The U.S. economy is barreling ahead. For now. But Trump's economic policies will prove to be anathema to U.S. stock prices. How deep will the fall be? Read on.
Imbalances in The U.S. Economy Will Drive Stocks Lower; With a Note on China
By Robert Z. Aliber
Donald Trump appears to have a golden touch as a manager of the U.S. economy. The U.S. unemployment rate is below four percent, the lowest in more than fifty years. More Americans are at work than at any earlier date. More blacks are employed than ever before, the black unemployment rate has declined from 7.8 percent a year ago to 6.6 percent. The labor force participation rate has been increasing modestly. U.S. real GDP increased by 2.2 percent in the first quarter of 2018 and 4.2 percent in the second quarter; the estimate of the Federal Reserve of Atlanta is that the economy will grow by 3.8 percent in the third quarter. Real wages are increasing modestly, and somewhat more rapidly for those with jobs, because the entry of many unskilled workers gives a downward bias to economy-wide data. Corporate profits are soaring; the profit share of GDP is higher than ever before. Stock prices are at new peaks. Consumer confidence is very high. Wal-Mart sales are booming. House prices have been increasing and mortgage interest rates are low for qualified borrowers, especially after adjusting for upward creep in the consumer price level.
The price of the U.S. dollar has increased significantly in the last year —and the British pound and the Euro have declined, while the Chinese yuan, the Turkish lira, and the Argentinean peso have tanked.
What’s not to like?
Trump’s business history is less impressive. He paid $390 million for the Plaza Hotel—perhaps the most elegant property in New York City —in March 1988. Trump installed Ivana as president of the hotel and spent $50 million on renovations. Trump was forced to give up ownership of the Plaza four years later because the debt servicing burden was too large relative to operating income—in effect he overpaid. He acquired the Eastern Airlines shuttle between New York, and Boston and Washington in 1989; the business failed to take off despite the gold-plated fixtures that he had installed in the lavatories. Same story, he overpaid. His name was on four casinos in Atlantic City that tanked. A Trump-inspired hotel in SoHo failed.
Trump became wealthy despite these set-backs. He has his own air fleet, including a Boeing 757. Trump has been a classic asset-stripper; take as much out of the business today in salary and dividends as you can. If today’s cash drains lead to bankruptcy tomorrow, that’s a problem for the lenders who know the “rules of the game”. While it might seem that there is an infinite supply of assets that can be plucked, the chatter is that Trump turned to foreign sources of credit because the New York banks were miffed by his reluctance to adhere to loan agreements. Trump is in the Guinness Book of World Records for having stiffed more tradesmen than anyone else in Manhattan. (Truthful hyperbole rubs off, I made that up.)
Trump’s personality has become part of his business strategy since his TV program “The Apprentice”; he is unlike Warren Buffet or Bill Gates or Steve Jobs or Larry Ellison. His name has positive cachet for thousands of individuals and much of his recent income is from renting his name, like many star athletes—although Trump steaks and Trump vodka are no longer available. His real estate sales development program that was marketed as Trump University has been closed.
His style as President has been confrontational, much as if he were involved in episodic negotiation with lenders to receive more favorable terms and with suppliers to secure lower prices. It’s a parody on the theme “I can get it for you wholesale”. He told Boeing that the replacement for Air Force One was much too expensive. (A Chicago anecdote. Trump’s first real estate success in Manhattan was the transformation of the Commodore Hotel on 42nd Street into the Grand Hyatt; he was a 50-50 partner with the Pritzkers. The partners had agreed to spend $50 million on the renovations. Trump said they would spend $500 million at a press conference announcing the renovation. After the press conference the Pritzker partner asked about the much higher estimate. Trump’s reply was that “$500 million will get much more attention.”
NATO and NAFTA are up for renegotiation, Trump continually seeks a better deal, as if he is stiffing the caterer at the wedding of one of his children. Threats are part of the negotiation.
