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A fascinating and wide ranging interview with one of the world’s best economists who unpacks one of the biggest mysteries of recent times – why investment markets steamed ahead despite the Brexit shock and Trump voting results. Keith Wade, long-time head of the economics team at UK’s biggest asset manager Schroders explains why economists got the major geopolitical events wrong and looks ahead to what has been learnt – and what to expect next. – Alec Hogg
Keith Wade is the Chief Economist at the UK’s biggest and oldest asset management firm, Schroders, We kicked off our chat with geopolitics, which is dominating our newsfeeds and our investments…….
Last year we had Brexit and the Trump election, both events, which markets focused on very intensively and we had some quite interesting reactions. It wasn’t really the reaction that markets might have expected. I would have thought and many investors, before both of those events, would have said they would want to be very defensively positioned. And of course, the thinking which economists have been very much behind is that uncertainty is bad for economies and markets, but what we saw last year was actually quite positive outcomes in terms of equity market reaction to those two events, those are very much at the fore.
Then of course we’re going into 2017 now with the European elections coming up, so we have more political uncertainty there, particularly given the number of populist politicians who are in quite strong positions in the Netherlands, in France, and I’d also point to Italy, where we may see a general election later this year or early next year.
If you look at it from the outside, you’d expect the volatility index to be skyrocketing, and yet it’s very low, how do we read that?
Well, I think that part of it is the kinds of political events that we’ve had, have contributed to the rally in markets and although economists are saying uncertainty is bad, the kind of uncertainty that we’ve had recently in the US is not so bad in the sense that many people voted for Trump for a change and they believe that Trump will make the economy better. So one of the things we’ve been highlighting has been the big rise in small business confidant’s, which is really off the charts, indicating that in small business things, the deregulation policies that Donald Trump has got and his policies to expand fiscal policy and get the economy going, mending the structure and so on.
These are seen to be good things for the US economy, so confidence has really risen very sharply. I think in some ways this highlights where economists got it wrong, they kind of thought, “Yeah, well there’s going to be all this uncertainty”, but of course many people voted for Trump on the basis that he was going to make things better and so their confidence has risen as a result.
Perhaps on the ‘promise’ that he’s going to make things better. Whether or not he’s going to do so, I guess is still an open question.
Well it is and I think this is where the focus has moved to now. We’ve heard quite a lot of news from the Republicans on what they want to do with tax policy, which is quite different in many ways from what Donald Trump wants to do, or at least what the Republicans want to do, is provide a sustainable fiscal policy. So they’ve proposed this border adjustment tax and that does meet some of Donald Trump’s aims in the sense that it will actually tax imports and subsidise exports. It helps that kind of, you know, “Make America great” kind of, “make it in America” sort of stuff, but it also raises quite a lot of money and it’s designed really to pay for the cut in the headline rate or corporation tax.
The Republicans are obviously looking for more of a fiscal neutral tax change, more of a tax reform, whereas Donald Trump is still looking for a big stimulus, so in many ways, when Donald Trump spoke last week, I think markets did take it positively because they saw him as being more conciliatory than before and markets recognise that he needs the support of Congress in order to get these changes through because Congress might have a different agenda. Deregulation and tax cuts, protectionism as well, all those things, he will need a certain amount of congressional support, maybe less on protectionism, but certainly on the tax side. So, the focus really is on…you know we don’t know what he’s going to do, but can he cooperate with congress, can he get some of his policies through congress. He’s going to need to have a more diplomatic approach to congress.
The markets think he will do that, there’s some kind of a compromise?
Yes, I think the markets do think that, but what concerns us is that either the markets are a bit too optimistic about what he can achieve, so we’ve already scaled back the amount of fiscal stimulus that he’s going to be putting into the economy. The other worry that we have is if he does achieve the policies, that they won’t actually deliver on what he’s saying. He’s said he wants to grow the economy at four percent and create 25-million jobs. When we look at the US economy, it looks like that’s a really big stretch for the US economy to achieve.
When last did it grow at four percent?
