Author Archives: Nicholas Sargen

About Nicholas Sargen

NICHOLAS SARGEN is Senior Fellow, Global Markets and Investment Management at CFS, and an international economist turned global money manager. Having been involved in international financial markets since the early 1970s, Nick is currently the Senior Vice President and Chief Economist, Western & Southern Financial Group and a Senior Investment Advisor at Fort Washington Investment Advisors, Inc., a wholly owned subsidiary.

Sargen: How Tariffs and China’s Slowdown Impact US Companies

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As U.S. companies report fourth quarter earnings, a growing number have cited China’s slowdown as adversely impacting their businesses.  The most recent include industry bellwethers such as Apple, Caterpillar, and Nvidia.  In prior reports, multinationals such as Alcoa, Coca-Cola, Ford, GE, Harley-Davidson, and Whirlpool stated their earnings were being hit by higher tariffs on imports from China.

This list, moreover, is likely to grow if China slows further and/or tariffs on Chinese imports are increased.  However, this begs two questions: (i) Why is China’s economy softening; and (ii) Will the government be able to stabilize growth as it did in 2016?

One of the challenges investors confront is to assess whether China’s slowdown is primarily cyclical or secular.  Its growth rate has slowed steadily throughout this this decade, from about 10% in 2010 to 6.6% last year, the lowest in three decades.  In dissecting the recent slowdown, investors need to disentangle the effect of higher tariffs on Chinese imports from the impact of structural changes inside China.

There is general agreement that last year’s slowdown coincided with tariffs being imposed on 10% of Chinese goods imported to the U.S. during the first half of 2018.  The economy weakened further in the second half, when the list was extended to cover one half of imports from China.  Accordingly, investors believe a resolution of the trade dispute is critical to stabilize China’s economy.

Beyond this, China’s potential growth rate is decelerating for structural reasons. The country’s economic miracle was founded on agricultural workers in rural areas migrating to urban areas along the coast with higher-productivity manufacturing jobs.  But this process has become more challenging as wages in manufacturing have increased and unit labor costs have surged. Consequently, some economists believe China confronts a “middle income trap.”

Amid declining productivity growth, China’s government has relied increasingly on fiscal stimulus and credit expansion to achieve its growth target of 6.0%-6.5%.  But this has also resulted in a doubling of China’s overall debt burden from about 150% of GDP before the GFC in 2008 to 300% currently.  The problem with this strategy is it is not viable, as more and more credit is required to support each unit of output.  The reason: Much of the credit expansion has gone to SOEs, some of which the IMF labels as “zombies” – or firms that pile on debt but do not contribute positive value added.

Faced with this predicament, China’s policymakers pursued several measures last year to bolster the economy.  They included lowering short term interest rates by more than 200 basis points, allowing the yuan/dollar exchange rate to decline by 10%, while also expanding credit and lowering tax rates.  Similar actions were undertaken during China’s slowdown in 2015-2016, which proved effective in bolstering the economy.

Thus far, however, their impact is not readily apparent.  Auto sales, for example, declined in November by nearly 14% over a year ago, and Apple’s recent public filing indicated softness in consumer spending on electronics.  China’s imports plummeted in December, and exports also appear headed for a fall based on recent purchasing manager surveys and weakness in Asia and Europe.

What is clear is China’s policymakers are prepared to take additional actions to keep economic growth above the 6% threshold.  The central bank, for example, announced a one percent reduction in reserve requirements, and the government is boosting spending and lowering taxes. What is unclear is whether such action will be as effective as in the past due to the country’s rising debt burden.

The wildcard is whether an agreement on trade can be reached by the March 1 deadline.  While both sides wish to do so, the underlying issues are complex.  If the disagreement were simply about the size of the bilateral trade imbalance, the issue would be resolved, as China is willing to boost imports from the US and could direct SOEs to do so. However, the more difficult issues relate to violations of intellectual property and subsidization of businesses by the Chinese government, which the US opposes.

The most likely outcome is a temporary truce will be reached, which would bolster world equities for a while.  However, because a lasting agreement is harder to achieve, officials may in effect opt to “kick the can down the road.”

The outcome will have an important bearing on global economies.  While the US economy has withstood the impact of China’s slowdown thus far, a growing number of US companies are feeling the impact as noted previously. Furthermore, there has been a significant downward revision to earnings expectations by Wall Street analysts over the past six months. They are now calling for S&P 500 EPS growth of 8.1% in 2019 from more than 20% last year.  Yet, some observers believe the results will be weaker.

Ultimately, the market’s outcome will depend on whether China’s slowdown can be arrested by policy action.  If so, equity markets are likely to rally.  If not, they are likely to stay volatile, as the impact of a permanent slowdown has not been priced into markets.

Sargen: The Fed Begins to Shrink Its Balance Sheet

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Highlights

  • The Federal Reserve is expected to announce it will begin to shrink its balance sheet over the next few years at this month’s FOMC meeting.  Investors are pondering how smoothly the process will go.
  • Opinions on this matter are divided.  Some observers are concerned it could disrupt financial markets, but the prevailing view is it will not.
  • Another issue is whether monetary policy will ever be as it was before the 2008 Global Financial Crisis (GFC).  Our take is it has been permanently altered, because the transmission mechanism increasingly works through capital markets.
  • We believe the Fed will aim for the funds rate to reach 2% and will then pause.  The changing composition of the Board of Governors, however, adds an element of uncertainty in 2018.

The Controversy Surrounding Quantitative Easing

During the GFC the Federal Reserve engaged in unorthodox policies that were intended to stabilize the financial system and to encourage investors to add to holdings of risk assets.  The Fed did so by purchasing massive amounts of government securities and residential mortgage-backed securities (RMBS) that increased its balance sheet four-fold (Figure 1).  The initial round of quantitative easing (QE) is widely credited by economists as having stabilized the financial system and thereby averted an even worse outcome.  However, subsequent rounds were viewed more skeptically, as they occurred when the economy and markets had stabilized.

Figure 1:  Assets of the Federal Reserve ($ billions)


Source: Bloomberg and Federal Reserve.

The Fed’s intent was to encourage investors to add to risk assets such as corporate stocks and bonds, which would bolster the economy by creating a positive wealth effect and ease borrowing conditions for consumers and corporations.  From the Fed’s perspective, it was worth doing so in order to reduce the unemployment rate, which fell from a peak of 10% to below 4.5% recently.  One of the main criticisms, however, is that its actions also distorted capital market prices and thereby may contribute to another asset bubble.  Previously, the Fed primarily influenced short-term interest rates rather than the entire term structure and risk assets, so it would not distort capital markets.

