The late-night comics are having a field day, and you can’t really blame them. The events of the last few days in Washington are just so rich with potential comedic content.
Did you hear the one about Trump and ….never mind.
While the optics of the situation are quite juicy for comedians, the issue for the markets is quite real. At current valuations, for equity markets – at least in the U.S. – to sustain themselves or go to the next level, economic fundamentals have to be accelerating and the reflation thesis has to maintain its traction. For that to happen, we need fiscal policy support from the Trump administration.
Nevertheless, the policy support we need has nothing to do with healthcare reform. At the end of the day, while healthcare reform would have been good for Republican political goals, its economic impact would have been marginal at best. To the extent it would have had an impact on growth, it was likely to be consumption-negative and therefore growth-negative as well. The additional income retained through tax cuts for the higher-income quartiles were more likely to be saved and healthcare spending would have gone down from the lower-income quartiles.
U.S. Fiscal Deficit Must Widen
The fact that Republican leaders in the House of Representatives could not generate enough support within their own party to even bring the American Health Care Act (AHCA) to the floor for a vote, in and of itself, really does not endanger the reflation trade.1 That trade is still very much contingent on investments picking up and leading to future growth, without policies hurting robust consumption levels. In other words, the reflation thesis remains contingent on infrastructure spending and tax cuts that are not paid for. That is, the net impact must be that the U.S. fiscal deficit widens, as I have stated previously.
Certainly, all is not lost. While the markets may be lamenting the death of the AHCA, the impact of this outcome on the markets in general and the reflation trade in particular is still unclear. Specifically, a case may be made that the entire Trump economic agenda is in jeopardy as a result of the AHCA’s failure. On the other hand, an equally compelling case may be made that fiscal conservatives in the Republican congress have lost a lot of ground by being seen as obstructionists, and the likelihood of a debt-financed tax cut or infrastructure spending is now more likely to be passed with the help of more moderate Republicans and even some Democrats. We don’t know right now and won’t for a while.
The bottom line is that the AHCA’s failure may be good political theater and provide fodder for late-night comedians and other political pundits, but it does not tell us much about the future of the reflation trade.
The real issue for the markets and the reflation trade was, and still remains, whether a Republican congress will pass economic legislation that leads to fiscal expansion. In my judgment, the probability of that has gone up marginally. But we will find out soon enough.
In the interim, while we are focused on U.S. politics, let us not forget that European and emerging market (EM) economies continue to surprise on the upside and the strength of the dollar is fading. That combination is making European and EM equities quite attractive relative to U.S. stocks.
1The “reflation trade” is commonly defined as a broad set of investment outcomes favoring stocks over bonds that are likely to occur if more normal inflationary pressures return to the U.S. economy after the prior decade of little inflation.
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