I hope that you have enjoyed the 2016 Travelling Economist series covering Japan and the US - two of the world’s most important economies and financial markets.
I hope that you have enjoyed the 2016 Travelling Economist series covering Japan and the US - two of the world’s most important economies and financial markets. After visiting Tokyo, San Francisco, New York and Washington I have returned with much greater clarity on the key issues affecting these economies, the policy outlook and the political dynamics at play. Perhaps most importantly, I believe there are some clear implications for financial markets.
Japan – The Economy:
In Japan, the economy is expected to continue to grow at a very modest pace - at around 0.6%/yr in 2016 and a little higher around 0.8%/yr-1.0%/yr in 2017. Growth is expected to be supported by the 2016 easing in both monetary and fiscal policy - helping the consumer and business investment.
However, inflation in Japan remains very low. Data for September showed Japan's headline CPI running at
-0.5%/yr. The Bank of Japan (BoJ) favourite measure of core inflation (ie. ex food and energy) declined in September to 0%/yr, from +0.2%/yr in August. This is the lowest level for this measure of core inflation in two year and is, quite clearly, well below the BoJ's 2% inflation target. There is are overwhelming expectations (which I share) that inflation in Japan will not reach the BoJ's 2% target over the medium term.
Japan – Monetary Policy:
Indeed, when I met with the BoJ I had two questions for them; i) was the BoJ confident that they had the ability to keep 10 year Japanese government bond (JGB) yields at the new target of 0%, while also keeping the short-term rate at -0.1%, and ii) how would holding 10yr JGB yields at 0% help ensure the BoJ hit their 2% inflation target.
The answer to the first questions was 'Yes' and I do indeed believe that the BoJ has the necessary tools and desire, via managing its Y80 trillion per year asset purchase program, to cap 10yr JGB yields at "around 0%".
But the answer to the second question left me far from confident that inflation in Japan would hit 2% any time soon or indeed, for many years to come. The BoJ still seems to hold the view that, despite evidence to the contrary over a number of years, that if they keep interest rates low enough for long enough, then they will get inflation. Frankly, I cannot see this happening in any reasonable time frame.
Still, given the likelihood that the effects of the 2016 monetary and fiscal policy easing will fade into 2017 and that the BoJ's measure of core inflation will remain well below the 2% target next year, there is a growing view that the BoJ will ease monetary policy again around mid-2017. This easing is expected to take the form of a further reduction in the short-term rate to -0.2% or -0.3% (from the current -0.1%) and a reduction in the 10yr JGB yield target from 0% to -0.1%.
I took the opportunity to ask the BoJ directly why, in the face of all the evidence of a structural decline in Japan’s inflation, they were sticking to the 2% inflation target. The answer I got was that 2% is the global standard for inflation targeting and the BoJ did not want to be the only major central bank to abandon this target as this would be seen in a bad light by the BoJ's global counterparts. This seemed like a poor reason to me. Perhaps this debate will have to await the next BoJ Governor, as Governor Kuroda’s term expires in April 2018 and he is unlikely to be reappointed.
Japan – Fiscal Policy:
At the Ministry of Finance (MoF), I focused on both the fiscal policy outlook and some other key aspects of the outlook for Japan. The MoF is sticking with their target that Japan's primary budget deficit will be back to balance by FY2020, from the current deficit of -3.1% of GDP. Interestingly, the MoF's base case is that their funding costs will rise in the years ahead, assuming that 10yr JGB yields will move to 1.5% by 2020. When I pointed out that this was not consistent with the BoJ's target of holding the 10yr JGB yield at 0%, the MoF just repeated the line that they are assuming the BoJ's policy is only 'temporary'. However, if the BoJ is successful in holding 10yr JGB yields at 0%, or even lower, in the years ahead (as I expect they will be) then Japan's budget will improve further and the funding 'costs' of running a budget deficit will be close to negative, ie. the MoF will be paid to borrow!
One of the more interesting discussions I had with private sector economists, the BoJ and the MoF centered on Japan's potential economic growth rate. Estimates of potential growth ranged between 0%/yr and 0.5%/yr, well down from around 2.5%/yr in the 1990's and around 0.7%/yr pre-GFC. The key aspects behind this substantial decline in potential economic growth were, not surprisingly, the ongoing decline in Japan's population (ie. a negative population growth rate), low labour force participation rates and very weak productivity growth. The Abe government is trying to work on these problems via its “Work Style Reform” package – but real progress is frustratingly slow.