Normalizing Monetary Policy

The ultimate test of the QE experiment is the Fed’s ability to develop a successful exit strategy.  The Fed’s staff has been working on a game-plan since the early part of this decade.  One of the first actions was the decision to pay interest on bank reserves.  By doing so, the Fed created an additional means to control bank reserves and thereby lessen the risk that the money supply would expand unduly once bank lending expanded materially.  Officials were also cognizant of mistakes their predecessors made during the Great Depression, when the Fed doubled reserve requirements and banks responded by reducing loans outstanding considerably.

One of the key differences today is that monetary policy works through capital markets, as well as through the banking system.  Therefore, the Fed ultimately must influence investors’ expectations by communicating its intentions clearly.  Policymakers learned this lesson all too well during the so-called “taper tantrum” in mid-2013, when Ben Bernanke mentioned in Congressional testimony that the Fed was considering winding down its purchases of securities in 2014.  Much to the Fed’s chagrin, bond yield surged by a full percentage point during the remainder of 2013 as investors believed the Fed was about to tighten monetary policy.

In light of this experience, some observers are concerned that a similar outcome could occur as the Fed pares its holdings of securities.  The prevailing view, however, is that this news already is priced into markets, and a spike in rates is only likely if there are surprise developments. Recognizing this, Fed officials have gone out of their way to reassure investors that it will shrink its balance sheet very gradually: It has stated that it will not sell securities outright, but will allow a portion to roll off its books as bonds mature.

The Fed also indicated at the June FOMC meeting that its balance sheet would eventually decline by $50 billion on a monthly basis ($600 billion annually) until it chooses to halt or reverse the process.  At this pace, the monetary base would revert to its pre-crisis growth trend by 2021. However, Fed watchers do not expect it to get there: Estimates vary, but the general consensus is the terminal size of the balance sheet the Fed range is around $2.5 trillion, or roughly one half of the current level.  The Fed has indicated that the balance sheet will be no larger than necessary to manage monetary policy in the current framework, which requires more reserves than pre-crisis policy.

Challenges Confronting Policymakers

It remains to be seen how well the transition to policy normalization will go.  Although the initial process has been smooth, the Fed nonetheless faces formidable challenges ahead.  One is to ascertain the natural rate of unemployment, commonly referred to as NAIRU, below which inflation rises.  This is important because the Fed utilizes econometric models that assume the Phillips curve relationship between wage increases and unemployment holds.  The relationship, however, is far from stable: Previously, wage pressures would typically be evident when the unemployment rate is below 5%, but this has not happened currently.  The reason is unclear to policymakers and market participants, but one reason may be is that there is a large pool of workers who are currently working part time that are seeking full time jobs.

Meanwhile, the core rate of inflation has drifted below the Fed’s 2% target.  This has increased uncertainty about whether it will raise the funds rate at the end of this year, as it did in 2015 and 2016.  Nonetheless, while the timing of rate increases is uncertain, we believe the Fed is aiming for a funds rate of 2.0% and will then pause.  This is well below the average rate of 4%, which is typical for an economy growing at 2% and inflation close to that pace.

Will Monetary Policy Ever Return to Normal?

This begs the question of whether monetary policy will eventually revert to the way it was conducted before the GFC, when it mainly influenced the volume of bank reserves by purchasing or selling treasuries to influence the funds rate.

Our assessment is that the conduct of monetary policy has been altered permanently, as the transmission mechanism increasingly occurs through capital markets.  If so, investors need a guide to assess whether policy conditions are becoming easier or tighter.  The standard procedure today is to look at a variety of financial market indicators — such as short term and long term treasury yields, credit spreads, the stock market, and the trade weighted dollar – to compute a financial conditions index.  Thus, based on the latest readings, financial conditions have actually eased despite the increases in the funds rate, because equities have risen while credit spreads and the trade-weighted dollar have declined (Figure 2).

Figure 2: Financial Conditions Have Eased Recently

Source: Bloomberg and Goldman Sachs.

Finally, it remains to be seen how monetary policy may shift as the composition of the Board of Governors changes.  By next year, for example, there could be a new Fed Chair, along with a new Vice Chair and three new governors.  It is too early to speculate about what is in store. Nonetheless, investors will be keen to assess whether monetary policy will remain highly discretionary and consensual, as it was during the Bernanke-Yellen era, or whether it will become more rules based, as some Fed critics have argued.  In this respect, the changing of the guard will become a focus for market participants in the coming year.

Sargen: A Tale of Two Countries: UK and France

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Highlights

  • Theresa May’s decision to call an early election as Prime Minister has come back to haunt her:  Labor Party leader Jeremy Corbyn mounted a credible campaign that denied the Conservative Party a parliamentary majority.  The outcome has added to uncertainty about how the newly-formed British Government will negotiate leaving the European Union (EU).
  • By comparison, the political picture in France continues to improve, as Prime Minister Macron’s newly-formed political party posted a decisive victory in the parliamentary elections.  This outcome has boosted hopes that Macron will press forward with plans to overhaul France’s antiquated labor laws.
  • The contrast between the fortunes of the UK and France is striking.  Britain’s economy was among the most dynamic in Europe one year ago, but its future is now clouded by political dysfunction, whereas Macron’s election has raised hopes that France can transform its economy and stabilize the EU.
  • Amid these developments, we continue to favor continental European equities, but are wary of the UK due to political and economic uncertainty.

UK Elections: Another Surprise Outcome

For the second time in twelve months, the electorate in the UK has defied the pollsters, this time by denying Prime Minister Theresa May and the Conservatives a clear parliamentary majority in the British elections.  When May called for an early election two months ago, the initial assessment of pollsters was the outcome would cement the Tory Party’s majority in parliament, thereby strengthening her hand in negotiating Britain’s departure from the EU.

Instead, the opposite happened. The opposition Labor Party, led by Jeremy Corbyn, a staunch left-winger, mounted a credible campaign that attracted younger voters who had abstained from voting on the referendum to leave the EU.  As a result, May is now scrambling to see if the Conservatives can form a coalition government with a splinter party that represents North Ireland.

Investors are now focused on what the change in political fortunes means for Britain’s exit from the EU.  If May and the Conservatives had won decisively, investors were expecting a so-called “hard exit”, in which the UK would sacrifice free trade arrangements with the EU for increased national sovereignty.  Now that the Conservative’s hand has been weakened, other political parties are insisting on participating in the negotiations with the EU, and the outcome could be a “soft exit,” meaning Britain would seek trade and financial concessions from the EU while surrendering some sovereignty to obtain them.