Trump taunted the North Korean leader Kim Jong-Un with fire and brimstone, and a few weeks he played kissy-kissy make-up with Kim in Singapore. U.S. tariffs on imports from Turkey are a put-down for President Erdogan; the demand that the Ankara government release Pastor Andrew Brunson from house arrest provides Trump with an opportunity to demonstrate his prowess. Bob Woodward’s new book on Trump in the White House is titled FEAR. Personality has replaced policy.
Trump’s tariffs on imports of aluminum and steel and on $35 billion—or $200 billion--of imports from China do not appear to have dampened the U.S. growth rate. The U.S. economy is now in the 112th month of its second longest expansion; the longest in the 1990s went on for 120 months.
The spurt in the U.S. growth rate in the last six months has resulted primarily from the reductions in the tax rates at the end of 2017, which led to an increase of $170 billion in after-tax corporate and personal incomes. The U.S. Congress approved a $90 billion increase in annual spending on defense and on social programs. The U.S. fiscal deficit has increased by $260 billion—1.3 percent of U.S. GDP-- and is approaching five percent of U.S. GDP.
A fiscal deficit at five per cent of U.S. GDP when the economy is at full employment is a major non-sustainable imbalance. The ratio of the deficit to GDP will be much higher when there is significant slack in the economy because fiscal revenues will decline.
It’s not a surprise that a one percent plus increase in the U.S. fiscal deficit has led to a one percent increase in the reported growth rate, most of the increase in after-tax incomes has been spent. Most of the increase in the growth rate represents increases in the price level rather than in real income because of labor shortages. It’s remindful of the floor numbering in a Trump building, the top floor in a forty story building is the 55th. Trump discovered that people will pay more for an apartment on the 55th floor than for one of the 40th floor even though both apartments are 400 feet above street level.
The U.S. government now is involved in Ponzi finance, since the increase in its indebtedness is twice as large as the interest payments on the indebtedness. This pattern developed because interest rates have been exceptionally low since the 2008 crash, in part because of the Fed’s Quantitative Easing policy.
If interest rates were at their historic normal levels, the U.S. fiscal deficit would be $200 billion higher. Trump once said he would “pay off” the debt; the likelihood that the U.S. government can outgrow the deficit is trivially small. When the next recession develops, the decline in tax revenues will lead to a surge in the deficit; as the debt to GDP ratio increases above one hundred percent, some investors will become increasing skeptical about the credit worthiness of the U.S., government. Sort of the “United States as Italy”. It doesn’t help that the asset stripper in the White House likes to screw creditors.
President Trump believes many hundreds of thousands of jobs in U.S. manufacturing have been lost because of the increase in the U.S. trade deficit. NAFTA and China’s membership in the World Trade Organization have contributed to the deficit. Trump has threatened to limit U.S. imports from Canada and Germany and China unless they reduce their trade surpluses with the United States.
The increase in the U.S. trade deficit in the last forty years has been associated with higher prices for the U.S. dollar and a larger U.S. fiscal deficit. The purchases of U.S. dollar securities and U.S. assets by sovereign wealth funds and foreign central banks have contributed to the U.S. trade deficit and the U.S. fiscal deficit even as they helped finance both deficits. The increase in the U.S. trade deficit has eroded the tax base in the tradeable goods sectors and contributed to larger U.S. fiscal deficits. The tax reductions in 2017, like those in the 2001 and 2003, also have contributed to larger deficits.
And now a brief detour to China, the second largest economy (by some measures its economy is larger than the U.S. economy.) The rapid growth in its exports in the last thirty years has led to the decline of hundreds of thousands of U.S. manufacturing jobs, although many of the electronic products like I-Pads that the United States imports from China were never produced in the United States. China’s exceptionally high savings rate has enabled it to develop a first-world infrastructure of toll roads, airports, high speed railroads, and to make large loans to many foreign governments and to buy $4,000 billion of U.S. securities. Individual Chinese have relied on domestic saving to finance the purchase of hundreds of thousands upscale U.S. homes.
