The market crash that I (and others) predicted after the election has not yet come to pass, mostly because investors are seeing with their hearts and not their heads. The recession will arrive sooner or later; it is just a matter of time. How severe the “Trump Slump” will be will depend on which of his campaign promises are jettisoned after he takes office.
I can imagine three different scenarios:
1. Funhouse Reaganism: The Reagan tax cut was approved in a recession largely caused by large interest rate increases engineered by the Fed in order to break the back of inflation. While the tax cut caused the deficit to balloon, it in some respects mitigated the impact of the interest rate increase, and when the Fed relented, it was Morning in America.
There is no doubt that there will be a huge, and hugely regressive, Trump tax cut in 2017. Unlike the Reagan legislation, it will be approved at a time when the Fed is already worried about the economy overheating. In this scenario, I also assume large spending increases on defense and infrastructure, and minimal spending cuts. As a result, interest rates will unquestionably go up substantially, the dollar will rise, emerging countries will struggle, and exports and real estate will slump. Most of the tax cut will increase the size of the pre-existing cash mountains instead of being spent. Before long, the economy will heave into a recession, and Trump will no longer spout the current GOP line that interest rate increases are a good thing.
2. Reverse Robin Hood: In this scenario, the size of the regressive tax cut is largely offset by cuts to anti-poverty and entitlement programs, so the deficit does not balloon as much, and interest rates peak at a lower level. The reduction in demand caused by the federal spending cuts still causes a recession, but its impacts are more chronic than dramatic.
3. Trade Warrior: Unlike the other two scenarios, in this one I assume that the regressive tax cut is accompanied by the promised trade wars with China and Mexico. Prices rise; supply chains are disrupted; and businesses relying heavily on exports are crushed by retaliatory tariffs. The Fed, faced with stagflation, jacks up interest rates to deal with the price increases. This recession is by far the worst of the three.
So which will it be? We’ll have to wait and see.