Beyond this is another looming issue – namely, how will the UK be governed when it is deeply divided as a nation?  According to The Economist, Britain’s main political parties appear polar opposite in many respects:  “Jeremy Corbyn has taken Labour to the loony left, proposing the heaviest tax burden since the Second World War. The Conservative Prime Minister, Theresa May, promises a hard exit from the EU.  The Liberal Democrats would prefer a soft version, or even reverse it.”[1]  Yet, The Economist goes on to observe that the Tory and Labour leaders, despite differences in style and core beliefs, have one thing in common: “Both Mrs. May and Mr. Corbyn would each in their own way step back from the ideas that made Britain prosper – its free markets, open borders and internationalism.”[2]

Since the Brexit vote one year ago, the UK economy has held up better than many observers expected, as a 13% – 14% depreciation of sterling versus the dollar and euro have helped cushion the blow on exporters.  However, the latest indications are the economy is slowing, as real wages have stagnated and public funding is stretched. As a result, investors are becoming nervous about the country’s future.

France: More Positive Surprises

Meanwhile the political picture in France continues to improve, as President Macron’s newly-formed political party En Marche scored a decisive win in the French parliamentary elections on Sunday.  With Macron’s party gaining a clear majority in parliament, the 39-year old president is in strong position to enact his pro-reform agenda that includes weakening France’s protective labor laws, changing tax laws, and reducing pension benefits for some workers.  Moreover, whereas a year ago France appeared to be swept up in an anti-European, anti-immigrant wave, the nation has now rallied around a centrist and unabashed globalist, who seeks to strengthen the EU.

The key challenge Macron faces is whether he can make headway in reducing France’s high unemployment rate, which stands at 9.6% – the lowest in five years. For decades French politicians have tried to reform France’s antiquated system, which makes it prohibitively expensive to fire employees, only to back away in response to public protests. While only 8% of French workers belong to a union, 98% are covered by national and industry-wide contracts negotiated by unions.[3]  This arrangement is particularly problematic for smaller businesses that cannot negotiate terms on their behalf.

Macron is attempting to rectify the situation by making it easier to fire employees, capping damages in unfair dismissal cases and decentralizing collective bargaining.  At the same time, he plans to expand worker protections by making those who voluntarily quit their jobs eligible for unemployment benefits.  Macron’s goal of transforming France’s labor laws by the end of summer is considered ambiguous, and it remains to be seen how he will stand up to tumultuous strikes and protests.  That said, this appears to be the best chance to reform the system in decades.  Should Macron persevere, France hopefully would see the benefits of declining unemployment, much as Germany did when it enacted its labor reforms during the past decade.  Note: Germany’s unemployment rate currently is 3.9%, well below other EU members.

Investment Implications

Weighing these considerations, we continue to favor European equities, as political risks in EU have diminished while economic performance has improved. (See Time to Consider Europe, May 23, 2017)  That said, we would underweight UK equities on grounds the political situation has deteriorated and there is considerable uncertainty surrounding Britain’s exit from the EU.

Equity Markets:  France (CAC-40) versus UK (FTSE), January 2016 to Present

Source: Bloomberg. Local currency returns.

 

[1] The Economist, June 3rd-9th, 2017, p.13.
[2] Ibid., p.13
[3] See Catherine Rampell, “Macron attempts a feat that Trump wouldn’t dare,” The Washington Post, June 8, 2017.

Sargen: Time to Consider Europe

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Highlights

  • Emmanuel Macron’s election as President of France has buoyed European markets, as it is the third election this year in which populist candidates have been defeated.  Moreover, with Angela Merkel’s party scoring key wins in regional elections, her chances of being re-elected in the fall are high.
  • In addition to lessened political risks, investors have been attracted by better-than-expected economic performance in the European Union (EU) this year.  Germany’s economy has been the locomotive, and Macron’s election has raised hopes that France will finally embark on much-needed structural reforms and that a renewed Franco-German partnership will revive the EU, as well.
  • Weighing these considerations, this may be a good time to add exposure to European equity markets: Profit growth has surged recently and political risk has lessened, while the discount on European stocks relative to the U.S. is in line with long-term norms.  The main risks are that Macron may not be able to deliver reforms and a populist leader could become Italy’s next President.

Background: EU Political Risks Lessen, while European Economies Improve

At the start of this year, a key issue relating to Europe was the prospect that elections in several countries – notably, Austria, Holland, France, Germany and Italy – could result in populist victories that would threaten the EU’s viability in the wake of last year’s vote in the UK in favor of Brexit.  France’s election was perceived to be the most important, because Marine Le Pen, the far right candidate, advocated that France should leave the EU and the euro.  While the odds of this happening were low, investor concerns heightened leading up to the first round elections, when there was a possibility Le Pen and far-left candidate, Jean-Luc Mélenchon, could be the two finalists.  In the event, Emmanuel Macron, a centrist politician who campaigned as a reformer, emerged as the front runner and went on to defeat Le Pen handily in the run-off.

In the wake of these developments, European equity markets rallied at one point by 5%, led by an 8% advance for the CAC.  The rally not only reflects investor relief that France will remain a core member of the EU, but also that the tide of populism on the continent has been contained:  The French election is the third in a row in which populist candidates were defeated, and recent state elections in Germany indicate that Angela Merkel’s prospects for being re-elected Chancellor appear very good.

At the same time, the EU has experienced better-than-expected economic performance, led by Germany: The 2.5% annualized rise in German GDP in the first quarter was the biggest in four quarters, and was well above potential (1.8% according to European Commission estimates.)  Investment in machinery and equipment also picked up in the quarter, suggesting a broadening of the expansion, which had been led by personal consumption.  German GDP in real terms is now 8.5% above its pre-crisis peak in 1Q 2008, well above other EU members.  Meanwhile, unemployment in Germany has fallen below 4% from a peak of more than 10% during the crisis.

For the EU as a whole, real GDP growth was 2% annualized, the best showing in the past two years. The improvement in growth is linked to the European Central Bank’s policies to keep interest rates near zero while expanding its balance sheet via asset purchases.  In addition, the 10% depreciation of the euro against the dollar in the past three years helped boost exports.

