It’s been only four months since President Trump took office and he’s had anything but a smooth start. Marko Papic, Chief Strategist, Geopolitical Strategy, BCA Research, talks to Kim Parlee about whether Trump can carry out his growth agenda and what that could mean for markets.
Well, welcome to Money Talk. It's been only four months since President Trump took office, and he's had anything but a smooth start to his presidency. Apart from finally pushing through the health bill through Congress, Trump has had no other legislative win to speak of. And now with the Russian probe hovering over Trump's White House, many are openly questioning whether Trump will be able to carry out any of his growth agenda and what that could mean for the markets.
Our next guest has some interesting thoughts around this, and we're lucky to have him with us for the next half hour. He says the political risks might be overstated for 2017, understated for 2018. And he's got some new thoughts on the adage buy in May and go away. He's going to put that on his head. Joining me from Montreal is Marko Papic. He is chief geopolitical strategist at BCA Research.
Marko, great to have you with us, and I'm glad we have the half hour, because wow. I have to start and ask this one question-- you're in the business of looking at news and understanding how it's going to influence the markets. And I've been following the news for more years than I care to disclose right now. How do you discern what is material news for the markets and what isn't?
Well, I think that it's a very difficult process. You have to talk to a lot of people who are in the market. And I'm very fortunate to work at BCA Research, which is read very widely in the financial community. So you get a really good pulse by speaking to investors and financial industry peers.
The other issue is that you look at how markets and various assets move on different news items, if you will. And it was very interesting on March 21 when the first version of the Affordable Care Act reform and repeal, the first attempt at getting the health care bill through the House, failed. It was very interesting how the markets immediately reacted by essentially voting against the populist theme that had driven the markets to that point.
We had a selloff in the bond market after the election. We had a steepening of the yield curve. We had the dollar, the DXY index, really go up after the election. So the dollar and the bond market was reacting as if there was going to be fiscal stimulus, which makes sense given that Trump is an economic populist who wants to generate nominal GDP growth.
And on the news that the first version of the health care act failed, the market reacted by saying, wait a minute. His agenda is going to have difficulty getting through Congress. If he can't get the health care repeal and replace through, then why would he be able to generate the kind of stimulative tax reform that would boost nominal GDP growth that would be good for the dollar, bad for the bond market?
And so you can basically trace how assets move on individual news items and ask yourself the question, is the market correct. Because the market clearly believes that economic populism will not happen. But is that the actual reality?
OK. What's your belief, then? Let me back up here, because these are big questions. I want to break this up a bit if I could.
You say that political risks are overstated in 2017. And since this piece that's come out that I read that's on my desk here, we've had James Comey come out. He's been fired. There has been-- I would say the headline political risk has even accelerated since you've put this out. So why do you think-- or do you still think political risks are overstated in 2017?
Well, first of all, I think a lot of the headline risk that's out there is very interesting. It's definitely a soap opera. I certainly enjoy reading the updates on these issues. But the question is how will they affect the economy, how will they affect assets, particularly risk assets.
So first of all, we've had some really important geopolitical risk that's dissipated since pretty much April and May, starting with, of course, the French election. Now, it was our view at BCA Research that my chocolate Labrador had a greater chance of winning the French election than Marine Le Pen. But that was our view.
That wasn't the market's view. And so we had a lot of risk dissipate on the question of whether the euro area will collapse. We have elections coming up in Germany. We have elections coming up in Austria. Most of these elections-- all of these elections will have market-neutral or market-positive outcomes. So the populism narrative in Europe has really been defeated this year. Also Netherlands-- let's not forget March 15th election in Netherlands.
Then we had risk of Brexit. Brexit is a nonevent as far as the global markets are concerned. Maybe there is some sector allocation that will be influenced, maybe the pound will move. But even the pound really bottomed in January on Brexit fears. And so a lot of these big picture risks-- protectionism is another one.
So will Donald Trump call China a currency manipulator, will there be tariffs going up right within the first quarter of his presidency-- these risks have come off. And so I think that this is important, and it articulates why risk assets-- especially the US equity market, euro stocks in Europe, European equities-- are doing, actually, quite briskly so far. Because these real, genuine risks have come off.
Now, impeachment process is a complicated one. It's very difficult for me to see it getting anywhere with the Republicans controlling the House. We can talk a little bit about that process if you're interested. But to me, it's really just noise right now.
And in fact, in fact, it creates this Goldilocks window for investors, this really strange window of opportunity in which Donald Trump is embattled enough that Republicans in Congress have to wonder if they will still control all three branches of government come November 2018 after the midterms. And so they actually are accelerating their tax reform agenda, which is really investment-relevant.
And that's positive for the markets. And I think that's something that perhaps the bond market and the dollar market are not pricing in. And the equity market as we saw today, for example, simply doesn't care what's happening with the Comey investigation.
Marko, I want to delve a little bit into the tax reform here. And you've got some really interesting things you talk about here. The ones that stood out for me in terms of the research was that-- people believing that there needs to be some sort of revenue offset to get tax reform through. And you tell me if I'm interpreting correctly. You believe that might be false.
