the ECB will begin tapering. This has been a long time coming, and the euro area economy has positively surprised this year, making it more likely the ECB will begin tapering soon. However, it does not mean that tapering will occur without incident. Keep in mind that a number of central banks in major developed economies are in uncharted territory with their bloated balance sheets brought on by experimental monetary policy; we just don’t know how markets may react as the ECB joins the Federal Reserve, the Bank of Canada and other central banks in becoming less accommodative. We will want to follow this situation closely.
4. U.S. tax bill in progress
Negotiations on the U.S. tax reform proposal are underway, and markets seem to be anticipating it will be successful. However, I can’t stress enough that we can’t be sure what this bill will ultimately look like (right now it is an a la carte menu and legislators are just lining up at the cafeteria to make their selections) and of course whether or not it will become law, and when. In fact, just this morning, President Trump, responding to public pressure, announced via Twitter that the dramatic drop in the 401(k) tax benefit was no longer on the table. I continue to believe there will be significant negotiation on other elements of the bill in coming weeks. For example, I expect the elimination of the estate tax to be removed, and the state and local tax deduction elimination to be hotly contested.
Investing in a volatile world
For all these reasons, I believe chances are lower that a significant tax package will be passed. Interestingly, U.S. Treasury Secretary Steven Mnuchin has already warned Congress about the dangers of not passing this tax bill. In fact, he specifically said that failure to pass the Republican tax overhaul would trigger a “significant” drop in the stock market. As he explained to Politico, “There is no question that the rally in the stock market has baked into it reasonably high expectations of us getting tax cuts and tax reform done.” These are the concerns I have been sharing for some time now. Stock prices seem to reflect the expectation that the Trump agenda will be implemented as planned. Ultimately I do believe some type of tax bill will be passed – but I expect it to undergo enough changes that it will look like a distant relative of the current tax reform proposal.
I’ll be watching several developments in the coming week, from the ECB meeting to developments around tax reform negotiations to earnings announcements.