Donald Trump arrives to speak about the Iran war at the White House on Wednesday.Alex Brandon/Reuters
Anyone who listened to the prime-time ramblings of U.S. President Donald Trump this week has to wonder where the United States is headed next. Rarely has a world leader sounded so clueless.
Not only did Mr. Trump fail to muster a convincing case for why he launched a war on Iran, he couldn’t even explain whether he was doubling down on the conflict or stepping away.
The President’s bristling incoherence should make investors nervous. You don’t have to be a radical leftist to start thinking about what might transpire if the market’s love affair with U.S. equities and bonds begins to falter under the weight of Mr. Trump’s incompetence.
To be sure, any shift won’t happen overnight. The U.S. still dominates key areas of technology. It is also energy independent and unrivalled in terms of the size of its capital markets.
But all those advantages are already reflected in the U.S. stock market’s sky-high valuations. What doesn’t appear to be built into the market’s assumptions are Washington’s fraying finances and increasingly erratic leadership.
Trump’s budget proposes increasing defence spending by $500-billion while cutting elsewhere
The deterioration in the first 14 months of Mr. Trump’s second term has been remarkable. The President “has effectively inverted the traditional role of the global hegemon, from provider of public goods such as open sea lanes and maritime security, to a creator of global bads and insecurity,” writes Stephen Kirchner, an Australian economist who publishes the Institutional Economics newsletter.
The most immediate danger from the President’s antics is stagflation – the toxic combination of stagnant growth and high inflation that scarred the 1970s. Stagflation could stage a comeback if a continued impasse in the Persian Gulf keeps oil prices at painful levels for months.
The probability of such an outcome is rising. “Coming on top of the ongoing Ukraine and tariff wars, the Iran war is shaping up as the biggest stagflationary shock the world has seen in five decades,” Harvard economist Kenneth Rogoff told the Financial Times.
If stagflation were to recur, Washington’s already shaky finances might begin to teeter. It would have to shell out more to support a slowing economy while simultaneously paying higher interest rates to bond buyers to offset rising inflation.
Even without stagflation, the U.S. budget situation doesn’t look great. “While the U.S. has outperformed Europe and much of the rest of the world during these past 10 to 15 years, [its strong performance] has come with a stunning build-up in debt to the rest of the world,” writes Erik Fossing Nielsen, an independent economist formerly at the World Bank and Goldman Sachs.
The U.S. federal budget deficit has averaged a massive 6.2 per cent of gross domestic product per year over the past 15 years, he notes. The deficit is still at that level, and it is difficult to see how Mr. Trump – or any president, to be fair – can bring it down to sustainable levels.
To do so, Washington would have to cut its budget shortfall in half. To reduce its deficit by that much would require it to raise existing taxes by a third or cut discretionary spending by more than two thirds, Mr. Nielsen calculates. Neither option seems politically possible.
Yet doing nothing seems equally implausible. As things now stand, a “whopping” 18 per cent of all U.S. federal tax revenue needs to be allocated to the payment of interest on the public debt, according to Mr. Nielsen. Without policy action, the interest-to-revenue ratio will increase to 23 to 25 per cent during the next 10 years.
Mr. Nielsen argues the most likely outcome of the huge imbalances in the U.S. economy is a large depreciation of the U.S. dollar. He suggests that the greenback is likely to shed a quarter of its existing value versus its major trading partners over the next couple of years.
A move of this magnitude will strike many people as just too big to be likely.
However, it is difficult to ignore how many forecasters are now busily marking down their outlooks for the U.S. market.
The stock market has a history of missing the shock in plain sight
Man Group, the big British money manager, noted this past week that, despite recent losses, U.S. stocks are still trading at some of their most lofty valuations in the past 40 years. If trouble in the Gulf were to trigger a global recession, these highly priced stocks would be especially vulnerable to a reset.
A slowdown in growth and more normal valuations would result in a 30-per-cent fall from Wall Street’s pre-war highs, Man Group calculates.
Elm Partners Management, a respected money manager in Philadelphia, also has a downbeat outlook. Looking out over the next decade or so, it sees U.S. stocks producing real returns of a paltry 3.27 per cent a year. In contrast, it predicts that non-U.S. stocks will generate after-inflation returns of nearly twice that size, or about 6.45 per cent a year.
Investors may want to ponder this comparison. After more than a decade in which betting on U.S. stocks paid off magnificently, it may be time to start tilting your bets in the direction of other markets.