With all the talk of new President Trump, and how his proposals may impact the economy and financial markets, we thought we would pick up on something that seems to be slipping under the radar that may just be important in the months ahead. Also, without knowing greater detail on Trump’s policies in areas like tax changes, trade policies, infrastructure, energy and regulation we would rather wait before making any more judgement calls. Of course, the direction of travel in these areas may be reasonably clear (he has been more hawkish on trade for example than we would have expected), but the details are lacking and will be important.

So, leaving Trump to one side, the issue that has piqued our interest is an increase in talk of the Fed reducing its balance sheet. If we had been asked at any point last year, we would have been fairly confident that balance sheet reduction would simply not be on the agenda, and yet it seems to be moving up fairly quickly. Perhaps the consensus will look at balance sheet reduction as simply part of the policy normalisation that the Fed clearly wants to achieve. However, we think it could be a bigger deal.

We know that the Fed will not actually sell any asset outright in the open market, so the process of balance sheet reduction will be via the non-reinvestment of maturing bonds. We suspect that the Fed is unlikely to go immediate cold turkey and stop reinvestments completely, and so we are left guessing how much. What we do know is the size of maturing bonds over the next few years; $426 billion in 2018, $346 billion in 2019 and $220 billion in 2020.

The point to understand here is that if the Fed won’t reinvest maturing bonds, then it falls to either the private sector (households or non-financial corporations) or the overseas sector (via the current account) to fund the increased issuance of Treasuries. This greater burden will come at a time when;

 

1. The federal budget deficit is set to increase quite a lot (from over 3% already – see chart below)

 

1. Trump seems to want to reduce the current account deficit

 

1. The non-financial sector in recent years has been borrowing to buy back shares and pay dividends and so seems uninterested in funding the Government

 

1. Foreign investors have been reducing their US Treasury holdings, a trend that may continue given Trump’s trade rhetoric

 

Chart 1 – The US Federal Government Budget Balance

There a few things in economics that are certain, but accounting identities are one of them. Basically, the following equation has to hold true;

Government deficit = private sector net savings minus the current account (N.B. a current account deficit actually equates to overseas investors helping fund the US government)

Our fear here is that the household sector will be forced to fund an increasing government deficit via higher savings, and higher savings has to come from either higher income or deferred spending. Clearly, Trump will be hoping that his (unrealistic) target of 4% real economic growth will create a virtuous circle of increased income, increased spending and ultimately lower budget deficits. In our opinion, the deficit is likely to get larger, the economy is unlikely to break out of its 2% growth range. In fact, the risk is that households end up spending less in order to fund an increasing government deficit, and the reduced household spending actually reduces economic growth.

Therefore, if the Fed choose to reduce their balance sheet and therefore increase the burden of the household sector in funding the Government, whilst at the same time raising interest rates, perhaps the tightening in financials conditions that lies ahead will be greater than the markets currently anticipate. And if there is no offsetting pick-up in growth, the risk of a Fed policy error could be greater than many currently believe.

Will any of this matter in markets? Well, in theory, risk premiums should be higher and at some point this may actually become reality through lower equity and bond prices. Of course, bullish sentiment has been extremely high recently, and as always we need to see a change in the current narrative for investors to change behaviour. We suspect the narrative may change once the details of Trump’s policies become clearer. In particular, we worry about his trade agenda which has a nasty look of the 1930s era when trade wars are widely seen as exacerbating the economic outcome.

It should be clear to investors now that politics is significantly more important than it has been in recent years, and the Fed is withdrawing its support. None of us knows exactly how this will work out in the end, however, we continue to believe that a flexible tactical approach will help investors navigate what will surely be a very interesting few years ahead.

 

Stewart Richardson

RMG Wealth Management