The last time it grew at four percent was really in the late 1990’s, just at the turn of the century; it was at the end of the tech bubble. We had a few years where the economy really accelerated, massive tech investment, and business investment and of course the consumer was getting very strong at the same time and we haven’t seen that, and actually the average rate of growth over the last five years is about two percent, so the economy’s really slowed. That’s not to say that it can’t grow at four, but you would need to have a lot of spec passed in your economy, you’d need to be at a much earlier stage of the cycle. Economies can grow pretty strongly when they have a lot of slack, but the US economy doesn’t have a lot of slack at the moment.
What about those 25-million jobs?
I think that’s out of reach because you have about 8-million people unemployed, you have people who are working part-time and people who are discouraged, you can get a few more people into the workforce that way and you might be able to increase the participation rate, but I would say there’s a maximum amount of people, spare capacity of say, 14 or 15 million, maximum, so 25 million jobs is well out of reach. The concern that I have is not to say, “Well, that’s crazy, it’s not going to do that”, the concern I have is that if he tries to do that and he ends up pushing up wages in the economy, because of course you’re going to overheat the economy quite a lot to do that.
For example, he said they’re going to approve the pipelines and all the steel for the pipelines is going to come from American firms, American workers. Well, that’s fine, but you’re going to have to probably create quite a lot of capacity pressures and recruitment pressures to do that and push up wages. He may think that’s great, wages need to rise, they’ve been too weak, but of course at a later stage of the cycle that could bring inflation and it could bring quite an interesting clash with the Fed.
There are some interesting assumptions being made by people who are at the extremes of the pundit, saying that inflation’s going to rocket and buy gold because that’s your only safe haven. If you take a more moderate approach towards it, if inflation does start rising because of wage pressure, how high can it go in the US and what would the impact of that be on various investment vehicles?
In our forecast, we do have inflation rising this year and that’s mainly been driven by energy prices, so inflation is rising globally, but the key thing for this kind of question is really what’s the core rate of inflation. We do think the core rate of inflation will probably nudge higher towards 2.5 percent, or go a bit above what the Fed is aiming for in the long run, but it’s not a big inflation problem. Although, it’s partly why we think the Fed will have to be raising rates next year and while we think that we’re getting near the end of the cycle, the classic end of cycle, tightening of monetary policy, and a slowdown in the economy probably going into 2019 and so on. The uncertainty about that is that Donald Trump can also choose the next head of the Fed and he can actually influence the shape of the Fed.
What happens this year?
Well, Janet Yellen is due to step down in February next year, but they will probably have to have somebody lined up and in place before that. If he’s concerned about a clash between the Fed trying to keep inflation down and him trying to boost growth. He might try to get round it by having a very dovish share of the Fed. Then if interest rates stay too low for too long then that’s going to be quite an interesting one for the markets because the Fed might be seen as behind the curve, bond yields would rise, at the longer end of inflation, expectation would rise.
I think that would be quite worrying for markets. All the analysis that we’ve done is that you can have an environment of rising bond yields as long as it’s not inflation that’s driving it because once inflation’s driving it, markets will realise that the end of the cycle will be coming and the Fed will eventually have to tighten and slow the economy to bring inflation under control. So that’s the kind of scenario that would undermine markets.
What’s quite interesting actually in the recent developments (because we’ve obviously seen quite an increase in expectations for the Fed), is it hasn’t been accompanied by a bad market reaction because people have seen it as confirmation of the good growth backdrop. It’s been quite interesting that the yield covers have actually flattened a bit with the two-year selling off quite a lot and the ten-year selling off a little bit, but I think markets are seeing that’s a good sign, they’re kind of giving the Fed the green light to raise rates.
Keith, we know Mr Market is a manic depressive who doesn’t have any medication, is Mr Market out of control here, does he know what he’s doing?
I think he’s right in the sense that, I don’t think there’s a massive inflation problem coming just yet, but the concern is if we did get quite a lot of stimulus from Donald Trump and if we did get some protectionist policies, we would almost certainly be looking at higher inflation and I don’t think the market’s focused on that at all at the moment.
Trump wants it though, he’s spoken about a weaker Dollar, and a higher inflation presumably would affect the Dollar in that way.