As in the United States, so-called “soft data” such as purchasing managers’ indexes and sentiment readings show a marked pick-up since the latter part of 2016.  Indeed, according to Credit Suisse, the latest PMI readings are consistent with EU growth accelerating to 3% (see Figure 1).  We would note, however, that hard economic data does not yet indicate the improvement in business sentiment.  Nonetheless, the latest EC forecast calls for the EU to grow by 1.7% this year, which is a considerable improvement from the past few years.

Figure 1:  European PMI Surveys Point to Stronger Growth 

Source: Thomson Reuters, Markit, Credit Suisse.

Another positive development is headline CPI has accelerated this year and is approaching the ECB’s 2% target, after running close to zero in 2015-2016.  This suggests the threat of deflation is waning, and the ECB can consider normalizing interest rates if this pattern continues.  That said, we believe the ECB will be very cautious about tightening monetary policy.

Will Macron Transform France and the EU?

To some extent, the boost in European equities since the first round of the French elections can be attributed to a relief rally that Marine Le Pen was not elected.  Beyond this, in the wake of Macron’s very decisive victory, some observers have asked whether the election could represent a turning point for France and the EU: Macron is a reformer who also seeks closer ties between France and Germany, which constitute the core of the euro-zone.

Soon after his election, Macron visited German Chancellor Angela Merkel, and both pledged to work closely to draw up a “road map” of reforms for the EU, including the possibility of implementing treaty changes, if necessary.  Merkel noted that work first needed to be conducted on reforms that are needed before changes in the EU treaty would be implemented.  One of the most important is the need for greater fiscal sharing if the EU is to evolve from a monetary union to a fiscal union. To go down that route, however, Germany wants to be confident France is committed to structural reforms that will make its economy more dynamic.  The reason: Germany undertook a comprehensive set of labor market reforms in the previous decade that are credited for reviving its economy.

For his part, Macron has called for a “revolution” to simplify France’s Labor Code, which is a 3,600 page document that regulates nearly every aspect of employer-employee relations.  This will not be easy to pull off, however, as he will encounter strikers and protesters, as previous French Presidents have.  For example, Francois Hollande, Macron’s processor, backed away from embarking on labor reforms in the face of stiff opposition.  Other reforms being considered include cutting the corporate tax rate from 33% to 25%, and reducing the size of France’s bloated government.  The latter goal, however, is modest, as Macron seeks to slow the expansion of government rather than to reduce its size, which is the largest among the leading industrial countries.

Having formed a new political party, Macron must first build a coalition with existing parties, so that he can gain a legislative majority in the parliamentary elections in June.  Those he has recruited so far lean strongly to the left, with many coming from the reform faction of the Socialist Party.  To appeal to the right, Macron is credited with making a wise choice of Édouard Philippe as Prime Minister.  Still, it appears unlikely Macron will win an outright majority, and he therefore may have to rule with a coalition.  Consequently, it remains unclear how successful he will be in achieving reforms that France desperately needs.

The Case for European Equities

The principal reasons for considering European equities are that (i) earnings prospects have improved with the economic upturn, while (ii) Macron’s election and the rejection of populism in several key European countries have lessened political risk.

The improvement in European corporate profits is shown in Figure 2.  It illustrates how far they lagged the U.S. market when economic growth trailed that in the U.S., and how they have improved recently.  Among developed countries, European stock markets traditionally have been the most levered to economic performance, and this continues to be the case, as earnings growth in Europe has exceeded that in the U.S. recently.  Moreover, the percentage of European companies beating expectations is the highest in a decade.  An additional factor supporting corporate profitability has been the weak euro.  Although it has firmed against the dollar recently, it is still relatively cheap on a purchasing-power basis.

Figure 2:  European Corporate Profits Lag the U.S. Until Recently
12-month trailing EPS, Index, Jan 2006 = 100


Source: Datastream, JPMAM. April 28, 2017.

On the surface, it appears European equities may offer good relative value, as the discount of European multiples to the U.S. is about 15%.  The latter, however, is close to the average of the past decade or so, when one takes into account differences in the sector compositions.  Therefore, we consider European equities to be reasonably valued relative to the U.S.

The other major consideration is that political risk in Europe has diminished considerably with Macron’s election and the likelihood that Angela Merkel will be re-elected Chancellor of Germany.  This has contributed to inflows of funds into European markets recently.  The principal risk for investors is disappointment that Macron may not be able to deliver on his reform agenda.  Another risk is that populism could resurface in the Italian presidential elections that must be held no later than a year from now.

Weighing these considerations, I believe now may be a good time to add to European equities, after years of being cautious about European markets.

Sargen on Corporate Tax Cuts versus Tax Reform Revisited

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Highlights

  • As part of “the largest tax cut in history” the Trump Administration is proposing to lower the corporate tax rate to 15% while shifting to a territorial system in which U.S. companies no longer would be disadvantaged on taxation of overseas profits.  The stated goal is to boost long-term economic growth through increased business capital spending.
  • The one page proposal, however, is really a wish list of tax cuts for corporations and individuals, rather than a plan to reform the tax code.  That is the goal of the bill Paul Ryan and House Republicans drafted last summer; however, prospects for its passage have been hurt by failure to repeal Obamacare.
  • While equity investors are banking on corporate tax cuts to be enacted later this year, the unanswered question is how they will be paid. The President and his supporters contend the proposal pays for itself with stronger growth.  However, the risk is the federal deficit will blow out from already high levels.

The Trump Administration’s Wish List

Throughout the 2016 campaign, Donald Trump advocated lower taxes for businesses and individuals as a way to bolster economic growth, and he called for the corporate tax rate to be lowered to 15% from the current rate of 35%.  Because there were few details to back this proposal, however, investors focused on the tax bill drafted by Speaker Ryan and the Republican House leadership, as it had broad support among the Republican rank and file.  It contained four key provisions: (i) reduce the corporate tax rate to 20%; (ii) allow immediate expensing of capital outlays, but exclude interest deductions; (iii) incent businesses to repatriate profits earned abroad; and (iv) implement a border-adjustment-tax (BAT) that would effectively subsidize exports and tax imports.

The intent of the Republican bill was to streamline the tax code and facilitate passage by making it deficit neutral.  With the first three provisions generally consistent with the President’s agenda, market participants focused on the BAT provision that is controversial because of the adverse consequences for firms that rely on imports.

In the wake of the health care fiasco, the prospects for a tax bill that is deficit neutral were dealt two major blows: (1) The failure to replace Obamacare meant the Republican leadership could not garner the projected savings in revenues of more than one trillion dollars over ten years that would have occurred if Medicaid expansion had been halted.  (2) The wrangling over health care made it less likely that the BAT provision would clear the tax bill, because it is too complex and too controversial.