And secondly, that if you had to, they could get this done in five months, which is just-- I had no idea you could get it done that quickly. What is that based on, and how likely do you think that is?
So we looked at past tax reform efforts. And really, there was only one successful one in 1986. Every other tax reform effort-- 1981, 2001, 2002-- most of them simply ended up with tax cuts-- which obviously, there's no revenue offsets. They just cut taxes for households.
So corporate tax reform in 1986, that was comprehensive tax reform-- that was the last time it was accomplished. It was difficult. It took well into the next year. So if we were on that timeline, we would have tax reform around April, May of next year.
So I think if we go for the full corporate tax reform, I think we're going to have outlines of the plan by the August recess. We will have a budget resolution, what's called a reconciliation resolution, probably by the end of this year. And then we will have the actual bill that passes this reform in the first quarter of next year.
And we're just basing this off of previous reconciliation bills. It's a complicated process. It involves the House and the Senate reconciling through a conference committee. It takes some time. We're basing it on what happened with the Affordable Care Act in 2010 and the 1986 tax reform.
So that can be done by the first quarter of next year. But the market will begin pricing it when it starts reading the outlines of this plan. Now, in terms of why we think it's not going to have revenue offsets-- and this is really crucial for the market.
If you want to get the dollar right, if you want to get the 10-year treasury note right, you have to know whether this tax reform is going to be stimulative for the economy, i.e. whether it will blow out the budget in a significant way or whether it will be revenue neutral, in which case it can still be mildly stimulative, but it's not going to be as stimulative as certainly the market began pricing in after Trump was elected.
And the reason we believe, with a high conviction view, that the Republicans who talk like they're fiscal conservatives-- the reason we believe they're not fiscal conservatives is because, first of all, the track record of the Republican Party, whether they controlled the White House or Congress, is absolutely atrocious. They're actually quite fiscally profligate.
And the second reason is that it's very difficult to find offsets. It's very difficult to find ways to raise revenue. There's all sorts of lobbies and interest groups that are opposed to these offsets. And so the path of least resistance will be just to blow out the budget.
And the beautiful thing about doing that is that the Republican Party has a ready-made tool for that. It's called dynamic scoring. It's basically a macroeconomic model that simply argues that when you cut taxes, you will produce revenue far off into the future, because you release the animal spirits, and so on and so on.
There's some truth to this, but they will probably overshoot their estimates. And that will be politically a way they will sell this budget-busting stimulative tax reform through their constituents.
Now, one thing I want to ask is-- I'm getting very micro into some of the stuff you were writing, but it was fascinating. You were noting in the research that some of the high tax bracket companies, those that are paying the highest taxes, you have seen a selloff in the market on the anticipation that these tax cuts, tax reform won't come through. And you think that might be an opportunity.
Right. So that's an opportunity. Part of the equity market, the S&P 500 companies that are taxed at a very high level that don't have various loopholes and offsets, they haven't been able to lobby them in, they should benefit from the lowering of the top rate from 35% to 20% or 25%, whatever happens. Also, I would argue that there will be opportunities in the dollar, dollar in the bond market.
So if you look at the two 10-year yield curve, if you look at the inflation expectations through the five-year, five-year forward, if you look at what happened to the dollar-- so basically, both the bond market and the dollar have lost a lot of the enthusiasm they had for this stimulative economic policy. And I think that there's too much bullishness in the bond market and there's too much bearishness in the dollar.
Right now, if you look at what the market expects in terms of hikes, the market is expecting, over the next 24 months, only 65 basis points of Fed interest rate hikes. That's counting the one coming in June that we know for a fact is coming. So after June, for the next two years, only one rate hike, a little bit over that?
That's basically-- the market is massively wrong on that. I don't know how else to put it. Because we will get some form of tax reform or tax cuts. It will be stimulative. The Republicans will err on the side of being profligate. And that will stimulate the economy sufficiently to allow the Feds to raise interest rates more than two times for the next two years.
Marko, I've only got about a minute--
That's obviously dollar bullish.
Obviously. Thank you for getting that in there. You're dollar bullish. I hear it.
I want to-- in a minute here, before we have to go to break again-- one thing I was looking for-- and I couldn't find the chart here-- but you have a chart here showing approval ratings of presidents going into midterm elections and the number of seats they lost based on those approval ratings. And it's looking pretty ugly, based on history, in terms of the approval rating of the President Trump right now.
So if all these tax reforms get done before the midterm elections-- I assume that happens-- but if it doesn't, then what happens?
Well, hey, if you're a Republican congressman or congresswoman right now, and you look at Trump's approval ratings, and you look at the history of performance of your party in midterm elections, you're saying to yourself, hey, guys, we have 12 months to get tax reform through. So I don't know what happens if they lose the House. I assume nothing. Certainly there won't be any legislative movement.
But that's not really what I'm trying to forecast here. What I'm trying to forecast is the next 12 months. And I think for the next 12 months, that's a motivating tool for the Republican Party to get tax reform through, or else they may not have another chance for God knows how long.
