When Donald Trump was elected US president in November 2016, with Republicans retaining control of both the House of Representatives and the Senate, markets leapt to the conclusion that Trump would have little difficulty enacting his pro-growth policy agenda.
But if the internecine battle within the Republican Party that so far has resulted in the repeated failure to repeal and replace the Affordable Care Act (‘also known as Obamacare’) is any indication, it looks as though Trump’s legislative path is likely to be rockier than investors expected, making a successful pivot to infrastructure or tax reform more challenging.
Ongoing talks on health care reform between the White House and the fractious House Republicans to come to an agreement on health care reform have thus far failed to bear fruit, and the efforts have added more ink to an already crowded legislative calendar. The more protracted the health care effort, the less time there is for other policy priorities.
Turn the page
Adherents of the ‘Trumpflation’ trade argue that it might make more sense for Trump to turn the page on health care, which could accelerate fiscal stimulus by moving it forward on the legislative calendar. With the fight over Obamacare apparently lost, the argument goes, potentially pro-growth policies might be enacted sooner, impacting the economy earlier than had been forecasted. But regardless of the timing of any fiscal policy initiatives, without the repeal and replacement of Obamacare the scope for fiscal reform will likely be limited. One trillion dollars in potential savings will remain unavailable for other endeavours. Gone, too, will be a significant cut in the capital gains tax that would have come as part of the Obamacare repeal.
Three potential approaches
Assuming the president eventually admits defeat on the health care overhaul, which way will he turn legislatively? There seem to be three potential approaches he could take. The first is to pick some low-hanging legislative fruit. For instance, he could pursue modest corporate and personal tax cuts instead of large-scale, comprehensive tax reform. These, however, wouldn’t move the dial much in terms of providing economic stimulus, rationalising the tax code or fostering growth. The second approach is to put forward a substantial and unfunded fiscal package, one that would produce large fiscal deficits. That may prove difficult, as the deficit hawks of the Freedom Caucus, a group of about three dozen small-government fiscal conservatives, would likely oppose such a course of action. The third approach is a major reshaping of the US tax code, including the adoption of a border adjustment tax (BAT). Such a levy would tax imports into the US, while exports would be tax free. A BAT would mean a major boost in government revenue, which would allow for a significant cut in corporate tax rates. This approach is the most economically and politically risky, and therefore the least likely to occur at this point. But given this administration’s penchant for unpredictability, it can’t be ruled out.
Could legislative success prove counterproductive?
No matter which path the White House chooses to pursue, markets need to be mindful of how the US Federal Reserve might react to a fiscal policy shift. Should Trump rebound from a health care defeat and rack up victories that materially loosen fiscal policy, the Fed may feel a need to ‘take away the punchbowl’ before the party gets out of hand. This reaction, all things being equal, could potentially boost the dollar, ultimately tightening financial conditions considerably. Therefore, a major legislative victory for the Trump administration could, ironically, end up jeopardising the longevity of this lengthy business cycle. However, a smaller fiscal package, which would be less of a political win for the president, could in fact lead to a more prolonged cycle since it might allow the Fed to raise rates more gradually while keeping dollar gains muted and interest rates relatively well contained.
Are we set up for disappointment?
Given the market’s initial sky-high expectations that Trump’s agenda would improve the investment backdrop regardless of any legislative setbacks, it was always going to be hard to live up to the hype. And having struggled mightily in its first foray into murky legislative waters, logic would suggest that the Trump White House will now advance a more risk-averse, less ambitious agenda. Taken together, it looks increasingly likely that whatever boost the US economy gets on the fiscal front will be smaller than anticipated and later in arriving than the market’s earlier expectations. Indeed, Treasury secretary Steven Mnuchin recently admitted that it is unlikely tax reform legislation will be enacted by August, as he’d promised earlier.
Shortly after the election, investors seemed to conclude that the Republican Congress would be given free rein from a Republican Congress to enact his program. To date, that has been far from the case, setting markets up for disappointment, the initial effects of which we may just be witnessing now.
Erik Weisman is chief economist at MFS Investment Management, an asset manager with $US440 billion in assets.