“With monetary and fiscal policies remaining loose, or potentially being eased further, the economy is likely to continue running hot,” the report noted. “That is clearly a positive backdrop for financial markets.”
Capital Economics says the 2020 election could be a “nail biter,” given the president’s low but stable approval rating. According to FiveThirtyEight, only 42% of the country approves of a Trump presidency. Since he was elected, his approval numbers have never risen above 45%. But the current strength of the economy could prove to be a tailwind to the Trump campaign.
The current unemployment rate of 3.5% is close to a 50-year low, and the economy continues its record expansion.
Under Trump, Capital Economics writes, there might be a push to make the FOMC more dovish, as Fed Chair Jay Powell’s term ends in early 2022. Even with the Federal Reserve signaling that it will keep rates low for the time being, it’s likely the president will nominate more doves to the FOMC. And while the Senate could prevent highly partisan nominees from being confirmed (as seemed clear with previous potential nominees of Herman Cain and Stephen Moore), it’s unlikely if the president nominates more credible dovish picks to the committee. With even more doves at the Fed, it’s possible interest rates could lower further.
The one risk to this, the report notes, is to the Fed’s long-term independence, which could be eroded with such a move, and cause a rise in rates “at the long-end of the curve.”
Further tax cuts are also a possibility, Capital Economics notes. Treasury Secretary Steve Mnuchin on Jan. 23 pledged a new round of tax cuts for the middle class while at the World Economic Forum in Davos, Switzerland. While Capital Economics finds it “unlikely” that a tax cut package would be as large as the 2017 Tax Cuts and Jobs Act, “we know that leaders in Congress would like to extend the individual tax cuts.”
“That, together with the higher spending caps agreed to last year, means that the federal budget deficit would rise above 6% of GDP by the mid-2020s,” the report stated. While the tax cuts would be deficit-financed, tax credits for companies could be beneficial for business investment, and wouldn’t cost as much as headline tax cuts. However, this is reliant on Republicans not only maintaining control in the Senate, but also winning back the House this year.
Deregulation would also steepen under another Trump term.
“So far, deregulation appears to have had little impact on economic growth. But the benefits could build with time, providing a more meaningful boost to the supply side of the economy over the coming years,” the study noted.
Another Trump term would likely also mean nominations in federal courts, which would mean there could be regulatory rollbacks. While the energy sector has seen benefits from a loosening of environmental regulations and easing Dodd-Frank regulations on smaller banks gave a boost to lending, Capital Economics said there could be long-term impacts to the downside.
“To the extent that deregulation is successful, however, it also could raise the risks of a financial crisis further down the road,” the study stated.
The biggest downside risk, the report noted, would come from overseas, particularly as the U.S. and China continue to press through trade issues.
“With the fundamental source of tensions unchanged, we think that the dispute is more likely to deepen than abate over the coming years,” the report noted. “There is also strong domestic pressure on Trump to take a hard line on China.”
Capital Economics, however, doesn’t expect an increase in punitive tariffs, but rather “non-tariff measures” that would push businesses to develop supply chains outside of China.
“A switch in focus to non-tariff barriers would be potentially more bad news for U.S. firms with significant business in China, posing some downside risk for the stock market. But with tariffs on final consumer goods seemingly off the table, the risks for the domestic economy appear smaller.”
Other risks, the report highlights, exist if Trump escalates tensions with other trading partners like the EU, Mexico, Vietnam, and Taiwan. “The prospect of more tariffs means that trade disputes would remain a downside risk for both financial markets and the economy in 2021 and beyond,” the study noted.
So far, corporations have largely absorbed the cost of the trade war, but as the study highlights, “over the longer term, it’s more likely that those changes feed through to upward pressure on consumer prices.”
Ultimately, however, despite the threat of more tariffs, the economy is “likely to continue running hot,” supported by loose monetary and fiscal policies that might ease even further. This should provide a boost to financial markets, but isn’t without risk.
“A combination of a loose policy mix, a long economic expansion and continued deregulation mean the risks of another financial crisis or unsustainable asset price bubbles are likely to grow over the next five years,” the report noted. “That raises the specter that the next recession, when it eventually arrives, will be deeper and longer lasting at a time when policymakers have only limited firepower to respond.”
Kristin Myers is a reporter at Yahoo Finance. Follow her on Twitter.