Japan – Politics:
On the political front, there is ongoing speculation in Japan that Prime Minister Abe will call (yet another) snap election for the Lower House in early 2017. Now that Abe has been able to alter the rule of his Liberal Democratic Party (LDP) and stay on as Leader for a third 3 year term, if Abe wins an early 2017 election he would then be able to remain as Prime Minister until 2021 - seeing him through the 2020 Tokyo Summer Olympic Games (not to mention the 2019 Rugby World Cup!).
Japan – Market Implications:
In terms of the financial markets in Japan – unfortunately it looks like more of the same. The BoJ is likely to be successful in holding 10yr JGB yields at a little under 0% for some time to come. Indeed, the risk is that the BoJ eases monetary policy again around mid-2017, taking the cash rate target down to -0.2% or -0.3% and the JGB 10yr target to -0.1%.
Under this environment the Yen is unlikely to depreciate significantly, as the BoJ outlook represents the status quo. Indeed, the risk for the Yen is that the markets thinks the BoJ is ‘tapering’ their JGB purchases, in which case the Yen would be more likely to appreciate in value.
BoJ support for the economy, JGB yields and equities directly (ie. through their ETF purchase program) could be expected to keep the Nikkei supported. But the ongoing very subdued nature of the Japanese economy and the relative strength of the Yen is likely to keep the Nikkei from posting more than very moderate gains in the months ahead.
USA – The Economy:
The most common phrase on the US economy I heard from my meetings was "slow and steady". For 2016 as a whole, real GDP growth is expected to come in a little below 2%/yr. At this stage, the outlook for 2017 looks to be a little stronger, but not by much.
Expectations are that US inflation could drift higher in the year ahead. The headline CPI is expected to come in around 2%/yr at the end of 2016, before rising towards 2.25%/yr-2.5%/yr at the end of 2017. Perhaps more importantly, the core PCE measure of underlying inflation is expected to move up from the current 1.7%/yr toward the Fed's 2%/yr target in the year ahead. Very few economists, however, expect core PCE inflation to rise significantly above 2%/yr out to the end of 2018.
Nevertheless, some of the cyclical forces holding down inflation are expected to slowly reverse over the next year or so. But, the structural forces holding down inflation, especially demographics and technology, remain firmly in place.
An upward trend in wages growth, although from very modest levels, is also beginning to reveal itself in the US and this could also place some upward pressure on inflation. Economic growth through 2017 is also likely to be supported by some fiscal policy easing. Both major Presidential candidates are promising some fiscal policy stimulus, although Hillary Clinton's plans are more modest than Donald Trumps.
USA – The Fed:
The easiest part of my analysis of the US Federal Reserve (the Fed) is that the path to higher interest rates will be (very) gradual. My view remains unchanged that the Fed will raise the official Fed Funds target range to 0.5%-0.75% at the December FOMC meeting, having, as widely expected, held rates steady at the 2 November FOMC. One Fed watcher I spoke with implied that the Fed would be 'embarrassed' if they did not raise interest rates in December - much as they were in December 2015.
Going forward, I continue to expect two rate hikes each year (likely June and December) in 2017, 2018 and 2019 - taking the Fed Funds rate to around 2%-2.25%. Markets have a slightly lower path than this, while the Fed's 'dots' remain more aggressive.
The difficult part of the Fed's outlook is what the peak in interest rates is likely to be in this cycle, how this differs from previous cycles and whether targeting inflation at 2% remains the best way for the Fed to help manage the US economy.
As evidenced by recent comments from the Fed Chair, Janet Yellen, the overriding view in the Fed remains that if interest rates are held low for an extended period then the economic recovery in the US will deepen and broaden and this, eventually, will see strength in the labour market translate into an upward trend for wages and inflation.
So while views within the Fed differ on the exact timing and extent of the rate hikes to come, the view remains clear that a gradual upward path for US interest rates should be expected over coming years.
My expected peak in the Fed Funds rate of 2%-2.25% in late 2019 remains, however, well below the Fed's current long-run rate of 3.0% - as indicated by the Fed's 'dot' forecasts in September 2016. However, this long run 'dot' has been trending down for a number of years (from 4%) and I would not be surprised to see further downward move in the months and years ahead.
It is very interesting to see the open discussion at the Fed on the level of the neutral level of interest rates in the 'new normal' environment, ie. what is R*?. In the pre-GFC days it was considered that the neutral real interest rate was around 2.5%. Adding in a 2% inflation target implied a neutral nominal interest rate of 4.5%, which gave the Fed plenty of room to cut interest rates to support the economy in any downturn.
