USD exceptionalism squared or pared

Donald Trump’s sweeping election victory paves the way for far-reaching policy changes. This could enhance the USD’s exceptionalism or bring it to an end. Much will depend on the persistence of US economic outperformance as well as the market’s confidence in Fed independence and the sustainability of US government debt.

As we go to print, Donald Trump has won the presidency and the Republicans have won the Senate and most likely the House of Representatives as well. As a result, the new Trump government is in a strong position to implement its policy agenda: 1) introduce across the board trade tariffs, 2) close the borders to immigrants and deport illegal immigrants, 3) cut taxes and 4) deregulate transportation, environmental and energy policies. Most likely, this is not all going to happen immediately and there are legislative and legal hurdles, but a fundamental policy shift is in the making and will have a profound impact on the US economy as well as the rest of the world and financial markets. For the USD, much will depend on US economic outperformance as well as the credibility of the Fed independence and government debt sustainability.

US economy on solid ground

The US has recovered much stronger than any other major developed economy since the start of the pandemic (see table). Importantly, it outpaced its own potential, while all other major developed economies have fallen behind their potentials. China has grown even more than the US, but it also fell behind its potential. In nominal USD terms, moreover, the US has grown faster than China over the last three years.
US strength is built on strong employment and productivity growth (see table). However, this is concentrated and not broad based. Four fifth of the employment growth comes from foreign workers, which account for less than one fifth of the US work force. On the productivity side, less than 5% of the employees account for more than half of the total productivity growth. Not surprisingly, much of that is concentrated in IT services. Such concentration bears risks and could lead to excesses such as during the dot.com bubble. However, the US has a unique ability to overcome such setbacks thanks to its structural capacity to constantly create and distribute new products and services.1
US strength is also built on high business profit margins, which means that firms are in a favorable position to hire and invest. In turn, businesses hiring is good for household incomes and spending. Furthermore, households have done a good job putting their balance sheets in order, which is visible in low debt service payments. Finally, important support comes from the shale-gas boom, which has made the US energy independent.

What could go wrong?

One concern is the current AI boom, which could end in a bubble. The bigger threat, however, comes from policy. The aim of the Trump policy agenda is to make the US economy even stronger through tax cuts and deregulation and to protect it from foreign competition and immigrants. In our view, trade and immigration restrictions are negative for growth and raise inflation. Tax cuts and deregulation may support growth, but that will probably add to inflationary pressures as well and further bloat the already large fiscal deficit. Ironically, US exceptionalism could still continue at least for a while despite these negatives, because the US may suffer less than the other major economies from the negative policy implications (notably in trade) and because the US is unlikely to lose its productivity advantages abruptly, while other countries will probably not overcome their structural problems quickly (e.g. Europe and China).

Squared or pared?

US economic exceptionalism has been a key driver of US financial and USD outperformance. The US equity market has on balance outperformed other major
equity markets by more than 2:1 over the last five years and even more so in USD terms (see table). In our view, the USD may continue to do well if US economic exceptionalism is sustained at least for a while despite the negative policy implications. However, that also requires ongoing market confidence in the Fed keeping inflation under control and in the sustainability of US government debt. The combination of loose fiscal policy and tight monetary policy boosted the USD during the first term of the Reagan administration. Back then, however, Fed independence under Paul Volker was unquestioned and the debt/GDP ratio was about a quarter of what it is now.
In the short term, we think the USD will benefit from the market’s favorable view on the implications of Trump’s policy agenda (higher growth and interest rates). But that is likely to change over time, if Trump prevents the Fed from tightening policy in the face of rising inflation while the Treasury announces at the same time ever larger bond auctions.

QCAM MONTHLY | 07.11.2024 | Issue #109