Economic implications of the surprise Trump victory

Surprise! Mr. Donald Trump has won the U.S. presidency and the Republicans have taken over the House and the Senate in a full sweep.

The Trump victory feels very similar to Brexit in terms of polls underestimating how far voters were willing to go to express their frustration and anger (and also in terms of how little economists get to sleep).

In his snap reaction to the election, well-known (left-leaning) economist Paul Krugman wrote in the New York Times, “… the economic ramifications [of a Trump victory] are way down my list of things to fear.” We disagree with Mr. Krugman on this one; in our view, the economic ramifications of a Trump victory should sit at the forefront of everyone's minds.

With a full sweep, the president-elect will face fewer obstacles in pushing through his economic vision and policies. As with any candidate in an election, it is difficult to parse out what a candidate says he or she will do versus what he or she finally does try to implement. This election is no different. There is a high degree of policy uncertainty, and Mr. Market does not like uncertainty—as we saw in the immediate Asian and European market responses to Mr. Trump's victory. Taking Mr. Trump's campaign rhetoric at face value, we think there is reason to believe that the policies he supports could push the United States into a recession and could create wider contagion.

Once Mr. Trump is finally inaugurated as the 45^th president of the United States on January 20, 2017, he will need to put his new administration in place. This involves hiring thousands of workers, some of whom must be confirmed by the Senate and many of whom require lengthy security checks and clearances. Whatever Mr. Trump stands for, some have argued, he won't be able to do anything until he has filled all the roles in his government.

While much time and energy will be spent building an administration, there are a few things Mr. Trump can do under executive order. At the top of the list is trade policy. He has indicated that he would like to withdraw the United States from the North American Free Trade Agreement and proposed to impose tariffs on some U.S. trading partners. If Mr. Trump were to insist on tariffs on China and Mexico, this could spark a trade war. Potential GDP growth stands between 1.5% and 2.0%, in our view, and if the Trump administration implements trade policies that lean toward protectionism, as was implied during the campaign, the U.S. economy will tip into recession.

While the markets in Asia and Europe fell immediately, they rebounded moderately as Mr. Trump delivered his victory speech. This was largely due to references he made to infrastructure spending. Mr. Trump has been consistent on supporting a fiscal stimulus, both in terms of infrastructure spending and significant corporate and income-tax cuts. These policies, in theory, should be inflationary and should buoy asset prices; however, we think the problem comes when you work out how to pay for them. A self-proclaimed King of Debt, Mr. Trump could push the government to borrow more to pay for a stimulus and hope that the debt ceiling is repeatedly suspended. The plan he laid out during the campaign involved using the revenues from economic growth rates of 5% to 6% to pay for a fiscal stimulus. Growth of this magnitude is very unlikely, and we believe the fiscal stimulus Mr. Trump is planning is unlikely to be as large as originally promised.

Mr. Trump has also been consistent in his stance on regulation. He vowed to repeal Dodd-Frank during the election campaign. If he manages to succeed in achieving this, banks in particular will have more room to operate. Dodd-Frank succeeded in pushing the banks to derisk and deleverage significantly, though, and a reversal could potentially allow banks to return to the types of risky lending that contributed significantly to the global financial crisis.

While the U.S. Federal Reserve (Fed) is independent and therefore does not consider political developments in its rate decisions, it does consider the economic implications of political developments. Given the high degree of policy uncertainty and the heightened probability of a U.S. recession under a Trump presidency, we expect the Fed will not hike rates in 2016.

The bigger question going forward is whether the Fed's next rate move will be to hike or to cut rates. If the United States goes into recession under Mr. Trump, as we expect, the Fed does not have many tools left to stimulate the economy. It would certainly have difficulty hiking rates into a recession.

At the same time, we believe Mr. Trump's policies are likely to be inflationary, and the Fed would want to defend its 2% inflation target. This is a dilemma with which the Bank of England has become familiar post-Brexit: Given the choice to prioritize growth or inflation, the Fed is likely to defend growth.

Of course the Fed's monetary policy would be much harder to predict if Mr. Trump succeeded in carrying out his campaign pledges to reduce the independence of the central bank or to replace Fed Chair Janet Yellen. We expect Ms. Yellen will stick out her role at the Fed until the end of her term in February 2018.

That the U.S. election was not just an American event but rather a global one was evident in immediate market moves in Asia and Europe. Over the next few days, we expect the markets to follow a path similar to the one they followed post-Brexit-beginning with a significant sell-off of U.S. assets followed by a moderate rebound. Emerging markets are likely more vulnerable.

But the contagion is not only in the markets. In our view, a recession in the United States could drag the rest of the world into recession, as well, at a time when many central banks already have the pedal to the metal trying to stimulate demand. The result is likely to be binary: Either the global economy will be pushed into another crisis or policymakers will recognize that previous policy orthodoxies have been insufficient to stimulate global aggregate demand-in which case new policy mixes might be tried.

Another important avenue of contagion from the U.S. election outcome is political; however, the brand of anti-elite, antiglobalization, us-versus-them politics that some commentators say Mr. Trump has promoted is not unique to the United States. Not only was it present during the Brexit campaign, but it is also embedded in populist platforms across Europe.

We believe Mr. Trump's electoral success is likely to embolden populist movements in Europe in what is going to be an incredibly busy election year across the Atlantic. The first test of this will be on December 4, 2016, when Italy goes to the polls in a referendum on constitutional reform. If the referendum is defeated, Prime Minister Matteo Renzi has promised to step down and there is a risk that he could be replaced by the anti-European, populist Five Star Movement. Mainstream politicians will also be tested in national elections in the Netherlands, France, and Germany in 2017. Even if populists do not win these elections, they are already shaping and shifting the mainstream political discourse.