As these developments unfolded, I envisioned a situation in which Speaker Ryan would tell the President that he could no longer support a 20% corporate tax rate unless additional revenues were forthcoming.  Instead, the President upped the ante on Speaker Ryan and the Republican leaders in Congress this past week by stating he favored a 15% corporate tax rate and that he was not concerned about the budgetary consequences. (According to the Urban-Brookings Tax Center, lowering the corporate tax rate to 15% could entail a revenue loss of $2.4 trillion over 10 years, or $600 billion more with a 20% tax rate.)  In addition, the Administration’s proposal appears to drop the BAT provision, which is estimated to generate more than $1 trillion in revenues over the next ten years, and is silent on the issue of deductibility of interest expense.

In the Trump Administration’s view, a lower tax rate would spur stronger economic growth, which would boost tax revenues.  The problem, however, is that tax cuts may provide a boost to the economy by increasing aggregate demand, but the effects are likely to be only temporary if they blow out the budget.

Do Budget Deficits Matter?

This issue loomed large during the 1980s when the Reagan Administration achieved significant tax cuts for businesses and individuals that helped boost the economy.  Although they were accompanied by a significant expansion in the budget deficit, interest rates plummeted from record levels, mainly because the Federal Reserve succeeded in reining in inflation and inflation expectations.  Accordingly, many people at the time concluded budget deficits did not matter for the economy or financial markets.

One needs to be careful about drawing this inference today, however, because the economic environment is very different.  First, inflation and interest rates are near record low levels, and they are likely headed higher as the economy improves and the Fed normalizes interest rates.  Second, the trend rate of economic growth has fallen from more than 3% per annum to about 2% p.a. in the past decade. The challenge the Administration and Congress face is that it is not easy to boost productivity growth and increase labor force participation.

According to the Congressional Budget Office (CBO) projections based on recent trend growth, the budgetary picture is about to worsen in the absence of any policy changes: The federal deficit is projected to grow from less than 3% of GDP to more than 5% by 2027.  This is mainly due to increased outlays for entitlement programs such as Social Security, Medicare and Medicaid owing to the aging of the population and medical costs that have outstripped the pace of inflation.  Stated another way, ten years from now all federal revenues would go to pay for entitlements and debt servicing costs, meaning that all discretionary programs would have to be covered out of deficit financing.

Supporters of lower tax rates counter the picture is far less bleak if trend growth of 3% is restored. (See the commentary by Stephen Moore “Growth Can Solve the Debt Problem” in the Wall Street Journal dated April 26.)  This line of reasoning, however, is risky, because one can always assume the problem away via optimistic growth rate assumptions.  (See the commentary by former CBO Director, Douglas Holtz-Eakin, “Trump’s Tax Plan is Built on a Fairy Tale” in the Washington Post dated April 26.)

So far, at least, financial markets have adopted a “wait and see” posture.  Equity investors are banking on a boost to the economy and corporate profits from tax cuts being enacted, while the bond market is dubious, but supported by lower interest rates abroad.

Speaker Ryan and Republican leaders in Congress, however, are more concerned about prospects for the budget. They are likely to push back on the President’s tax initiatives, especially when he is also supporting increased spending on defense and infrastructure and no checks on the growth of entitlement programs.  It remains to be seen, therefore, how the political process will play out, and whether the President’s tax proposal or the Congressional Republicans’ will prevail. Meanwhile the process is expected to drag on for a long time and possibly into next year.

Sargen on Healthcare, the Budget, and Tax Reform

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Highlights

  • Economic policies of the Trump Administration are key to assessing the economic and market outlook.  The Republican House tax bill drafted last summer and slated to be voted on later this year has been the focal point for investors. Meanwhile, they are assessing the Republican replacement plan for Obamacare and the 2018 budget proposal submitted by the Office of Management and Budget (OMB) this past week.
  • Both plans are highly controversial, and it remains to be seen what will ultimately be enacted. The proposed budget would fund a 9% increase in military and security spending via steep cutbacks in non-defense related programs that Congressional Democrats and some Republicans oppose.  The main worry for the Republican leadership, however, is that the replacement plan for Obamacare may not attract sufficient Republican support to ensure passage.
  • How these proposals play out could have important consequences for tax reform legislation.  The healthcare plan supported by Speaker Ryan will halt Medicaid expansion in 2020 and shift funding from open-ended entitlements to a per capita cap.  The Congressional Budget Office (CBO) estimates it will generate $1 trillion in savings over a decade, although it will also reduce the number of people receiving insurance substantially.
  • Prospects for enacting tax reform would be enhanced if the Congressional Republicans coalesced on a healthcare plan, whereas failure to reach agreement could jeopardize tax reform and lessen investor confidence.  The vote in the House this week will provide an early read.

Focusing on Economic Policies

One of our main messages for investors since the presidential election has been to focus on policies of the Trump Administration that will have an important bearing on the economy. They are the news that will drive financial markets, as opposed to comments and tweets by the President that many regard as noise.

Until recently, the only substantive policy proposal was the House tax reform bill drafted by the Republican leadership last summer.  It contains features that President Trump supports including: (i) a significant reduction in the corporate tax rate (albeit to 20% instead of the 15%); (ii) immediate expensing of capital outlays but no interest rate deductibility; and (iii) incentives for multinationals to repatriate profits earned abroad.

The most controversial element is the border adjustment tax (BAT) that effectively subsidizes exports and taxes imports of overseas affiliates.  The intent is to eliminate incentives for U.S.-based firms to shift production abroad, and the BAT is also estimated to create more than one trillion dollars in tax revenues over a decade.  The latter is deemed essential by the Republican leadership to ensure tax reform is neutral for the federal budget.

The prospect of significant tax reform combined with regulatory relief, in turn, has been a major driver of the stock market rally since the election.  Indeed, some surveys indicate that approximately 70% of those polled believe legislation will be passed later this year.  The principal uncertainty is whether the BAT provision will clear the final bill.  If not, prospects for the budget deficit expanding considerably are higher, as it will be difficult to make up the loss in revenues.

Beyond this, investors suspect the budget deficit is set to widen during the Trump Administration for the following reasons: (i) President Trump supports a large increase in military and security spending as well as a one trillion dollar infrastructure program; (ii) during the campaign he indicated he would not touch entitlement programs such as Social Security, Medicare, and Medicaid; and (iii)  the President has stated he would help pay for these programs by making large scale cuts in other discretionary spending; collectively, however, they account for only 15% of total federal spending.