It would do because in the long run higher inflation does tend to weaken the Dollar. The problem is that in the short run it could lead to tighter policy from the Fed and against this backdrop where the ECB is not really doing anything, the Bank of Japan’s not doing anything, and then I think that would tend to strengthen the Dollar more than anything. So the ideal environment, I think, for the market is one where Donald Trump is quite constrained by congress on fiscal policy and he doesn’t actually get to put in the full stimulus. Then the economy can probably be more kind of Goldilocks-like rather than ‘boom and bust’. That’s the way I would see it, but at the moment I get the feeling that the US equity market is looking for more stimulus and perhaps more so than the US economy can really take.
Big tax cuts as well?
Yes, that’s all part of it, so tax cuts for households and corporates coming through.
Let’s be logical about all of this. You’re cutting taxes, you already have excessive debt, the markets are loving it, or investors, or traders perhaps are enjoying it enormously, but what is the endgame of all of this, if this Trumpian economics is allowed to run its course?
Well, I think the endgame, unfortunately, is probably a bigger budget deficit, higher inflation, and then ultimately, a weaker economy. Yes, the tax cuts will all support consumer expenditure and corporate tax cuts will help companies thinking about investing. They’ll be able to bring money back as well, probably more easily. That’s another measure that he’s talked about, but you know, we always have to think about where the economy is and it’s had a good, long expansion of seven or eight years.
We’ve said several times, it would have been better if Donald Trump had come in about six or seven years ago when the economy probably did need 25-million jobs and the unemployment rate was ten percent, than coming in now. So, unfortunately, fiscal stimulus is not really what’s needed in the US at this particular point in time and yes, there are deregulatory measures and you could say, “Well, cutting corporation tax is an overdue move for the US because it’s made itself uncompetitive, so some of those measures are going to help”, but they’re all things that you could say will help in the long run, but in the short run it’s probably going to add to overheating pressure.
So, overheating potentially in the United States in the short-term, what about Britain? Again on geopolitics, Brexit has been a big story? We’ve seen the Pound under enormous pressure subsequent to it and again, some pundits are saying it’s going to collapse after Article 50 has been triggered, how are you reading it?
I don’t think triggering Article 50 will make a lot of difference now because everyone’s expecting it and so I think that’s fairly well priced in. What isn’t really priced in is the outlook for the economy. I think the market is pricing in a kind of a muddling along economy, growing near to two percent this year and maybe slightly weaker next year because people recognise that the Brexit negotiations are going to cause a lot of uncertainty and will cause businesses to put plans on hold, they’ll have to because they just won’t know what trading arrangements are going to be. What concerns us more immediately, though, is that one of the consequences of Brexit has been a big fall in the Pound and that’s now feeding through into higher inflation and that will cut into real wages in the UK and will slow down the consumer.
So we, like all economists look at the fundamental drivers of the economy, which real income and the willingness of households to take on credit and debt. They’ve been taking quite a lot of credit recently, but what concerns us is that the inflation rate will begin to rise and will exceed wage growth, so people will have cuts in their real wages. That usually means that they’ll slow down their consumer spending. That’s been the driver of growth since Brexit, so I think there are some downside risks for the UK coming up just as a result of the inflation increase and you’re not going to see investment really accelerate in an environment where there’s so much uncertainty.
So the Pound isn’t fully reflecting?
No, I think there’s still a risk to the Pound on the downside, that the economy is weaker than expected and consequently people push out the time when the Bank of England begins to raise rates again and that could hit the Pound again, so that would be the concern I have.
In Europe, is the geopolitics playing a big role there too?
Yes, absolutely. We have the Dutch election coming up in the middle of March, and I don’t think that’s going to be that significant in the sense that, Wilders, although he could be the biggest party with the Freedom Party, he won’t be able to form a government, so his plans for a referendum on Europe are probably not going to be realised because of the coalition. However, I do think the size of the vote that he achieves will be seen as a barometer of what we’re likely to get in France in April, in the first round of the presidential election. So it will be significant and I think people are probably downplaying it a bit too much to be honest. It’s like, “Oh no, they can’t, he won’t be able to do anything, and it’s all fine”, but actually if he gets a very strong vote, people will look at that and extrapolate and say, “Oh, maybe Marine Le Pen will do much better” and she has more of a chance of becoming president.
