The market's reaction to the new American political reality has entered its third phase. The first lasted two months and was inspired by an holographic vision of Trump as a great friend of growth and business. It was a knee-jerk reaction, a sigh of relief that we hadn't entered a Clinton administration that would have raised taxes and made the rules even more numerous and stifling. It was also a messy reaction, which saw the stock market, interest rates and the dollar rise together.
The second phase, which started with the new year, tried to put a minimum of order. It was understood that a too rapid rise in rates and the dollar would soon block the hypothesis of acceleration of economic growth on which the stock market rise was based. Bond and dollar have corrected, the latter also thanks to Trump's tweets, and their correction made it possible to continue the stock market rise.
The third phase kicked off on February 9, when Trump announced that by the end of the month will be ready, in his words, a phenomenal tax reform proposal. Stocks rallied once again, the global equity index hit a new all-time high and a great deal of positive excitement allowed markets to shrug the increasingly real possibility of a rate hike already in March.
These three phases have had a logic and have always remained within areas of reasonableness. We have no complaints about the market levels achieved by stocks, bonds and currencies and we remain constructive. However, we would like to dedicate this issue to an examination of the considerable complexity of the situation, a complexity that we do not always see reflected either in the narratives that circulate or in the subjective perception of the markets.
Let's start right from the tax reform, the most characterizing aspect, together with the French elections, of this 2017. The markets have got a certain idea of this reform and think that with the guidelines that Trump has undertaken to present already in the coming days we will have an almost definitive version on the basis of which to start re-price all financial assets. Moreover, we recall that the reform, in any case, will have enormous effects not only on every single company listed in America but also in the rest of the world. The dollar, and therefore the entire international exchange system, will suffer the consequences, dragging interest rates along with it.
The problem is that of this reform, the most important since the XNUMXs, not one but at least four very different versions will circulate for months and with possible consequences on equally different markets.
The first version is the original one elaborated by the numerous hard Republicans of the lower house after many years of reflections and various attempts in other directions. Trump has nothing to do with it here, while Paul Ryan has a lot to do with it.
It is the most radical and revolutionary version of the four that we will see and its philosophy goes back to ideas that were already circulating at the end of the XNUMXs that have never found application. If realized, it would be a great social experiment which, if successful, would soon become global. This version of it is called Destination-Based Cash Flow Taxation (DBCFT) and has two separate and independent components. The first is a global novelty (the taxation of cash flows), the second (the territorial tax) is a novelty only in the United States because (with the more polite name of VAT and not with the rude one of border tax) it is already present in the rest of the world for decades.
The implications of a cash flow-based taxation there are many but the most significant are two. The first is that any investment in plant and equipment will be paid for immediately and not with depreciation spread over several years. Attention, we are talking about a permanent measure, not the usual accelerated depreciation that the legislator adopts when trying to revive investments.
Immediate amortization is an incentive to invest and immediately raises the level of profits. The second (the system is based on real transactions and ignores financial ones) is that the deductibility of passive interest no longer exists. Firms will have less incentive to finance themselves with debt rather than with equity.
The second aspect of DBCFT, as we said, is the introduction of a territorially based system similar to that of VAT (which we pay at customs when we return to Italy after making purchases in Mendrisio and which our exporters do not pay or have been reimbursed). Here we go to correct a distortion whereby today it happens that imported products are taxed less than those produced in America. Even in NAFTA, American products in Mexico pay Mexican VAT, but not the other way around.
Proponents of this reform, which big exporters like Boeing are enthusiastic about, say that the border adjustment is a precondition for approval. If it is not introduced, in fact, the cost of the reform will be unsustainable and will cause the public deficit to explode.
The second reform version is much more traditional and consists of a modest lowering of rates financed by the abolition of almost all deductions. The anti-Trumpian Republicans, almost all the senators and all the companies that import are lined up for this version. Among these, those that just import, such as Walmart, are among the most opposing fairs and explain that with the border tax their profits will disappear and the prices of what they sell in their department stores will rise.
Proponents of the first version respond that with the border tax the dollar will rise, allowing importers to offset the border tax in this way. In principle they are right (introducing or increasing input VAT and removing or lowering output VAT is equivalent to a devaluation and therefore makes a subsequent revaluation of the nominal exchange possible) but there is no guarantee that the exchange moves mechanically in the correct direction.
The third version of the reform is the one that Trump will propose in the next few days and that we can only try to imagine. Trump is intellectually attracted to the radical version but is aware of the political cost it could entail. It is not the importers' lobby that worries him, but the effect of the border tax on the cost of petrol and on that of many imported consumer goods. For this, probably, Trump's version will be a compromise and will provide either exemptions from the border tax for oil and consumer goods or its gradual introduction. Trump is also worried about the upward thrust of the dollar that would derive from the radical version at the very moment in which the Fed seems on the verge of decisively taking the path of raising rates. Trump's ability to direct the debate, currently overestimated by the markets, will be a function of his political strength, which in the muddy and stormy climate of post-election Washington cannot be taken for granted and stable.
The fourth version is the one that will eventually come out of the Senate, probably more like the Churchillian sausage than the pure and elegant original version of the lower house.
As can be seen, depending on the versions, the public deficit will either remain under control or explode, the dollar will rise (first version) or stand still (second version) and rates will rise at normal speed or at accelerated speeds.
We are only at the beginning of a journey that will end at the end of the year or at the beginning of next, ie with times much longer than those imagined by the markets. In this year lobbyists will work full time to distort or defend the framework of the reform. Foreign governments will turn up the volume of propaganda, perhaps denouncing other aspects of Trumpism to cover concern for an America that reform could make truly competitive.
The proposal that Trump will present, which the markets will tend to assume as almost definitive, will in reality only be a stage in this very long journey. Any excessive reaction to his proposal, positive or negative, must therefore be countered by selling what goes up and buying what goes down.