With the House Republican leaders recently having drafted legislation to replace Obamacare and the Office of Management and Budget submitting its plan for discretionary spending in the coming fiscal year, investors are now examining details of both plans and assessing the prospects they will be enacted.

Linking OMB’s Budget Plan and the Republican Health Care Bill

The budget plan submitted by OMB and the Republican bill to replace Obamacare were submitted separately; consequently, they have each drawn considerable scrutiny.  To understand them better, however, it is important to recognize that both are key components of the FY2018 budget plan that will be enacted later this year.

The plan submitted by OMB last week, for example, applies only to discretionary federal spending, which represents about 30% of total federal spending.  Under the OMB proposal, military and security outlays would increase by 9% in FY2018, and would be funded entirely through cutbacks in other programs, of which the largest would be for social programs and the EPA.  However, because Democrats and some Republicans are staunchly opposed to large-scale cutbacks in non-defense spending, the OMB plan is widely perceived to be an opening move by the Trump Administration that lays out its priorities.

The main areas of spending that are not addressed in the OMB proposal are mandatory programs, which consist of entitlements (Social Security, Medicare and Medicaid) and net interest payments on the national debt.  Of these, the fastest growing segment is Medicaid, which was expanded as part of the Affordable Care Act (ACA) and resulted in the largest gain in insurance coverage, about 11 million people.  As currently constituted, it is an open-ended obligation of the federal government.

Robert Samuelson of The Washington Post observes (March 20, 2017) that Medicaid increasingly is another mechanism by which government skews spending toward the old and away from the young: “Although three-quarters of Medicaid recipients are either children or young adults, they account for only one third of costs.  The elderly and disabled constitute the other one-quarter of recipients, but they represent two-thirds of costs.”  Samuelson concludes that getting Medicaid costs under control is a much needed reform, considering the aging of the population, with the number of Americans 85 and older expected to increase by 50% by 2030.

This is where the Republican Health Care bill comes into play, as one of the key provisions is phasing out Medicaid expansion through 2020.  Under the Republican bill the program also transitions to a system of block grants to each state that is based on per-capita payments for the Medicaid population.  According to the Congressional Budget Office (CBO), the Republican bill cuts spending by $1.2 trillion net and it eliminates new taxes worth just shy of $900 billion through 2026, of which the vast saving is from reduced Medicare expense.

That’s the good news. The bad news is the cost saving is attributable to fewer people enrolling for medical insurance: CBO estimates there will be a decline of 14 million enrollees next year relative to the Obamacare tally and a cumulative decline of 24 million by 2026.  Even if the CBO estimates prove to be too high, they pose a political problem for the Republican leadership in Congress, who must bring the conservative wing of the Party that favors a quicker end to Medicaid expansion into the fold together with moderates in the Senate who are concerned about a voter backlash if coverage is diminished.

At this juncture, it is unclear whether the Republicans in Congress will be able to find an acceptable compromise.  The first clear indication will come this week when a voted is slated in the House of Representatives.  While conservatives favor an earlier end to Medicaid expansion or simply repealing the ACA, such action would still leave in place the expensive open-ended federal Medicaid commitment.

Thus far, President Trump has been supporting Speaker Ryan’s plan, but he could switch tactics if passage of the bill appears in trouble.  Also, if the President continues to back the plan, he will be criticized for breaking his campaign pledge of not touching entitlements and his assurance that no one will lose coverage under the Republican plan.

Implications for Tax Reform

The resolution of the Health Care bill not only matters for healthcare spending, which comprises 28% of total federal outlays, but also for the passage of tax reform.  If the Congressional Republicans are able to coalesce around a healthcare bill that can pass Congress, it bodes well for the passage of tax reform legislation that investors are counting on.

Conversely, should Republicans be unable to agree, it would damage the chances for meaningful tax reform and harm their chances for maintaining control of Congress in the 2018 elections.  Daniel Henninger of the Wall Street Journal (March 10, 2017) characterizes the Republican dilemma as follows:

            “The day the Republicans clutch on this (healthcare) reform, there will be six-column headlines across the Washington Post and New York Times: “Trump Abandons Promises on Health Care”

            “It will be a fast ride downhill from there. That is because the health-care reform bill is inextricably linked to the politics of tax reform, the second pillar of the Trump legislative agenda.”

The challenge of confronting entitlement program expansions is particularly formidable now, as the aging of the baby boomers implies a steady increase in the size of the federal budget deficit in coming decades absent any changes in current policies (see Figure 1).  Indeed, by 2025 people 65 years and older will comprise 20% of the total population.  Meanwhile, with the added pressure to increase military and infrastructure spending the inevitable question investors must ask is “who will pay the bills?”  Once market participants understand the nature of the fiscal predicament, investors may reassess the optimistic assumptions that are embedded in financial markets today.

Figure 1: CBO Projections of Federal Budget Deficit Assuming No Change in Policies  

Source: Congressional Budget Office.

Sargen on China – U.S. Tensions…Diminish for Now

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Highlights

  • Notwithstanding adverse political news at home, the Trump rally has continued amid favorable economic news and investor optimism about pending corporate and personal income tax cuts.  Diminished tensions between the Trump Administration and China have also lessened the risk of a trade war.
  • The key event was President Trump’s reaffirmation of the “One China” policy to President Xi in a telephone exchange earlier this month.  At the same time, Defense Secretary Mattis talked about the need for a diplomatic rather than military solution to the dispute in the South China Sea, which the Foreign Ministry in China welcomed.
  • With Steve Mnuchin assuming the helm as Treasury Secretary, market participants are awaiting the stance the Treasury will take on whether to declare China a “currency manipulator.”  Press reports suggest the Trump Administration may change tactics, so that China is not singled out.
  • The bottom line: The risk of an escalation in tensions between the U.S. and China has lessened, and it appears moderates in the Trump Administration are calling the shots.   Nonetheless, circumstances could change if the dispute in the South China Sea heats up or if China’s trade surplus with the U.S. were to increase.

President Trump Moderates His Stance on China

At a time when the Trump Administration has been engulfed with a series of adverse political developments, market participants appear oblivious to them, and the so-called Trump rally lives on.  The principal reasons are that news on the economic front has been favorable, consumer and business confidence readings remain high, and investors are focused on the prospect for significant cuts in both corporate and personal tax rates.