On the strength of the United States in Britain, you’d then have to buy French shares.
Well, exactly and I mean, that has been one of the lessons. It’s been a question of – market reactions have surprised. The thing is, of course, we’ve got to look at the policies of each one and think about what Marine Le Pen would do if she gets into power and she says she’s going to have a six-month period where she’s going to go to the EU and say, “We need to renegotiate, you’ve been taking too many powers, we want to change immigration” and so on and if her experience then is the same as the UK when we tried to (ahead of the Brexit, David Cameron tried a similar thing and didn’t get anywhere), then she’ll come back and call a referendum on France’s membership of the EU.
Then if there was a vote to leave the EU that would be pretty shattering actually because France has obviously been a cornerstone and a driver of what’s been going on in the EU and of course, the main thing from the market’s point of view is that they would have to leave the Euro. So the Euro really would be breaking up and that’s the difference between the UK and France and the elections this year in Europe, is that all these countries that have their populace parties, would actually have to leave the Euro, whereas the UK of course, didn’t have to do that. So in some ways it could be much more significant.
Keith, why is all this happening, why has the world gone crazy, or has it gone sane?
Well, I think what’s happened is, because economists look at things like unemployment and say, “Well, look our employment rate’s very low in the UK and the US, why did you get this big shock?” I think it’s because wage growth has been very weak for a significant period of time, real wages have barely grown in the UK since the financial crisis, and we’ve had austerity on top of that. It’s a similar story in the US, we’ve had less austerity, we had quite a bit initially, but we’ve not seen real wage growth.
So people have jobs, but they’re not good jobs and they’re insecure in their jobs, they don’t get the benefits they used to get, they’re not as well-paid and not as high status. I think you saw that very strongly in the kind of areas that voted for Brexit and the areas that voted for Trump. In the US, they call it the rust bowl, in the UK we call it more like the sort of ‘depressed north’, you know, the areas like Sunderland, for example, which do actually have some manufacturing, but they all voted, Brexit was one of the first results that came in, it was a big surprised.
So the middle class is being rational, from their perspective anyway.
Yes, I think they are because they want something better. I think the problem is will we get something better as a result of these things? We already talked about the US and about the difficulty there, of creating good jobs and it’s the same in the UK, productivity growth has slowed down enormously and economists don’t really fully understand that, because ultimately, it’s productivity growth that determines real wages and you can see that big slowdown has taken place.
To some extent that does reflect globalisation. A lot of high productive manufacturing jobs have gone out of the economy, they’ve gone to the Far East and so on, or parts of Eastern Europe and so Trump is saying, “Well, we’re going to have those jobs back” and if he’s right and he brings those jobs back then those jobs will be more productive for the economy, so in some ways it’s more of a solution, but it’s less efficient because the reason those jobs went in the first place was because it was cheaper to produce overseas, but maybe he can recreate a manufacturing industry in the US.
I think unfortunately, that is against such a massive structural headwind of the emergence of China, those emerging economies with lower costs. It’s very difficult to get companies to say, “Right, okay we’ll bring jobs back” or what have you.
What are the unintended consequences, the things that Donald Trump has clearly not thought through or has he?
In terms of trade, the big unintended consequence is he will make working people poorer, because you put tariffs on, and you do increase inflation. Even if you do it indirectly, say through a border adjustment tax, is a big increase in import costs. That will add to inflation. It will either add to inflation directly in terms of the goods that households are buying, importing a lot of white goods from China, you know, say washing machines or electronics and so on, or indirectly, through the supply chains.
A company like Apple, for example, if you put tariffs on China, which will affect their supply chains, it will increase the cost, not by a huge amount, but people will have to pay for these tariffs. Those are the unintended ones. The other unintended one is that if you deport a lot of migrants, you can say, ”Oh, well they’re illegal, they’re not really affecting the economy”, but actually they are because they are actually working in the economy and you’ll increase wage costs and that will again add to inflation.
In the 1930’s, isn’t this what America tried, to close its borders to “Make America great again” and in fact, the opposite occurred?
