Article / 26 January 2017 at 14:56 GMT

'America first, protectionism first' — #SaxoStrats

Head of Macro Analysis / Saxo Bank
  • 'Trump trade' a bubble set to burst
  • Protectionism remains a flawed model
  • ECB policy crisis a real risk in 2017

Donald Trump
US president Donald Trump's election may have spurred an asset rally, but Saxo's Christopher Dembik says the post-election surge has feet of clay. Photo: iStock 

By Christopher Dembik

The Trump effect is a speculative bubble, and as with all bubbles, it will finally burst when investors realise that the new president is unable to keep his promises. 

Until now, the most visible immediate effect of his victory has been the rise in interest rates (plus 50 basis points on US 10-year bond yields since November 8). Investors have already anticipated that Trump's economic policy will be inflationist. However, market complacency is unjustified in view of the protectionist policies reaffirmed by the new president in his inaugural speech ("we must protect our borders from the ravages of other countries making our products, stealing our companies and destroying our jobs"... "buy American and hire American"). 

The return to reality could well be brutal for investors as within a globalised world; protectionism will be economically costly for any country putting it into practice on a large scale.

The US economy does not really need Trump

The first question to be asked is whether to know if the US economy really needs Trump. After all, the economic record of the Obama years is largely positive.

The economic indicators are quite solid. Barack Obama and Federal Reserve chair Janet Yellen have left an economy in good health and in many ways stronger than before 2008, particularly as far as the financial sector is concerned. 

As shown by the Citi Economic Surprise Index (see chart below), the last data are much better than what was expected by the consensus for Q4 2016 and the beginning of this year. This is Obama's legacy.

Citi surprise index

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Source: Saxo Bank
The labour market is close to full employment. Over the past two years, the labour market has created 4.9 million jobs, leading to an unemployment rate of 4.7%. The number of initial jobless claims (four-week moving average) is the lowest since 1973, as shown in the graph below. 

Even for categories of the population usually most affected by precariousness, a clear improvement has been seen over recent months. As a result, the number of Americans aged between 25 and 34 without a job fell below 22% at the end of 2016 for the first time since September 2008. 

Nevertheless, despite recent improvements the labour market participation rate remains low (62.7% in December), which means that the US economy has certainly not yet really reached full employment, although this is not far off.

Initial jobless claims (US)
Source: Saxo Bank

Furthermore, "good" inflation is back. Contrary to the Eurozone, the rise in inflation is not only caused by higher energy prices but also by an increase in average wages (plus 0.4% in December), resulting from employers' difficulty in finding qualified employees. 

The balance of power between employers and employees is gradually shifting in favour of employees, which is a rather positive signal. We can consider that higher inflation (forecast at 2% in 2017) could reduce the debt burden of US households (around $12.29 trillion) and limit the risks linked to the US education bubble (which represents more than $1.23 trillion according to the Fed).

However, Obama’s record is not all bright. His main economic failure lies in his inability to fight the rise in inequality, which is certainly a key factor explaining Trump’s victory. Indeed, the share of income held by the richest 1% has once again reached the top level seen at the end of the 1930s (around 17%), whereas it had been constantly falling from the mid-20s to the mid-70s.  

The economic measures proposed by Trump are clearly not capable of tackling the inequality question, which could quickly create resentment from his electoral base. Actually, only two economic measures make economic sense: the infrastructure spending plan, and to a lesser extent the tax cuts.

The $1.5 trillion infrastructure investment plan is based on the recommendations of the American Society of Civil Engineers, which state that nearly $3.6 trillion expenditure is needed by 2020 to maintain existing infrastructure (some of which dates back to the Eisenhower era) at a good level. 

This programme could help strengthen productivity, which is a long term challenge to US growth, and could lengthen the economic cycle – but there is no guarantee as to its implementation. This rests on the good will of Congress and the Republican party. President Trump had initially considered financing infrastructure investment entirely by the private sector, but has recently changed his tune by calling for a resort to borrowing by issuing 50 and 100 year T-bonds. 

Although the Republican Party is following the same line as the president regarding the repeal of Obamacare, frictions might rapidly emerge regarding this programme, which will inevitably increase public debt. In this sense, Paul Ryan, Speaker of the US House of Representatives, could well be the real leader of the opposition during Trump's first term.

Politically speaking, the tax cut plan is likely to gain a broader consensus. Historically, tax credits (such as those voted in 2001 and 2008) have led to a rise in consumption, particularly by the poorest, and by debt-burdened households. Sixty to 70% of the money distributed is mostly spent in the following months, and the risk of hoarding is rather low. 

The only noticeable difference with previous periods is that this measure intervenes outside a crisis, so it can be supposed that a larger proportion than usual may be saved, above all by middle class households.  

