Shifting Paradigms And The Market Adjustment

Around the middle of the year, St. Louis Federal Reserve President James Bullard revealed his new economic approach. He argued that during economic phases, or paradigms, economic relationships wee fairly stable, such as unemployment and inflation.  

We cannot predict when a new paradigm emerges. Economic forecasts must assume the continuation of whatever is the current paradigm. Bullard accepts the need for one more interest rate, perhaps next month to bring the Fed funds to a neutral target within the existing set of economic relationships. 

Investors see two trends which could very well portend a changing paradigm. First is reflation. It was clear that whichever candidate won the US presidential election, fiscal policy was set to turn more accommodative. Trump promised a large stimulus package, which included tax cuts as well as spending increases. The size of the package he talked about during the campaign, and his economic advisers are maintaining after the election, is on par with the February 2009 measures when the economy was in the throes of the credit-crisis-induced recession.   

The limits of monetary policy were gradually becoming recognized and emphasized by economists and policymakers. A few countries, such as Canada, led by a new Liberal government, provided modest fiscal support. The UK is also widely expected to increase government spending.  Investors anticipate that Hammond, the UK Chancellor the Exchequer, will outline an increase in infrastructure investment (rail and roads) in the Autumn Statement on November 23. Trump’s campaign rhetoric stands out for its size and the fact that it is for a US economy that is already growing near trend, which the Federal Reserve estimates near 1.8%. The inflationary implications of provided significant stimulus under such pre-existing conditions are not lost on investors.  

The other trend is toward nationalism and away from globalism, or integration. The UK decision (by a slight majority) to leave the EU and the election of the populist-right Trump as US president (where he secured the necessary electoral college votes but did not the most popular votes) are the first two steps on the trend, with the focus turning to Europe. For various reasons, beyond the scope of this note, polls appear to have failed in capturing the strength of nationalism and support for populist-right positions.  

We have long argued Europe was a man-made construct more than a geographic entity defined by Nature. Monetary union was similarly a political construct and was designed to cope with the reunification of Germany. We were able to help navigate the troubled waters when many thought that a Greek exit was imminent by appreciating the significance of political considerations, including will. The trend toward nationalism, if that is what it is, questions precisely that political will.