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Tapered Trump could be just the tonic for markets

Tapered Trump could be just the tonic for markets
 

That the US midterm elections that did not bring any major surprises has been taken as a positive by stock markets. The FTSE 100 has rallied, other European markets have risen and the US Dow Jones and S&P 500 are poised to jump when they open this afternoon.

With the Democrats taking control of the House of Representatives and the Republicans maintaining their hold on the Senate, investors have welcomed the resulting split Congress.

‘A greater Democratic voice on Capitol Hill increases the chance of gridlock, often a good outcome for equity markets,’ said Ian Heslop, manager of the Merian North American Equity fund.

‘A split Congress has historically been bullish for equities and we expect to see the same pattern again,’ added Torsten Slok, chief international economist at Deutsche Bank.

The longer-term impact for markets will be driven by the effect of this redrawing of the US political map on three key areas of US president Donald Trump’s agenda: taxes, trade and infrastructure.

Further tax cuts 'off the agenda'

The Democrats’ wrestling of control of the House of Representatives from Republicans now makes the prospect of Trump enacting further tax cuts much less likely.

The signature move in Trump’s 2017 tax cuts was to slash the corporate tax rate from 35% to 21%, alongside cutting the ‘deemed repatriation’ charge on companies bringing cash into the US from overseas from 35% to 15.5%.

Cuts to individuals’ income taxes were more modest and set to expire in 2025. The Democrats’ victory in the House means stalled efforts to make those tax cuts permanent, or even deliver a further fiscal stimulus, will be much harder to enact.

‘The Republican direction of a second tax reform bill and the prospect of making some of the temporary tax cuts in the first bill permanent is now off the agenda,’ said David Page, senior economist at AXA Investment Managers.

This can be seen in the dollar’s reaction to last night’s elections. The US greenback has fallen as investors readjust to the prospect of less fiscal stimulus driving US economic growth.

US government bonds have also rallied, with the yield on US 10-year treasuries, which moves in the opposite direction to prices, dropping below the 3.2% mark, as an inflationary threat in the form of more tax cuts recedes.

This could ease some of the pressure on global stock markets, whose October slump was sparked by a rise in US treasury yields as the Federal Reserve hinted it could move faster in raising interest rates.

Richard Buxton, manager of the Merian UK Alpha fund, argued the US election results was broadly positive for stock and bond markets, and emerging markets in particular.

‘Democrats winning the House is likely to mean slightly less fiscal stimulus going forward. The bond market may take that well because the Federal Reserve will have less work to do,’ he said.

‘That would be good news for emerging markets – with fewer rate rises ahead and a dollar that’s not so strong. It should generally be a more constructive environment for risk assets.’

Will Trump double down on tariffs?

But the worry for markets is that, faced with an intransigent House of Representatives, Trump turns to the areas of his agenda that do not rely on Congressional support, like trade policy, doubling down on his tariffs tit-for-tat with China that has rattled investors.

‘In foreign trade, the president has much greater room for manoeuvre,’ said Bernd Weidensteiner at Commerzbank.

‘The more difficult situation for domestic policy means that there are now even more incentives for Trump to bet on this card.’

James Knightley, chief international economist at ING, agreed. ‘The president is likely to focus his attention on areas where his executive powers give him more leeway to set the agenda, such as trade policy,’ he said.

‘This suggests that he is likely to continue pushing hard on China to make concessions that will contribute to getting the bilateral trade deficit lower and do more to protect US intellectual property rights.

‘However, China's response so far leaves us sensing that tensions will likely escalate further in the near term, with tariffs being increased and broadened next year.’

One of the few areas with which Trump and Democrats share common cause in on infrastructure spending. It formed a key flank of his presidential election campaign, as it did for Democratic candidate Hillary Clinton, yet in his first two years in office infrastructure has fallen behind tax cuts and attempts to repeal Obamacare in priority.

Any rapprochement on the issue could provide an impetus for further US economic growth, said Paras Anand, head of Asia Pacific asset management at fund group Fidelity.

‘Any development in this direction would further spur the overall economy, continue to push wages in an already tight labour market, and potentially challenge the current expectations around the Federal Reserve’s activity for next year,’ he said.

But despite Democratic House leader Nancy Pelosi’s call for bipartisanship, full-throttle co-operation on infrastructure remains an outside bet given the differences between the two sides.

‘We are wary on the infrastructure side, with Democrats likely to be focused on transport, while Republicans more interested on energy infrastructure,’ said James Rowlinson, head of fund selection at Mazars.

Page agreed. ‘We believe that the two sides would want to achieve different things from such a bill and any revival of opposition fiscal rectitude from Republican deficit hawks will make funding such a bill difficult,’ he said.

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