According to some, the Trump rally should have deflated already in the first days of January, when a wave of profit-taking should have hit the American stock market. In fact, selling in 2016 would have meant suffering a much higher capital gains tax than what Congress will decide this year with retroactive effect to January XNUMXst and many, it was thought, would rush in the new year to liquidate the positions that they had nervously kept in the drawer.
This sell-off has evidently been followed by a buy-sweep, as the index has not moved. For others, the Trump rally would have undergone a correction around Inauguration Day, January 20, when vague expectations would have given way to harsh reality. Again, however, the sell-off, if there was any, was met by a buy-sweep, as the index, again, didn't budge. The index then moved, but higher, in the last two days, when two new all-time highs were made.
Some have attributed this optimism to the fact that the Dow Jones has finally crossed the 20 mark, but this in turn should be explained. Others said the rally was due to the surprise at the lack of correction. Still others reported better-than-expected earnings. However, it seems to us that behind the resumption of the rise there is, as a deeper cause, the perception that the dollar can be kept under control and will not deprive the growth policies of the new American administration of too much oxygen.
This perception has two causes. The first is good macro data accumulating in Europe and Asia. The second are the pronouncements of Trump and those of Treasury Secretary Mnuchin, who spoke of a dollar that is already very, very expensive today. If the rise in the stock market makes Trump proud, who now hopes it will continue, the rise in the dollar, which initially narcissistically gratified him, now becomes, together with rates, a sword of Damocles hanging over his ambitious goal of raising growth at 3 percent.
The dollar has various structural reasons pushing it higher. The first is placement in the cycle. Indeed, the US currency tends to strengthen during expansion phases, when the interest rate differential widens, and to weaken abruptly during recessions. The second reason is that, from now on, in addition to the interest rate differential, the growth differential will also increase and this even if, as we have seen, the other economies will continue to surprise in a positive sense.
The third reason is the repatriation of funds that American companies currently maintain abroad. This reason is less important than you think (foreign funds are traditionally held in dollars) but it is not completely negligible. The fourth reason is that the sweeping reform of the US tax system that Congress is working on will provide a very strong incentive for American-based multinational corporations to move production home. In this regard, there is improper talk of a border tax, or a customs duty of 20 per cent, but the reform is, in its great simplicity, more extensive and more subtle. In fact, American companies will be taxed only on the difference between domestic revenues and domestic costs and the rate will presumably be 20 percent (against 35 today). Foreign costs will therefore not be deductible, will be treated as income and will be taxed accordingly at 20 per cent. Exports, as non-domestic income, will instead be tax-free.
The United States will thus become much more competitive even if it will take a few years for companies to adjust their production chain to the new fiscal reality. Since exchange rates between currencies tend to follow the evolution of the competitiveness gap, it is clear that the currency of the country which improves its competitiveness will tend to strengthen.
UBS analysts have recently contrasted these factors of strength with some factors of weakness, which for them would be so strong as to lead them to forecast a depreciation, and not a strengthening, of the dollar. These factors are the undervaluation of the euro, the market positioning (heavily biased in favor of the dollar and therefore vulnerable), rising US inflation and the increase in the US government deficit, already underway before the arrival of Trump and which Trump will further expand. These are all interesting and pertinent observations.
However, we observe that positioning is probably only a short-term factor, that the European undervaluation serves to keep a eurozone united that would otherwise risk politically unsustainable stresses and that the Fed, at least for this year, will surprise the markets with its toughness just as in Obama's time he surprised them with his meekness. As for the explosion of the public deficit, we recall that in Reagan's time this coincided for a few years with a very strong strengthening of the dollar. We're not even that convinced that Trump will actually blow up the deficit.
Obamacare reform will largely be left to the states. The infrastructure will be based on partnerships with the private sector. Public spending net of pensions and healthcare will be cut. Military spending will focus on armaments, but also on a radical cut in waste. One of Trump's first measures, on the other hand, was a very unpopulist freeze on the hiring of federal employees.
At the time of the signing of the decree Trump had on his left his chief strategist Steve Bannon, a man who until recently has been a militant in the Tea Party, a movement for the return to small government and the containment of public debt. All in all, a dollar close to current levels (between 1.05 and 1.10 against the euro) would be excellent for America (which can still hold up well at these levels) and would be fine for Europe and Asia. It is wrong to think that the weaker a currency is, the better it is, because beyond certain levels weakness only creates laziness in reforms, inflation, little desire to invest in productivity and, as in the German case, current account surpluses which are then badly reinvested in capital account.
A relatively stable dollar on current levels, even at the price of recurring verbal interventions, tweets and so on, would also be realistic and common sense. The benefits would be considerable not only for the American stock market, but also for those of the rest of the world, which would have very little to gain and much to lose if Wall Street, at a certain point, were to fall crushed by the too strong dollar. Most of all, the emerging markets would have the advantage, with respect to which one could concentrate on the study of (undervalued) fundamentals without being obsessed with the study of capital flows that come and go following the exchange rate trend. In Europe the advantages would be stronger for the Italian stock exchange.