The data on rail car loadings, electricity consumption, and copper imports suggest economic growth has slowed dramatically (much more rapidly than the official data suggest). The puzzle is that despite the slowdown in its growth rate and the decline in th price of the Chinese yuan, China’s trade surplus has fallen to one percent of its GDP.
Changes in China’s exports and imports have a major impact on the U.S. economy. If China’s growth rate slows and more of its savings flow abroad, both its trade surplus and the U.S. trade deficit will increase. If China reduces its holdings of U.S. dollar securities, the price of the U.S. dollar will fall. Trump has to choose between a strong dollar and a large trade deficit or a weak dollar and a smaller U.S. trade deficit.
As the trade surpluses of Germany and China decline, their demand for U.S. dollar securities will diminish. “Weaponising” the U.S. dollar has led the Russians to reduce their holdings of U.S. securities from $90 billion to less than $20 billion; Putin is concerned that Washington might adopt currency controls that would limit access to his money. The Chinese government shares this concern.
Economic expansions continue as long as spending increases, expansions end when spending declines. As their incomes increase, households spend more; the decline in spending that leads to the end of an expansion often has resulted from slower growth in the supply of credit, either because the Fed has removed its punch bowl or because the banks have become more cautious lenders.
The expansion of the 1970s ended because the Volcker Fed adopted a sharply contractive policy to crush anticipations that the inflation rate would accelerate. The expansion of the 1980s ended with a whimper because the sharp decline in stock prices led households to spend less. The expansion of the 1990s also ended with a whimper even though stock prices declined by forty percent between 2000 and 2003. In contrast the expansion of the 2000s ended with a bang in 2008 because the banks suddenly became much more cautious lenders as the losses on their mortgage loans surged.
The Trump administration has not made the connection between the U.S. trade deficit and foreign purchases of U.S. dollar securities. Trump has threatened China and Germany that their trade surpluses are too large. These governments will respond positively if grudgingly; some have observed the destabilizing impacts of Trump bluster on the prices of their currencies and on their stock prices.
The current U.S. expansion might end because of a goods market shock, especially a drop in U.S. exports because the sharp slowdowns in Turkey, Argentina, Brazil, and South Africa lead to a decline in their imports.
The current U.S. expansion is more likely to end because the perfect storm that is developing in the securities market from an irresponsible fiscal expansion at a time of monetary contraction will lead to a spike in interest rates that will puncture the prices of high-flying stocks like Facebook and Amazon. Trump’s tariffs will contribute to higher interest rates as the increases in the U.S. prices of imports put upward pressure on the inflation rate. (The price of tofu will decline because higher Chinese tariffs have led to a soybean glut.) The increase in money wages because of labor market shortages will cripple corporate profits. The Federal Reserve will continue to raise interest rates; since the inflation rate is nearly three percent while the interest rates on ten-year treasury bonds is 3.10 percent, the Fed is far behind the curve. The Fed has begun to unwind the massive portfolio that it acquired to increase prices of securities, which will lead to declines in their prices.
Many countries in addition to Russia and China will sell their U.S. securities because of they have no confidence in Trump’s judgment. (Trump’s shtick as an asset striper is to rip off creditors; he has thrown three grenades at the Fed to caution against further increases in interest rates and it is inevitable that he will threaten the Fed, perhaps by suggesting that it should become a ward of U.S. Treasury much as in the 1940s.) Once stock prices began to decline, investors will rush to convert the unrealized gains from the tripling of stock prices into cash, much as in 2000.
How far will stock prices decline? The last three declines have ranged from thirty five to fifty five percent. When might stock prices tumble—a month from now, six months from now?
If the imbalances can’t be sustained, they won’t be sustained.
Time to tighten seat belts.
Robert Z. Aliber is Professor Emeritus of International Finance at the Booth School of Business, The University of Chicago. He can be reached at email@example.com.