March 17, 2017 Patrick Oliver-Kelley

The Trump administration’s vision for disengagement from the world is a godsend for China. Look at Trump’s proposed budget, which would cut spending on “soft power” — diplomacy, foreign aid, international organizations -by 29 percent. Beijing, by contrast, has tripled the budget of its foreign Ministry in the past decade. And that doesn’t include its massive spending on aid and development across Asia and Africa. Just tallying some of Beijing’s key development commitments are estimated at $1.4 trillion.

The FOMC meeting produced several dovish surprises. First, the number of participants who expected four rate hikes or more did not increase. Second, the estimate for the structural unemployment was scaled down by a tenth of a percentage point to 4.7%. Third, the FOMC statement said that the Fed was looking for a “sustained” return to 2% inflation. Fourth, Minneapolis Fed President Kashkari dissented in favor of keeping rates unchanged, which few people had expected.

Having said all this, the market’s reaction still seems rather excessive. The key message from the March meeting was that the Fed now sees inflation reached its 2% target. Consistent with this, the FOMC raised its growth forecastfor 2018 from 2.0% to 2.1%. In addition, its inflation forecast for this is1.9%. Median projection for the funds rate went up to 3% for 2019.

All it means is that the Fed will not react too aggressively if core inflation were to drift somewhat above 2. The implication for investors is that the dollar is likely to rebound. Indeed, the longer-term risk to the dollar is not that the Fed turns out be too dovish, but that it turns out to be too hawkish – that it raises rates so much that the economy begins to roll over. However, with interest rates still low in absolute terms, this is more of a risk for late 2018 or 2019 than it is for the next 12 months. As such, investors should continue to cyclically overweight global equities, favoring stock markets such as those in Europe and Japan that have a “higher beta” to global growth than the U.S. A modest bearish tilt towards long-term government bonds is also warranted.

elephant in the room

Warning signs are flashing. Valuations are worryingly high. The cyclically adjusted price-earnings ratio is just under 30 times in the US market. Only twice has it been higher- during the dotcom era of the 1990s, and in 1929, just before the crash. There may be reasons for this. First, investors’ exuberance comes after a long period of restraint. Second, there are indications of a pickup in the global economy: Global trade is picking up; The volume of South Korea exports rose nearly 20% in the year. The fastest in five years. Commodity prices are ten per cent higher than a year ago; And European growth forecasts have been revised higher. Third, expectations of tax cuts, infrastructure spending and deregulation from Trump have invigorated the animal spirits in US. Small businessmen confidence is at a 40-year high. Profits for independent businesses are to rise by 12% for 2017. This is mainly because low oil price is just beginning to hit the energy market.

The caution is though- American economic data is mixed. After the eight years of strength, the recovery is looking long in the tooth. Consumer spending and industrial production fell in January. We think Trump’s stimulus package will take longer to get underway and even longer to take effect. And more importantly, his program of cutting immigration and throwing, people out of the country and threatening trade sanctions will harm growth. Also, the Fed policy is becoming less accommodating. Finally, China seems to be tightening its interest rate policy, too. A deeper problem lurks in a contradiction between politics and economics. European elections appear to set up chances of hammering established parties. Workers are backing insurgents candidates. But mathematics cannot square the surge in real wages with the market rally based on the hope of profits rising faster than GDP. Rejecting globalization, populism is a menace to the free movement of goods, labor and capital. It is impossible to keep both populist voters and the equity markets happy. Investors should keep their parachutes handy.

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