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Fading Trumpflation does not dim prospects for US and Fed rate tightening

Share Written By
Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

03 Apr 2017

Trumpflation hyperbole is now beset with scaling skepticism. The belief that Trump administration would quickly deliver the promised 3-4% growth through a swath of fiscal and protectionist measures is fast dissipating following the setback on getting the Obamacare repealed and replaced. This recent update has temporarily diminished enthusiasm as reflected in the treasury yields winding down again and equities losing steam following the 25% reflationary rally since Nov 2016. It has also rippled across decline in crude oil prices, stronger gold and some weakening in US dollar indices.

But will that really matter? Possibly the hype around Trumpflation trade overstated the scenario of a “V shaped” rebound in the US economy and corporate performance. It also probably overlooks the fact that the US economy was already on a mend, etching for a reasonably strong momentum. The fact that US public debt/GDP ratio has scaled up to 77% in 2016, more than double the pre-crisis level of 35%, bears out an important limitation for a fiscal reflation. And beyond just the US economy, European economies have also begun throwing some positive surprises.

Paradoxically, the fulcrum of US economic resurrection lies in the revival of private households, who are currently in a formidable position to rev up consumption, rather than being dependent on Trump’s reflationary histrionics. And in this, the Fed’s ability to smoothly migrate from a prolonged ingestion of monetary stimulus to a self-perpetuating expansion of the private sector will be pivotal.

The US job market is looking better, unemployment gap is positive now, the fear of deflation has receded, consumption has remained steady and the household net worth as a proportion of disposable income at 650% has surpassed the pre-2008 crisis levels. There also appears to be a significant improvement in household balance sheets with decline in private non-corporate debt/GDP to ~50% now from 57% in 2008 and household debt/GDP alone declining from 100% in 2008 to the current 80%. Within this, household mortgage debt at USD 8tn is still lower than in 2007. And thanks to the prolonged low interest rate regime in the US, household financial obligations are now just 15.5% of personal disposable income compared to 18% in 2007 and are currently at levels seen only in early 1980s

Exhibit 1: US households at inflexion point of re-leveraging; Fiscal stimulus may probably fade out 

Exhibit 2: Household & Non-profit organization-Net worth/Personal disposable income (%)

Source: Federal Reserve System (US), Emkay Research

 

Exhibit 3: Household financial obligations/personal disposable income (%)

Source: Federal Reserve System (US), Emkay Research

Exhibit 4: US Household Debt/GDP%: At an inflection point of re-leveraging

Source: Federal Reserve System8 (US), Emkay Research

Behind the curve position of Fed now compelling faster moves

A whole host of indicators including labor market, unit labor cost, compensation growth, inflation indicators, and import price inflation indeed substantiate the fact that Fed’s been quite behind the curve in rate normalization. A bunch of Fed rate projections based on forward looking and conventional Taylor Rule estimates peg the Fed rate close to 1.8-3.5%. It is therefore not a surprise that Fed’s Chairperson Janet Yellen now considers delay in further hikes as a risk and also sees Fed’s balance sheet considerably lower than the current USD4.5tn, bloated earlier due to the quantitative easing till 2013. 

Exhibit 5: Conventional Taylor rule estimates based on backward looking data indicate Fed rate at 3.8-4.5%

Based on various estimates of Taylor Rule reaction function for US Fed rate which is modeled on variables like inflation gap, output gap, unemployment gap, estimated desired real interest rate and inflation target; Emkay estimate based on Core PCE inflation, Unemployment gap=unemployment rate-natural rate of unemployment (NAIRU)

Source: Bloomberg, Emkay Research

Exhibit 6: Forward looking Taylor rule estimates, which incorporate future expectation variables (10 year US treasury yield-core inflation) is a better predictor; Also indicate further normalisation 

Source: Bloomberg, Emkay Research

Stronger evidence that global rates have bottomed

Positive inflation surprises are now being observed across the world, significantly in Emerging markets and Europe. Along with developments in the US, there is now a clear indication of bottoming out of global rates. The question therefore is whether hardening in global risk free yields would be sharp enough to unsettle the benevolent financial market conditions, which central banks led by the Fed, have assiduously built over the past decade.

 

Exhibit 7: Global inflation is sharply surprising on positive side especially in EuropeExhibit 8: ISM manufacturing suggest strengthening US economy
Source: Bloomberg, Emkay ResearchSource: Bloomberg, Emkay Research

The imperatives of sustained recovery in the US, as much also for continued revival in advanced economies, is to claw out of the near zero US interest rate trap without relapsing into another deflationary phase. Hence, there is high probability that central banks will continue lagging behind inflation trajectory. Sustenance of negative or low real rates will therefore provide enough space for inflation to keep rising, at least in the near future.

