Summary: While Wall Street has viewed a Donald Trump victory as a potential threat, an imminent rise in US interest rates has far greater consequences for global markets including ours.
Key take-out: When US rates are lifted expect a negative reaction on the share market as stocks adjust, a fall in the Australian dollar and commodity prices.
Key beneficiaries: General investors. Category: Economics and Investment Strategy.
Two key risk events in the United States gained clarity over the weekend.
Starting with the presidential election, the campaign of Republican nominee Donald Trump has reached the point of no return just a month away from the general election in November. Meanwhile, a favourable set of labour market data pushed the Federal Reserve ever closer to raising interest rates for the first time this year.
A Donald Trump presidency has been viewed as a major risk event throughout much of this year. Markets like stability and certainty and Trump is the antithesis to everything market participants want in a political leader. Even Trump’s promise to cut tax rates on companies and high-income earners hasn’t been enough to convince Wall Street.
The past fortnight has been a disaster for the Trump campaign. On September 24, FiveThirtyEight – the online website run by polling guru Nate Silver - gave Trump a 45 per cent chance of winning the election. As of right now, that number sits at just 16.2 per cent.
Based on those odds, Clinton is expected to win 49.2 per cent of the vote compared with 43.0 per cent for Trump and 6.4 per cent for Gary Johnson, the candidate for the Libertarian Party.
That Trump is behind in these polls isn’t exactly news. According to FiveThirtyEight, Trump has been in front during this campaign on just one occasion (July 30). But the dramatic shift, so late in proceedings, means that investors now face a more certain and more favourable risk environment.
A Clinton presidency is widely viewed as a continuation of the Barack Obama administration. Their policies are similar and the Clinton campaign is expected to make a smooth transition into office. Clinton represents a continuation of policies that have, for the most part, proven successful.
The US economic backdrop
Nevertheless, the anti-establishment sentiment that gave rise to Donald Trump won’t go away. The rise of hard-right nationalism hasn’t occurred in a vacuum: it is the product of eight years of economic and financial failure which built upon the foundations of earlier anti-globalisation sentiment.
It reflects the failure of monetary policy that have enhanced the market valuation of banks and other assets but have done little to support jobs and put food on the table. It reflects trade policies that have exacerbated inequality and subjugated a generation of lower-income and less-educated Americans.
Political clarity has also removed one source of uncertainty for the Federal Reserve. The bank also received good news in the form of another favourable read on the US labour market.
Non-farm payrolls rose by 156,000 jobs in September and the broader monthly trend suggests that the US economy is adding around 190,000 jobs a month. The result missed market expectations, though not materially, and it was a result that I’d categorise as being ‘good enough’ even if it wasn’t spectacular.
Rates set to rise
Market participants are now pricing in a more than 50 per cent chance that the Federal Reserve increases interest rates before the end of this year. The most likely scenario is a December rate hike, although a lot can change between now and December 13-14.
At various times over the past two years the Federal Reserve has been the central bank that cried wolf; promising that a rate hike was just around the corner but always pushing that decision out a few months into the future.
The argument in favour of a rate hike is relatively simple. Good monetary policy is forward-looking because it often takes 12 to 18 months to see the full impact of a change in interest rates. As a result, the Federal Reserve must make a decision about how it sees inflation and labour market conditions developing over that period and set monetary policy in accordance with that forecast.
‘Hawks’ within the bank are arguing that, without a rate hike, inflation will push above the Fed’s annual inflation target of 2 per cent. They are concerned that the Fed will get behind the curve and be forced to chase inflation in a dangerous game of catch-up.
There is very little risk that the latter happens given low inflation is now a global phenomenon. There is no sound reason why inflation would surge to such an extent that it becomes difficult for the Fed to rein in.
The Fed’s poor record
But the argument that policy needs to be ‘forward-looking’ holds weight. The main issue is that the Federal Reserve is terrible at forecasting the US economy and inflation. Forward-looking policy is sound if your forecasts are sound and dangerous when they aren’t.
The Fed’s record on inflation targeting is also suspect. It has met its 2 per cent annual target in just four months since the beginning of the global financial crisis. The core PCE deflator – the Fed’s preferred measure of inflation – has increased by 1.7 per cent over the past year and hasn’t touched 2 per cent since April 2012.
More importantly, it appears as though inflationary pressures have actually eased over the past three-to-six months as shown in the graph below. A pre-emptive strike on inflation runs a significant risk of undermining the Fed’s credibility.
A final complicating factor is lacklustre economic growth across the US. Real GDP has increased by just 1.2 per cent over the past 12 months and is expected to remain at around that level when the September quarter national accounts are released at the end of the month. The US economy rose at around twice this pace from 2013 until 2015.
It would take an exceptionally brave or foolish central bank to raise rates into a combination of softer inflation and lacklustre growth. Nevertheless, we stand on the verge of such a decision and we must consider the implications.
Positives and negatives
A Clinton victory will be viewed as a positive market event but a rate hike will be priced in negatively. I’d expect the latter to more than offset the impact of the former.
Global financial markets are more highly correlated than they were prior to the GFC and I’d expect some of this negativity to spill over into Europe, Asia and Australia. Loose monetary policy has been driving equity valuations since the crisis, and even a modest step towards policy normalisation will lead to some adjustment across the equity space. Fixed income products, such as government bonds, will also respond directly.
The good news from Australia’s perspective is that higher interest rates in the US narrows the spread between US and Australian interest rates and will put downward pressure on the Australian dollar. This will benefit the non-mining sector, which has made some gains in recent years but continues to struggle under the weight of an elevated currency.
A stronger US dollar will, however, hit commodity markets and put downward pressure on the likes of iron ore and coal. Separating the effect of a stronger US dollar from other demand and supply factors will be difficult and I anticipate heightened volatility for many commodity prices over the next six months.
This would hit Australia’s terms of trade and lead to weaker growth in national income, which will spill over into wage growth and inflation. The dollar would adjust downwards (above and beyond that caused by the narrowing of interest rate spreads) to contain the fallout of lower commodity prices, which will support the non-mining sector and help to facilitate our economic transition towards stronger growth across the non-mining sector.
As a result, tighter monetary policy in the US is both a blessing and a curse for Australian markets. It helps us get to where we need to be – a stronger non-mining sector – but it does create some short-term headaches and undermines some of the recent strength across commodity markets.