Market review: What to look for in Trump’s budget, and beyond

Investors have no shortage of headlines to absorb as we approach the summer months. Below, I highlight three key takeaways from the U.S. last week, featuring a new federal budget proposal from the Trump administration – and preview three questions that will be answered this week concerning jobs, productivity and growth in North America.

Three key takeaways from last week

1. Federal budget proposal outlines the Trump administration’s priorities.
The Trump administration released its first budget proposal for 2018, making a strong statement about several key agenda items: health reform; tax reform and simplification; immigration reform; reductions in federal spending; regulatory rollback; energy development; and welfare reform and education reform.

The budget proposes deep cuts to U.S. domestic programs – a decline of 20% from the 2017 budget. Most federal agencies did not go unscathed, but those hit particularly hard include the Environmental Protection Agency, where proposed cuts for 2018 are more than 30%. Also seeing a big drop in funding would be the Department of State, the Department of Labor and the Department of Education. There are also significant cuts proposed to aid programs for those in poverty such as Medicaid, the Supplemental Nutrition Assistance Program (known as SNAP or food stamps), the Children’s Health Insurance Program (CHIP), and Social Security Disability (also known as SSDI; it is not to be confused with Social Security Retirement), Supplemental Security Income and tax credits for the poor. It is important to note that the budget proposal does not touch Social Security or Medicare.

The budget proposes an increase for several different agencies. The Department of Defense would get a 10% increase in its budget for 2018, while the Department of Homeland Security and the Department of Veterans Affairs would see increases of more than 5%.

The budget is predicated on expectations of 3% economic growth by 2021 through stimulative tax reform. Some economists argue it will be difficult for the U.S. to reach 3% growth despite tax reform, and their arguments have some merit given productivity has faced limitations, arguably from demographics and low capital investment. In addition, I believe this budget is flawed in that it anticipates this higher growth level as a result of tax reform, but does not calculate the lost revenue from the tax reform.

Think of this budget proposal as more of a statement about the administration’s values and priorities. Congress may take a similar approach to the one it took with the Obama administration’s proposed budget for 2017: largely ignore it and work on its own version of the budget. However, that doesn’t mean this process will go smoothly. There is the potential for some level of chaos given that so much is riding on this budget (the Republicans plan to pass tax reform as a reconciliation to the 2018 budget, which means it must sit in the queue behind the budget).

2. The U.S. Federal Reserve (Fed) is committed to a gradual normalization process.
The May Federal Open Market Committee (FOMC) meeting minutes were released. They indicate the FOMC is committed to a very gradual and thoughtful balance sheet normalization process – more gradual than some had expected. The Fed will slowly taper reinvestment rather than end it all at once – this is a far gentler approach than ceasing investment in one fell swoop, which is the approach the FOMC seemed to have been seriously considering at one point. And it seems the FOMC gave a nod to Minneapolis Fed President Neel Kashkari’s call for transparency around balance sheet normalization by agreeing to announce the caps it planned to set on Treasury securities and mortgage-backed securities that would be allowed to run off rather than be reinvested each month.

The Fed tapered in the final stage of quantitative easing, and now it will taper in at least the first stage of quantitative tightening. Some are arguing that because normalization will be so gradual, the Fed 1) can start balance sheet normalization sooner; and 2) won’t have to slow the pace of its rate hikes. I would argue that this is not necessarily the case and, more importantly, it does not seem fully priced into markets. That doesn’t mean it won’t gradually become fully priced in, but we’ll need to follow the situation closely.

3. Trump in Europe – the strength of political alliances comes into question.
I’ve written about the theme of political disruption, in particular about populism, de-globalization and the threat to longstanding institutions such as the European Union and North Atlantic Treaty Organization (NATO). That theme seems to have only become more prominent in the last few days with the president’s meetings in Europe. It marked the first time since 1949 that a U.S. president did not explicitly endorse Article V, the collective defense clause of the NATO charter (informally known as “all for one, one for all”) and was a source of great concern – particularly since President Trump made some disparaging comments about NATO during his campaign. The key takeaway from the meeting came from German Chancellor Angela Merkel, “The times in which we can fully count on others are somewhat over, as I have experienced in the past few days … we Europeans must really take our destiny into our own hands.” Germany’s foreign minister went even further by stating that President Trump had “weakened the West.”

There is always the off chance that President Trump is taking an extreme position as part of negotiating tactics and fully expects to endorse NATO and maintain the U.S. foreign policy status quo vis-a-vis NATO allies. However, at least for now, political alliances are clearly weakening among some countries and strengthening among other countries.

What to watch for in North American data releases this week

1. How robust was Canada’s economic growth in the first quarter?
We will find out on Wednesday what the GDP print was for the first quarter. Expectations are that growth will improve, but there are certainly question marks around how much in the first quarter. The data will have to be compelling to convince the Bank of Canada that the economy is on a strong and sustainable economic growth trajectory.

2. Will May’s U.S. jobs report echo April’s strength?
The most anticipated economic event of the coming week is arguably Friday’s release of the May jobs report. Recall that April’s jobs report revealed that headline unemployment (called U3) declined to 4.4%, a level not seen in the last decade. A broader definition of unemployment (called U6), which includes people who are marginally attached to the workforce and those unable to find full-time employment for economic reasons, also experienced significant improvement.

In my view, another strong jobs report will “seal the deal” for the data-dependent Fed at its June meeting, ensuring a rate hike, barring unforeseen circumstances.

3. What will revised productivity figures reveal?
This coming Thursday we’ll get the revised report on nonfarm productivity and costs for the first quarter. The first estimate for productivity was -0.6%. Hopefully the revised estimate will be higher; weak productivity elevates labour costs as it takes more hours to produce the same item so companies need to add additional labour to produce the same item at the same rate. Productivity is a topic certainly worthy of more discussion, particular given the Trump administration’s focus on it.