You've got one report here with a bit of a twist on the old adage, sell in May and go away. And you're saying buy in May and enjoy your day. So what do you see?
What we're seeing is that as far as global growth, as far as global earnings and US earnings, all of our models are looking pretty good, pretty solid. So the macroeconomic fundamentals are positive for risk assets.
And so then the question comes in-- well, what about politics. There are so many different things going on. And for this year, most of these risks have been overstated in their relevance-- certainly Brexit fears, certainly issues surrounding Europe. And I think in terms of the US, the idea that the Trump legislative agenda is somehow going to blow up may or may not happen.
But as far as their market is concerned, even if we don't get stimulus, that may not work out for our dollar view or our bond view, but certainly for equities, I don't think equities really care. If there's no stimulus, well, that means the dollar will be relatively weak, which is good for S&P 500. And it also means that the Fed has no reason to really hike more than what the market does expect, which again is positive for risk assets. So that's why we--
No, go ahead.
Go ahead. That's why we concluded that we're not going to have the usual turbulence in the spring.
You also say-- and I think it's interesting-- that complacency has been-- and I love this-- spectacularly elevated ahead of the second quarter year. You've got the Yale US One-Year Institutional Confidence Index hit an all time high of 98.68% in February. I guess just having said all that, I think some people might say, well, that means there's probably more downside risk coming as well. But you think that's going to continue for next little while.
I think, one, it can continue, and two, the question is how are investors going to react to this. And one thing that's really prevalent among large institutional clients is that they're all in a buy in dips mode. And so it's very difficult to see how any correction is going to be sustainable or of large magnitude if every single large institutional investor out there is in a mode of buying on dips. It's very difficult to then have a correction because large investors will continue to buy on any sign of a correction.
A good example was last week. So we had basically a probability of impeachment of the US president significantly increase. And I agree with that. It is increased. It is elevated. And yet where did the S&P 500 close today? The market has shrugged it off. And probably some of those buy on dips strategies have been initiated already last week.
Let's fast forward the conversation if we could. So you and I are talking. It's January or, say, February of 2018. What does the world look like?
Well, I'm worried about several things in the first quarter of next year-- first of all, China. We're already seeing a slowdown in China. They are trying to engineer a tightening in their credit markets, which is coming faster than we thought ahead of a very important party Congress, which happens every five years. Other than President Xi and Premier Keqiang, the entire Politburo standing committee is going to be changed in September, October of this year.
And usually, in 2007 and 1997, the last two times there were these five-year mid-term processes, the Chinese use this as an opportunity to do structural reform, painful structural reform. So in other words, the policymakers use the first five years to build political capital by doing things people want, and then they do, for the next five years, what people need, usually painful reforms.
This could be deflationary for the global economy, because it will mean that China will accelerate the currency tightening. They may very well recapitalize the banks, realize non-performing loans, and probably cause some of their industrial capacity to basically default and go into bankruptcy. So that's something we're watching. If this happens, China could be a source of global deflation, a source of global slowdown in first quarter of next year.
The second issue that we're very worried is the Italian elections. So Europe has looked great this year. Politically speaking, populism has been defeated. But I think investors are too complacent about what's happening in Italy, where the median voter really is moving towards euroskepticism.
And finally, I worry that President Trump, at some point, either before or after the midterm election could begin to focus outward. As his domestic agenda passes and slows, especially after the midterm elections, he could be the earliest lame duck president in US history in that he may refocus towards protectionism. So there are the three issues that we would worry about for 2018.
In addition, if tax reform is stimulative, if the Fed does have a reason to raise interest rates more than only 2 and 1/2 times, as the market believes, well, then we have another problem, which is that the long-term interest rates in US will rise. They'll end the year closer to 3% and 2%. And at that point, you might start asking the question of whether the corporate sector in the US can withstand that hit in terms of the lending costs.
I've only got about a minute left here, Marko. But I want to ask you-- is there anything that could happen that says, OK, this changes things completely. And I know we're in a quick news cycle, and there's a lot of material things going on. But is there anything you say, yeah, if he was impeached, if this happened, then all bets are off the table.
No. I wouldn't worry about the US at this juncture. I'm really worried about China more than anything else. We're trying to figure out what this party Congress means. It is a black box. It's difficult to find out what the policymakers are thinking. And the way we could be wrong in 2017-- I don't think it's the US. I don't think it's Europe.
The way we would be wrong in 2017 and that it's actually a risk off year is if China's policymakers already feel emboldened, that they already feel politically capitalized sufficiently to begin some painful reforms. Now, this is very, very good for China in the long term. This is what they need to do. They need to deal with their leverage levels right now.
But obviously, it's going to be painful for the rest of the world, especially for commodity producers-- countries like Canada, Australia, and so on. So that's how I think our forecast will be very wrong.
Fascinating discussion. Thank you both so much for giving us so much time tonight, Marko.
Anytime. Thank you, Kim.
Marko Papic. He's a chief political strategist at BCA Research.