Now estimates of the neutral real interest rate, at least in some parts of the Fed, are around 1%, or perhaps even lower. A 2% inflation target, therefore, gives a neutral nominal rate for the Fed of close to 3% - ie. the current long-term Fed 'dot'. However, some in the private sector are of the view that the neutral real Fed Funds rate could be even closer to zero, meaning a neutral nominal rate of just 2% - this view is indeed closer to my own.
The concern is that such a low level of real interest rate gives the Fed very limited options to ease monetary policy substantially in an economic downturn (ie. interest rates are already so low in the good times), without having to resort to policy developments such as negative interest rates and/or quantitative easing.
One 'solution' to this problem is to have a higher inflation target, say 3.5%-4%, so that a very low neutral real interest rate would still give you a neutral nominal rate of around 4.5%. This idea has been put forward by the very highly regarded President of the San Francisco Federal Reserve, John Williams. While thinking about the neutral rate of interest and the Fed's inflation target is a really interesting concept, it is fair to say that the Fed is a long long way away from contemplating any change to their inflation target.
Nevertheless, it has been stressed to me, on this trip and previously (including by the Chicago Fed President, Charlie Evans, when he was in Sydney in October this year), that the Fed's 2% inflation target should be seen as an average and not a ceiling.
Interestingly, from my discussions it does also seem that one area the Fed is worried about, or at least conscience of, is the very low level of bond yields - not just in the US, but around the world. The Fed is thinking about what would happen to the bond market if the perception ever took hold that the Fed was 'behind the curve' in terms of raising interest rates in the context of a higher inflation rate. This does not appear to be much of a risk in the near-term, but it is very pleasing to see that the Fed is conscience of the vulnerabilities of the bond market and the interplay between its own actions and those of bond market participants.
USA – The Election:
The Presidency: The day I arrived in Washington was the same day the FBI announced that they were re-opening their investigation into Hillary Clinton's use of a private email server and the possible mishandling of classified information. Reactions to this news were swift – and relatively predictable across the political divide. The www.realclearpolitics.com poll of polls has, however, shown Hillary Clinton’s lead cut to just on 1.7 points as at 1 November, from 7 points as recently as 18 October.
However, based on the way the Electoral College vote system works, there is likely to still be enough support to give former Secretary of State Hillary Clinton the win - and most economists and political analysts I met are assuming this outcome, as am I. This conclusion comes with a warning, however, and that is that many people have been underestimating Donald Trump for over a year - and he continues to defy these expectations.
The Senate: This election will see 34 seats out of the 100 in the Senate up for grabs. Currently the Republicans hold the Senate 54-46. So to gain a majority in the Senate the Democrats would need to win a net 5 extra seats – although if Hillary Clinton becomes President the Democrats would have a majority in the Senate on a 50-50 outcome as the Vice-President can vote to break a deadlock.
The view in Washington (prior to the FBI news) was that the Democrats have a shot of regaining the Senate, perhaps with a majority of just a couple of seats, ie. a total of 51-53 out of the 100. Post the FBI news the Senate vote looks like it could be even closer. It is important to realize, however, that a simple majority of over 50 is no guarantee of being able to pass legislation through the Senate.
The House of Representatives: In the House, all 435 seats are up for re-election. Currently the Republicans have a majority in the House - holding 247 seats. So the Democrats would need to pick up a net 30 seats to reclaim a majority. The view in Washington is that this is highly unlikely.
So, with just a few short days to go, the base case for the election looks like this: Hillary Clinton as President, a Democratic Senate with a wafer-thin majority and a Republican House. As stated, this is the base case - but given the underlying uncertainty of this election any number of outcomes are possible.
If Hillary Clinton wins the Presidential election her priorities are expected to be: i) A package designed to ‘jump start’ the economy and ii) reforming and improving the health care system. In terms of the economic package the key components are expected to be:
-Tax reforms: this could include corporate tax reform, including lowering the rate to around 25%, but also removing a number of deductions – making the package revenue neutral overall. There is also likely to be a lower repatriation tax rate of around 10%-15%. Income taxes on wealthy individuals are likely to rise.
-Infrastructure: An infrastructure spending package of $US300bn-$US350bn over the next few years.
-Education: Increased spending on both Higher ($US500bn) and Early ($US200bn) education.
-Immigration reform: Better controls and a focus on skilled workers, but with limited move on a path to citizenship for illegal immigrants.