A new era of conflicts

The second point to be raised is to consider the relationships that Trump will have with his main partners. A little reminder for future reference is Trump's favourite quote from the Bible: "eye for eye, tooth for tooth". It is almost certain the Trump presidency will herald a new era of conflict, both at home and abroad. 

The American president is, above all, a businessman (not a "madman" as one of my Belgian colleagues dubbed him). He is an opportunist who will favour opportunistic alliances, rather like China does, which could initially seriously confuse the US' European partners.

As far as trade is concerned: Trump portrays himself as a champion of protectionism. Contrary to what one might think, this is not a posture, but certainly a conviction on his part. At the end of the 1980s, he had already spoken publicly against free-trade agreements. Protectionism is intrinsically linked to US political history. The economic development of the country was built to a large extent on protectionism during the 19th century. 

From 1812 to 1849, the average customs tariff increased from 25% to 40%, but this did not prevent a strong increase in wealth. The success of the U.S. experience can be explained in large part by the theory of the size of nations. This stipulates that there are benefits which flow from the large size of a country, based on economies of scale. Domestic companies perform better if they can access a larger market; this favoured the development of a very competitive US manufacturing sector in the 19th century. 

Brooklyn Bridge
The great monuments of Gilded Age America were fueled by manufacturing. Photo: iStock 

In a globalised world, however, this approach is no longer viable. Protectionism is equivalent to a tax to be paid by households because imported goods will be more expensive. It is an illusion to believe that it is possible to produce a good from A to Z in a developed country like the United States without increased costs. 

For the time being, Trump is taking aim at Mexico, which is an easy target as 80% of the country's exports go to the United States. But the true target of the new president is China. 

This will be a much tougher opponent. One figure demonstrates the economic cost of a trade war between Beijing and Washington: China and countries exporting to China account for 40% of GDP ($3.1 trillion). If necessary, China has two options to act against the United States: 

  • Deciding to buy less U.S. T-bonds, which would lead to a rise in interest rates and would render Trump's infrastructure programme more difficult.
  • Referring to the World Trade organisation's Dispute Settlement Body in the event of a trade dispute (e.g. an increase in customs tariffs). This would be a long and laborious legal process but whose decision would be binding on the United States, and in the event of non-compliance, it could lead to exit from this international organisation. This would be an economically dangerous choice because the WTO protects quite well U.S. exporters.

As regards monetary policy, the conflict between Trump and Yellen is nothing unusual. One just has to remember the conflict opposing president Carter and then-Fed chair Arthur Burns at the end of the 1970s, which culminated in the non-renewal of the latter's mandate. 

There are many similarities with the current situation; the rivalry started during the election campaign and crystallised around the independence of the Fed. It then led to strong criticism of monetary policy, once Carter was in power. 

The current conflict will certainly concern the normalisation of monetary policy. Trump's infrastructure policy needs relatively low rates to guarantee a competitive exchange rate and attractive borrowing costs. Nevertheless, the view of the Fed is clearly in favour of raising interest rates, perhaps even more quickly than the market anticipates. 

Janet Yellen, but also the candidates for vacant governor positions (Glenn Hubbard, John Taylor to whom we owe the famous Taylor rule, and Kevin Warsh) as well as the rotation of the votes of governors, will all favour higher rates. The inevitable replacement of Janet Yellen at the end of her term in February 2008 in no way guarantees her successor will be any more receptive to the White House’s wishes. 

Strong tensions, aired publicly between the Fed and president Trump, are to be feared during his tenure, which could harm communication from the central bank to the markets and potentially have a negative impact on monetary policy transmission. 

The impact on the Eurozone

Market consensus considers that monetary policy divergence between the European Central Bank and the Fed will lead to a strengthening of the dollar and a weakening of the euro. In the short term, it is quite difficult to see what could prevent a stronger USD, but in the medium term it is doubtful whether this trend will last. In fact, Trump's economic policy (even if partially implemented) should lead to an increase in sovereign interest rates coupled with growing inflationary pressures. 

In order to overcome this, the United States will have no other choice but to allow their its to depreciate in order to export inflation to its trade partners. This is none other than what Nixon did in the 70s and Reagan in the 80s under pressure from US industry. For the Eurozone, this should mean a new cycle of rising interest rates, a stronger euro and an increase in inflation, which will directly penalise households' purchasing power, particularly in low-growth countries such as France. 

In these conditions, the ECB will be obliged to maintain its accommodative stance for longer than planned, which could lead to increased tensions between supporters of Draghi and Germany and her allies, which are calling for exit measures. 

The Trump risk is real in 2017, but the greater risk, ignored by investors, is that of an open crisis within the ECB regarding monetary policy.   

Israel's border wall
President Trump seems determined to go down in history as a wall-builder, 
but economics rarely favour such an approach. Photo: iStock 

— Edited by Michael McKenna

Christopher Dembik is an economist at Saxo Bank's Paris office


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