In addition, a potential negative factor –namely, the prospect for a trade war between the U.S. and China – has also diminished recently.  The key development was a sudden reversal in President Trump’s stance toward China.  Throughout the presidential campaign, Mr. Trump took a hard line on China, claiming that its trade policies were unfair, and on several occasions he called for imposing tariffs of 35% on Chinese imports into the U.S.  Immediately after assuming office, President Trump upped the ante by congratulating the leader of Taiwan and by indicating he was open to reviewing the One China policy that China’s leaders regard as non-negotiable.

During the past month, however, the Trump Administration has softened its stance considerably.  In a telephone conversation with China’s leader, Xi Jinping, the President retreated from his earlier statement, and he indicated the White House had agreed to honor the One China policy “at the request of President Xi.”

The timing of the call was significant, coming just before President Trump met with Japanese Prime Minister Shinzo Abe to discuss the commitment of the U.S. to East Asia. It also coincided with a trip to Japan and South Korea by Defense Secretary Mattis, during which he talked of the need for a diplomatic rather than military solution to the dispute over islands in the South China Sea. The Foreign Ministry in Beijing welcomed the remarks and the Chinese press called them a “mind-soothing pill” that “dispersed the clouds of war.”1

Looking behind the scenes, these developments suggest that moderates in the Administration such as Secretary of State Rex Tillerson, Defense Secretary James Mattis and National Economic Council Director Gary Cohn are calling shots on China policy for the time being.  This is reassuring to those who worried that Peter Navarro, Wilbur Ross, and Robert Lightziger, who have a more protectionist bent, could be in charge of trade policy.

Is China a Currency Manipulator?

With Steven Mnuchin now confirmed as Treasury Secretary, market participants will now be watching to see whether the Treasury declares China to be a “currency manipulator,” as Mr. Trump suggested during the presidential campaign.  Since 2015, the criteria that the Treasury has used for making such a designation has been three-fold: (i) the country has a large current account surplus, defined to be in excess of 3% of GDP; (ii) it has a large bilateral trade surplus with the U.S.; and (iii) it intervenes in the currency markets to weaken its currency versus the U.S. dollar.

Based on these criteria, China meets only one condition – namely, it has a large bilateral surplus with the U.S.  Its overall current account surplus, by comparison, has fallen steadily over the past decade, and is currently less than 3% of GDP.  And while the Chinese authorities intervene regularly in the foreign exchange markets, since 2014 they have been primarily sellers of U.S. dollars.  The reason: China has experienced massive capital flight that far exceeds its currency account surplus, and the authorities have been trying to limit the depreciation of the RMB versus the dollar.

Weighing these considerations, the Treasury in the past has refrained from declaring China to be a currency manipulator.  If it were to do so now, the rationale would be political rather than economic.  Even then, it is unlikely the Trump Administration would want to escalate the issue at this time when it already has moderated its stance.

A recent Wall Street Journal article (February 14, 2017) stated that the White House is exploring a new tactic to discourage China from undervaluing its currency.  Under the plan the Commerce Secretary would designate the practice of currency manipulation as an unfair subsidy, without singling out China, and U.S. companies could then bring complaints to the Commerce Department.  While this tactic is in keeping with the stance adopted by previous administrations, Chinese officials reportedly are bracing for an unprecedented number of trade disputes, and they are considering possible retaliatory actions.

Avoiding a Full Scale Trade War

Both the United States and China for the time being are seeking to avoid a full scale trade war that would produce a “lose-lose” situation.  Investors, nonetheless, must consider the possibility of such an outcome in the future, especially if China’s bilateral trade surplus with the U.S. were to widen, while the RMB would weaken further against the dollar.

The latter outcome remains a distinct possibility for two reasons.  First, U.S. import demand is likely to surge if the U.S. economy continues to gain traction, and imports from China would in turn be boosted. Second, a stronger economy is likely to bring the Fed into play, and a widening in interest differentials between the U.S. and China would place added pressure on the RMB. In these circumstances, the Trump Administration could very well come down on the side of those who contend China is manipulating its currency, even if the Chinese authorities intervene to limit the depreciation of the RMB.

In these circumstances, markets are likely to focus on whether any sanctions imposed by the U.S. are targeted to specific items or are broadly based and severe. In the former case, markets would likely take the news in stride, as there are numerous instances in which the U.S. has imposed sanctions on select items.  However, if the Trump Administration were to up the ante by imposing broad-based sanctions – including high tariffs across a wide range of goods – markets would likely sell off, as investors would anticipate retaliation by the Chinese authorities and other countries that are affected.

Our assessment is the risk of a full scale trade war has lessened for the time being.  However, political developments such as a widening in the dispute over islands in the South China Sea or adverse developments in the U.S. could result in an escalation of trade tensions at some point.  In this respect, the risk of a trade war cannot be ruled out entirely.

1See Goldman Sachs report “Top of Mind,” February 6, 2007.

Sargen on Trump’s Trade Policy

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Highlights

  • During the election campaign, Donald Trump ran for office on restoring lost jobs in manufacturing by renegotiating trade deals and imposing tariffs on imports from countries that are deemed to hurt American workers. Now that he is President, market participants are focusing on what he will do.
  • One of his first decisions will be his stance on a “border adjustment tax” (BAT), a key provision in the House Republican tax bill that is intended to incent U.S. companies to produce at home rather than abroad.  In an interview last week, Mr. Trump indicated he favors a simpler approach of imposing stiff duties on countries that disadvantage U.S. workers and U.S. based companies that shift production abroad.[1]
  • A key problem with the President’s trade policy, however, is that it runs counter to market forces.  Because the dollar’s value is mainly driven by capital flows, stronger growth and rising U.S. interest rates threaten to propel it higher.  Also, the President’s fiscal stance of lowering tax rates but not broadening the tax base would likely balloon both the budget and trade deficits.
  • The bottom line: President Trump’s efforts to reduce the trade deficit and restore lost jobs in manufacturing are likely to fail.  Moreover, his policy of raising tariffs is bound to invite retaliation in which all parties would lose.

President Trump’s Views on Trade and the Dollar

Throughout the Presidential campaign, Donald Trump articulated a stance on international trade that reflects his long-standing views.  At the core, his world view is mercantilist: International trade is a zero sum game with winners and losers, and the losers are countries that run trade deficits.

While Mr. Trump’s views on trade are at odds with the post-war order, in which free trade was seen as a means for promoting world growth, he was by no means the only candidate to abandon free trade principles.  Indeed, in the wake of the 2008 financial crisis, for the first time in modern history no presidential candidate ran on a pro free-trade platform.  Where Mr. Trump stood apart from other candidates was his call to renegotiate existing trade arrangements and his threats to impose heavy duties on countries and U.S. businesses that are deemed to pursue policies that harm U.S. workers.