-Trade policy: A modified TPP, with worker protections, could be a focus prior to the 2018 mid-term elections.
-Wages: An increase on the minimum wage.
-Other: Housing finance reforms, improved climate change regulations, sugary-drink regulations, paid family leave and financial regulations.
-It has been estimated that Clinton's policies would improve the US budget position by around $US1.2 trillion over the 2016-2026 period.
In terms of her appointments, I was informed that if she becomes President, Hillary Clinton has promised much more diversity in her major job postings, including a large proportion of women and minority groups. The two leading candidates for Treasury Secretary that I were told are at the top of the list are both women. The first is Lael Brainard, a current member of the Federal Reserve Board and previously the Under Secretary of the Treasury for International Affairs. The other is Sheryl Sandberg, the current COO of Facebook, founder of the Lean In Foundation and former Chief of Staff to Secretary of the Treasury Larry Summers.
Interestingly, I was also told that the Hillary Clinton was likely to ask current vice-President, Joe Biden, to take on the role of Secretary of State. This would clearly be a critical role for the 73 year old, who was first elected as a Senator in 1972.
As a concession to the Left wing members of her party, especially Senators Bernie Sanders and Elizabeth Warren, President Clinton would likely nominate much more progressive heads of a number of government departments/regulators (ie. financial services, climate change, energy, anti-trust/competition, telecoms).
It is also worth exploring the Republican side of the 2016 election. If Donald Trump was to win, his policy priorities are expected to be:
-Tax reform: including a substantial reduction in both income tax (down to three basic rates, 12%, 25% and 33%) and cuts in the company tax rate to around 20%-25% (from 35% currently).
-Health care reform: Repealing Obamacare with a focus on reducing costs and entitlements.
-Defence: Increased spending on both Defence ($US450bn) and Veteran's programs ($US500bn).
-Trade policy: A much more aggressive trade policy, including naming China as a currency manipulator and imposing tariffs on selected Chinese imports, changing the terms and conditions of NAFTA and abandoning the TPP. I would note, however, that there is considerable uncertainty of whether Trump as President could act unilaterally on trade policy, or whether he would need the support of Congress (which may not be forthcoming) to change policy, especially treaties such as NAFTA.
-Immigration reforms: Reduce the flow of both legal and undocumented immigrants, including some deportation efforts and much tougher rhetoric.
-Infrastructure: An infrastructure spending program, similar to Hillary Clinton's, of approx. $US300bn over coming years.
-Other: Housing finance reforms, loosening M&A regulations, loosening media ownership and liberalizing energy drilling requirements, reversal of some climate change policies.
-It has been estimated that Trump's policies would worsen the US budget position by around -$US3.5 trillion over the 2016-2026 period.
Post-Election: If the Republicans do not win the Presidency and indeed, also lose the Senate, there is likely to be a significant period of ‘soul-searching’ within the party – some referred to this as ‘civil war’. One of the most important people to watch in this regard is the current Speaker of the House, Paul Ryan. The path of his career from here is likely to be a very good indication if the moderates are in control, or the Trump supporters, or the Tea Party!
Trump's Supporters: Win or lose, it is my view that politicians, economists, the media and financial markets will need to do some deep thinking over why such a large number of Americans were drawn to Donald Trump. What will be important is not to ignore and unfairly characterize those in the US that feel like they have been left behind - either in an income sense or a status sense - but to support them through sometimes painful economic adjustments, so that they are not drawn to politicians that promise a return to the 'good old days' and a policy prescription that would end up doing much more harm than good.
As it was put to me by a very experienced political analyst I met with; Donald Trump has tapped into the concerns of a large group of people who have either lost their jobs, their relative income or (perhaps most importantly) their status. Unfortunately he has added to this a sense of racism, xenophobia and sexism that was very unnecessary. The real question for US politics is, therefore, what happens if a politician comes along (from either party) who can tap into the same economic, income and status concerns, but without the racism, xenophobia and sexism? Surely that politician would do very well?
One of my US colleagues put the election in context. His view was that a Clinton victory would produce a relatively narrow and normally distributed set of consequences and possible outcomes - for policy, the economy and markets. In contrast, a Trump victory would produce a wide range of possible policy, economic and market outcomes, with significant tail-risk on both sides and the potential for a number of 'black swan' events.