There is that similarity, I think it was the Smoot-Hawley Tariff that triggered a whole trade war, and we saw a contraction of global trade in the thirties. It was very counterproductive. If we do go along the protectionist route, then that is a possible outcome. I think at the moment it’s a question of; Donald Trump is weighing up the kind of response that he might get from China if he puts tariffs on China. There has been talk about the US doing a kind of pre-emptive increase in tariffs, but I think the problem is that China could respond quite quickly, not necessarily by increasing tariffs on US goods, but it could devalue the RMB and the RMB is already under a lot of pressure. China of course, as you know it’s trying to prevent the RMB from falling.
So they could say, “Well, if the US puts tariffs on us…”, they could say, “Oh, you know, we’ve been trying to generate goodwill with our policies and that’s failed, so what the hell, we’ll let the RMB fall” and they could simply offset the tariff by devaluing by 20 percent or something like that. I think the Trump administration needs to be very cognisant of the potential reaction that they might get and they need to play this in the right way.
So I would have thought that they would start off with negotiations, saying: “This is what we want on the table” and then try to work towards a solution and in a way, tariffs would be the failure of those talks. In the meantime, you sort of bully, Mexico, and so on, the smaller kid on the block, but even there, I mean, you know the speech he gave to congress, he mentioned after, “I’m going to sit round the table with Canada or Mexico”, maybe they can refresh it after in a way that meets people’s agreements.
Let’s look at the upside. Everything that you’ve said, that Trump comes to his senses, that congress ensures that he doesn’t overplay his hand, what kind of a world economy are we then likely to have, that there is say, no trade war, that there is no insanity on things like NAFTA, that America doesn’t pull out of the World Trade Organisation, as Trump in his speech to congress was actually hinting towards, what then?
We’ve got a world that doesn’t look too bad and that’s still growing. You’ll see the expansion continuing in Europe and in Asia, trade gradually picking up. I think we’ll be moving towards a more positive environment, but I still think that the US cycle, coming to an end in 2019, that’s something that markets will have to prepare for. They’ll be able to push it out further and that’s good and we could say, “Oh yeah, we got back to a kind of Goldilocks environment, relatively low interest rates, steady growth” and markets could continue to do quite well, actually in that environment.
So you could stay invested in equities there quite comfortably?
You would, yes, and it’s our central view that you do get something like that. Investors are not really focused on 2018 yet, but it is our view that we do get that and you would stay fully invested in risk assets, you’d probably be quite light on government bonds, and you would hold equities in some of the high yield credit, you’d probably invest in emerging markets as well.
What if the craziness happens?
If the craziness happens, I think then, if you get the more aggressive tightening of policy and I think you’ll get a stronger Dollar, you would also have some protectionism going on, emerging markets would struggle in that environment, they would sell off, and I think people would begin to worry about the end of the US cycle because of the inflation that’s been created and I think it would mean you would go back to looking at the risk areas of the world, such as the highly indebted emerging economies and you’d start worrying about peripheral Europe again, Italy and Spain.
What are the signals, what do we look out for to make sure that we can see we’re not on the crazy path, but on a more sane one?
It all comes down to things like last week’s address to Congress, if he makes nice, (I don’t know what the right word is), a conciliatory, you know yes, I understand these constraints aren’t going to work with you” and all that, if we get that, then I think markets will feel reassured and feel that we’ll get some sort of measured response from Donald Trump. If we get more of the crazy comments, then no, I think people will get more concerned about that, so I think at the moment, it’s like looking at what he’s actually saying and the policies that he’s aiming towards. I think we will get a lot more clarity on tax in the next couple of months because what we should see, where the border adjustment tax goes, that would be a big change in policy if we do get that. That will help in terms of less fiscal stimulus, but on the protectionist side, it’s quite radical.
So as an investor, watch Donald Trump.
Yes, that’s right and listen to what he says in relation to congress and is it the presidential, pragmatic Trump or is it the much more confrontational Trump that we get and if it’s more the presidential and pragmatic, then I think markets will like that.
Keith Wade is the Chief Economist at Schroders.
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