Now that he is president, Mr. Trump has announced the United States will withdraw the U.S. from the Trans-Pacific partnership, and he is planning to meet with the leaders from Mexico and Canada to discuss NAFTA.  One of the first legislative decisions Mr. Trump will make is his stance on the issue of a border adjustment tax (BAT), which is a key provision in the House Republican tax bill. The BAT is called a “destination based cash flow tax,” because it does not include export revenues in corporate taxes, while it excludes imported items from costs. The Republican leaders in the House favor the idea because: (i) it incents businesses to produce at home rather than abroad; and (ii) it is estimated to raise $1 billion in tax revenues over a decade that would help fund the proposed cut in the corporate tax rate to 20% from 35%.

The BAT concept is very controversial, because it is untested and critics contend it could be disruptive to businesses with global supply chains.  Proponents contend this is not the case, because they claim there would be offsetting movements in the dollar.  For example, if U.S. exporters were able to reduce the price of a product sold abroad, it would increase demand for dollars and boost the value of the dollar.  Accordingly, some economists estimate that if the corporate tax rate were lowered to 20% the dollar would likely appreciate by about that amount, although that issue is subject to debate.

In a recent Wall Street Journal interview, Mr. Trump stated the BAT proposal was too complex, and he favors a simpler approach of raising tariffs on imported goods including those from overseas’ operations of U.S. based companies.  He also expressed concern that the dollar was “too strong” in part because China holds down its currency, the yuan: “The yuan is ‘dropping like a rock,’ Mr. Trump said, dismissing recent Chinese actions to support it as being done simply ‘because they don’t want us to get angry.”

It remains to be seen what the final legislative outcome will be.  Some commentators believe the House Republican leaders will continue to press for a BAT; however, to gain the President’s approval, they will have to compromise on provisions of the pending tax bill.  As discussed below, the House Republican tax bill is intended to be revenue-neutral, whereas the proposal that Mr. Trump favors would increase the budget deficit significantly.

An Inconsistent Trade Policy: Lessons from the 1980s

Whatever the outcome, President Trump’s approach to trade and the dollar is flawed, in my opinion, because it ignores the impact of market forces on the dollar and the trade balance.  In this regard, there are several valuable lessons from the experience of the Reagan presidency in the 1980s that apply today.

One of the main lessons is that the dollar’s value is determined primarily by international capital flows, rather than international trade flows.  During the Reagan era, for example, the combination of a resurgent U.S. economy and high U.S. interest rates relative to those abroad attracted massive capital inflows that sent both the dollar and the U.S. trade deficit to then record levels.

U.S. interest rates today, of course, are considerably lower than in the 1980s; nonetheless, they are still well above those abroad. The dollar currently is at a 14-year high on a trade-weighted basis, and it has surged since the presidential election.  Should the U.S. economy accelerate, as President Trump is seeking, the Fed is likely to tighten monetary policy further, which would drive the dollar even higher.  Similarly, if China continues to experience capital flight, the Chinese yuan is likely to depreciate further, despite efforts of the authorities to limit the decline.

A second lesson is the trade imbalance is likely to widen considerably if the budget deficit increases materially, as was the case in the 1980s, when the U.S. ran “twin deficits” (see chart). The intuition is that increased government spending on the military and infrastructure is likely to boost imports but do little to increase exports. More fundamentally, the national income identity holds where the imbalance on trade is equal to the sum of the budget imbalance and the saving-investment imbalance in the private sector. If the latter is unchanged, the trade deficit increases directly with the change in the budget deficit.

U.S. Budget and Trade Imbalances as a Percent of GDP


Source: Bureau of Economic Analysis, Dept. of Commerce.

 

In this regard, a lot hinges on the type of tax legislation that is forthcoming. Specifically, there is an important difference between the House Republican tax bill, which is designed to be deficit-neutral, with the plan that Mr. Trump campaigned on, which independent research institutions estimate would add about $6 trillion to federal debt outstanding over the next ten years. The primary reasons are the Trump plan calls for deeper cuts in the corporate tax rate to 15% versus 20% in the pending House bill, and the Trump plan does not seek to broaden the tax base, whereas the House bill does.

The bottom line, therefore, is that if President Trump’s efforts to boost economic growth via tax cuts and increased government spending unfold, the trade deficit is likely to expand considerably.

The Worst Outcome: A Needless Trade War

While President Trump’s trade policies are unlikely to produce the results he is seeking, the worst outcome for financial markets would arise if the policies culminated in an unnecessary trade war with China, Mexico, and other countries.

It is hard to tell at this juncture whether President Trump’s call for duties in the neighborhood of 35% on imported items from certain countries is a negotiating ploy to extract a better deal, or whether he is serious and will follow through.  Based on his selection of Cabinet appointees to handle trade matters, however, this threat should not be taken lightly.  They include Peter Navarro, a China critic to head the new National Trade Council, Wilbur Ross as Secretary of Commerce, and Robert Lighthizer, a lawyer who represents industries seeking government protection via trade barriers.  At the same time, President Trump appears determined to declare China a currency manipulator, even though the Chinese Government has spent one trillion dollars in foreign exchange reserves in an attempt to limit the yuan’s depreciation against the dollar.

Should the Administration pursue such a course of action, it would inevitably invite retaliation, either in terms of reciprocal duties on goods from the U.S. and/or diminished purchases of U.S. treasuries.  One may wonder why the U.S. would run this risk when unemployment is below 5% and overseas economies are fragile.  And while financial markets have shrugged off the possibility thus far, global investors are likely to turn wary if a trade war were to materialize.

One of the most disturbing aspects of all this is how world leaders today have lost sight of the benefits that free trade has conveyed on the U.S. and global economy during the post-war era.  From the early 1980s, when globalization took off, until the mid-2000s,    there was a fairly steady expansion of both world trade and economic growth, with world trade expanding at roughly twice the pace of global GDP growth, and free trade policies played a critical role (see chart).  However, in the wake of the 2008 financial crisis, both global growth and the volume of world trade slowed markedly. This development, in turn gave rise to populism around the world, which threatens to bring increased protectionism that could undermine what was achieved during the post-war order.

Growth in Volume of World Goods Trade & Real GDP, 1980-2015

Source:  International Monetary Fund, World Economic Outlook Database, October 2016.

[1] See WSJ article, “Donald Trump Warns on House Republican Tax Plan,” January 16, 2017.