USA – Market Implications:
As we have seen in recent days - an increase in the odds of a Trump election victory has seen a sell-off in the US equity markets, a weaker USD and a small rally in bond yields. This would be consistent with a short-term 'risk off' move in markets, if indeed Trump did win the election.
In contrast, a Clinton victory is likely to see a short-term rally in risk assets, ie. equities and credit, especially in those sectors of the market focused on international trade. In 2017 I expect some form of fiscal policy easing under President Clinton, ie. dominated by infrastructure spending, that should also be positive for the economy and markets. A Clinton victory should not alter the path of the Fed, with a rate hike expected in December 2016 and two further moves in each of 2017, 2018 and 2019.
President Trumps policies would, over time, be highly stimulatory, expansionary and, ultimately, inflationary. Although, as noted above, there would likely be an immediate sell-off in risk assets upon a Trump victory on 8 November, over the next year or so, if he was able to get is election policies through Congress, we are likely to see an acceleration in the pace of growth of the US economy and a surge higher in the USD. The equity markets are likely to respond positively to this stimulus. However, once these effects begin the fade, the downside risks are likely to mount.
The inflationary implications of Donald Trump’s policies are likely to see the Fed raise interest rates much more aggressively than currently priced into markets, taking bond yields sharply higher and short-circuiting the stronger economic data. Trumps anti-trade policies and commitment to increasing tariffs are also likely to be negatives for growth, so that within a year or so of the Trump policies being introduced the US economy could weaken significantly (perhaps heading towards recession), with the USD, bond yields and the equity markets all likely to decline as well.
In a general sense, it was also pointed out to me that a credible case could be made that the cyclical low in global sovereign bond yields has been seen, as the global momentum for monetary policy easing wanes.
This is likely to see a slow upward drift in government bond yields, not only in the US, but also in other major developed markets - with the exception of Japan given the BoJ's policy target of maintaining a 0% rate for 10 year yields.
Indeed, this is a theme that has been picked up by global markets in recent months, with US 10 year yields now around 1.80% from a low of 1.35% in July. German 10 year yields have risen from a low of -0.19% in July to +0.13% currently, while Australian 10 year bonds yields are at 2.30% from a low in early August of 1.82%.
Perhaps the biggest risk for the US bond market is that at some stage in the months or years ahead the market takes the view that the Fed is behind the curve and the bond market sells off sharply. The good news is, however, from my meetings in the US the Fed is very well aware of this risk. In addition, both the Cleveland Fed President, Loretta Mester, and the Chicago Fed President, Charlie Evans, discussed this point when they were in Sydney earlier this year.
The views on the US I took away from my meetings were all generally bullish for the USD.
The US Fed is the only major central bank that at every meeting is contemplating to either leave rates on hold, or lift them. Every other major central bank is deciding between leaving rates on hold or lower them further. This, along with the ongoing moderate pace of economic growth in the US, should generally act to put upward pressure on the USD.
As detailed above, however, a Trump win at the election could see the USD rally strongly over the coming months (perhaps after an initial sell-off next week), but then depreciate rapidly over the medium-term as the aftermath of the Trump policies drag the US economy down and create the risk of a retaliatory trade action by some of the US's biggest trading partners (ie. China and Mexico).
The ongoing moderate pace of economic growth and the very gradual interest rate path are both supportive for equities. A Clinton Presidency would, as noted above, likely be taken in a positive way by risk markets, including equities and would be unlikely to alter the path of the Fed.
Also, as detailed above, a Trump Presidency is likely to be met with an initial equity market sell-off, followed by sector specific improvements on the back of the stimulatory and expansionary nature of Trump’s policies. This could see some solid improvement for the US equity markets through much of 2017.
This relatively strong performance could, however, then be replaced by significant downside risk as higher inflation pushes the Fed into a much more aggressive tightening cycle, bond yields sell off, a ‘trade-war’ ensues and the US economy heads towards recession.
I trust that you, our clients, have enjoyed the 2016 edition of the Travelling Economist, covering both Japan and the US. Please let me know if you have any questions, comments or feedback.
I would like to thank my colleagues for their assistance in the preparation and publication of these reports, especially those in the Marketing and Communications team, as well as Carlos Cacho in the Economic and Market Research team.
I would also like to thank the economists and political analysts from the following organizations for their research and insights and for taking the time to meet with me in Japan and/or the US (in alphabetical order):
•Bank of America Merrill Lynch
•Bank of Japan
•Ministry of Finance - Japan
•The Observatory Group
•San Francisco Federal Reserve
Chief Economist, Colonial First State Global Asset Management