The big picture is to ensure that real rates are kept adequately low (or lower than the notional neutral real rate) to stimulate household re-leveraging, which in turn would generate enough inflationary pressure to deflate the elevated public debt. For example, the current real Fed rate at negative 0.8-1.0% (Fed rate at 1.0% and CPI inflation at 1.8-2.0%) is significantly lower than Fed’s recent estimate of 1% for inflation neutral real Fed rate. It will also be necessary for Fed rate normalization to be least disruptive for financial markets, such that household net worth/disposable income is not unduly impacted. This setup can sustain so long as higher inflation is still benign, say core inflation in 2.0-2.5% range.

 

Exhibit 9: Projected Public debt/GDP ratio-Decline in debt ratio will require higher inflation and low real Fed rate

 

Current scenario

Scenario 1

Scenario 2

Scenario 3

Nominal GDP

2.9%

4.0%

4.0%

5.0%

Primary deficit/GDP

4.5%

4.5%

1.7%

1.0%

10 year UST yield

2.5%

2.5%

3.0%

4.0%

Source: Federal Reserve of St Louis, Emkay Global 

Exhibit 10: Higher inflation can boost nominal GDP growth and enhance debt servicing capability

Source: Federal Reserve of St Louis, Emkay Global 

Will decline in global liquidity unsettle financial markets and EMs?

Since the beginning of 2017,  market behavior showcases a scenario of higher yields, leaving aside the temporary impact on the yields reacting to skepticism surrounding Trump’s administration . US equities have scaled up to new highs despite increasing signs of higher or faster Fed rate hikes, PE multiples have remained strong despite hardening treasury yields. This is a pleasant contrast to the taper tantrum days in early 2013 when a mere mention of ending of QE by Ben Bernanke sent jitters across global financial markets.

But will this positive confluence sustain as we move into a more rapid rate normalization by the Fed? The other question is what happens to global portfolio flows that have been a conduit that transmitted sympathetic exuberance into Emerging markets. Compression of market volatility has in the past suppressed spread for EM credit to negative territory; for instance, spreads over EM sovereign yields hardly make returns over the cover cost of carry. With risk free rates hardening, the spreads could start turning negative, thereby posing risk to portfolio flows. 

Answers crucially depend on the path the Fed takes and the ability of the US economy of delivering sustained better economic outcome despite Fed rate normalization. 

Exhibit 11: Asian financial carry trade confidence has started rising

recently and is significantly higher than pre-2008 crisis

                      Denotes the confidence of carry trade if USD is invested for three months in

countries including India, Indonesia, Philippines & Thailand

Source: Bloomberg, Emkay Research

While growth revival in the US and other advanced economies could lift prospects for emerging economies through trade channels, trade protectionism and tightening liquidity could limit the positive spill over. Historical evidence suggests that Fed rate normalization could be a risk for EM portfolio flows against the current backdrop of: a) reverse de-coupling, i.e., narrowing growth differential led by strengthening growth outlook for the US & other advanced economies, contrasting the earlier EM decoupling theme of widening growth differential led by stronger EMs and b) disproportionately large portfolio flows into emerging economies since 2009. Rising contribution of US to world GDP growth is a reminder of the 7-year US expansion phase till 2000, which saw continued tightening by Fed and a virtual drought of private flows into EMs.

Exhibit 12: Narrowing difference in world GDPExhibit 13: Rising influence of Adv. Economies growth in world GDP
Source: IMF, Emkay ResearchSource: IMF, Emkay Research

Exhibit 14: EM portfolio flows (USD) lags their relative growthExhibit 15: EM portfolio flows (% GDP) lags their relative growth
Source: IMF, Emkay ResearchSource: IMF, Emkay Research

India needs to deliver on reforms; resurrect banks

From India’s standpoint, the challenge is to deliver superior and sustainable growth performance with improving trade competitiveness, productivity and revival of domestic investment cycle. While tightening global liquidity and rate normalization will also fortify RBI’s recent shift to neutral monetary policy, it will be impending for India to sustain structural reforms to ensure stable financial market conditions. Expeditious resurrection of India’s banking sector becomes extremely vital.

Conclusion

To sum up, the fading out of the Trumpflationary euphoria embodies skepticism on US sustaining its recovery. But with its household sector having gained considerable strength and readying again for another leveraging cycle, there is enough gunpowder for the US to deliver a reasonable upturn. Hence, Fed rate normalization is likely to continue in a calibrated manner such that higher inflation is supported. Eventually, the strength in US dollar and higher global yields is likely to sustain, notwithstanding the recent genuflection. While such a scenario may still be initially supportive for Emerging economies, the challenges could intensify if the US Fed were to increase rate more rapidly in the face of more rapid rise in inflation.