Battles Brewing Over US Budget and Taxes

Steven Malin | 03/04/2017
White House

Summary

President Trump's ambitious plans are expected to encounter stiff resistance, but meaningful spending and taxation changes should happen well before year-end. The markets will respond well if Mr Trump's pro-growth, pro-business policies become reality.

Key takeaways
  • Before addressing the budget, Congress and Mr Trump must pass short-term spending bills and raise the debt ceiling to avoid a shutdown
  • Democrats dislike Mr Trump’s budget, as do many Republicans in both houses of Congress
  • Tax reform seems inevitable this year, but it will likely fall short of the Trump administration’s original goals

The new priorities of the US Congress and the Trump administration are designed to make US fiscal policy more pro-growth and pro-business. What these legislators will actually accomplish, however, is anyone's guess – particularly once political posturing and special-interest lobbying kicks in. On top of that, the federal budget process has many twists and turns that will ultimately dictate the timing, scale and scope of changes.

Complicating matters further, the Republican-controlled Congress and President Donald Trump have work to do before they can even get to next year's budget: They must approve new short-term spending bills that fund the government through September, the end of the fiscal year, and they will need to raise the debt ceiling to avoid a government shutdown. At every step along the way, they will be met by resistance from Democrats and many within their own party.

Significant changes to government spending

Mr Trump's fiscal-year 2018 budget proposal, sent to Capitol Hill on 16 March, sets in motion formal Congressional processes that will determine the funding levels for federal agencies, programs and operations – and most of them have little chance of being approved. The proposal calls for unprecedented cuts in civilian non-defense discretionary spending and the elimination of 19 federal agencies to fund increased spending on national defense, veterans' affairs and homeland security. As proposed, the budget would confine civilian non-defense spending to slightly more than 3 per cent of gross domestic product in fiscal-year 2018, a 56-year low.

Initial indications suggest that not only do congressional Democrats dislike the proposal, but much of the Republican base in both houses of Congress disagrees with the president's plan as well – with one prominent senator calling it "dead on arrival". Republicans on the political right already contend that the proposal, if enacted, would magnify the federal budget deficit; more moderate Republicans complain that severe cuts to programs important to their respective states or districts cannot be supported.

Major tax reform in Republicans' sights

Even as they prepare for a fierce budget fight, Congress and Mr Trump have begun serious consideration of tax reform for businesses and individuals. These proposals could turn into the most comprehensive new tax legislation since 1986 and are expected to spark a new round of political battles.

By most accounts, Republican leaders in Congress will seek to enact reform legislation by no later than late summer, so the pressure will build quickly. Tax reform will focus not only on businesses: Plans call for reduced burdens on middle- and lower-middle-income households, and a broader tax base for higher-income tax filers, designed to eliminate net reductions in their effective rates. Legislation along these lines will put many moderate Democrats in a tricky situation: Positioning against the tax bill could look like a rejection of benefits for low- and moderate-income taxpayers, while voting for the bill could seem like capitulation to the Republican leadership in Congress.

Regardless of the timetable, passage of business and personal tax-reform packages seems inevitable this year, even if they fall short of the original goals of the administration and House Speaker Paul Ryan. Compromise will be needed because several components of the comprehensive package – such as the border adjustability tax – are highly controversial. Nevertheless, proponents of radical reform will push hard for changes to taxes, spending, health insurance and regulation, considering them overlapping parts of a comprehensive program that works only if all of the key provisions remain intact. Think of it as a stack of Jenga blocks.

Change is coming

In the end, the overall tax-reform package as proposed by the administration and congressional leaders will likely raise the federal budget deficit over the next decade. Yet the increase can be offset partially if the package stimulates economic growth sufficiently to boost tax revenue and shrink government spending. Either way, meaningful changes in spending priorities and major tax reforms can be expected well before the end of 2017. The markets should respond well if Mr Trump's pro-growth and pro-business policies become reality and the economy strengthens.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Expert-Image

Steven Malin

Investment Strategist, US Capital Markets Research & Strategy
Steven Malin is an investment strategist and a director with Allianz Global Investors, which he joined in 2013. As a member of the US Capital Markets Research & Strategy team, he is responsible for making weekly US and global asset-allocation recommendations. Steven’s responsibilities also include analyzing global economic, financial, political and regulatory developments; and briefing institutional, retail and retirement clients. Before joining the firm, he was the director of research at Wealthstream Advisors, a private wealth management firm; and an advisor to Aronson Johnson & Ortiz, a quant-based institutional equity manager. Earlier, Steven was a senior portfolio manager at AllianceBernstein, serving institutional, sub-advisory, Taft-Hartley and private clients throughout North America. He also worked at the Federal Reserve Bank of New York for more than 16 years, and during this time he was an officer who held several senior position. Before that, he was the senior economist, founder and director of the regional economics center at The Conference Board. Steven has a B.A. in economics from Queens College and a Ph.D. in economics from the Graduate Center of the City University of New York.

How Will the Fed Evolve Under Trump?

Steven Malin | 21/04/2017
Data-focused Fed still dovish, but Brexit looms

Summary

Beset with low rates, slow growth and a new US president who wants a significant shift in policy, the Federal Reserve faces one of the most uncertain periods in its 104-year history. What could a changing Fed mean for investors?


Key takeaways

  • Mr Trump will have several opportunities to appoint Fed governors who favour policy adjustments that are in line with his administration’s goals
  • Although the Fed could encounter unprecedented oversight by the executive branch, its independence won’t be entirely eroded
  • A newly revamped Fed may elevate rates as quickly as economic conditions allow – perhaps as high as 4 per cent
  • The Fed has preannounced its intention to unwind some of its holdings, which should minimize market disruptions
  • New Trump appointees could relax enforcement of existing regulations, roll back others and guide the withdrawal of the US from some international banking standards

Changes afoot at the Fed

The election of President Donald Trump has already had significant implications for many US institutions – from the Supreme Court to the Board of Education – and the Federal Reserve is next in line. A complete revamping of the country’s central bank will start to play out over the next 12 to 15 months.

During that time, the Federal Reserve Board will likely welcome five or six new governors, implement new approaches to monetary policy, take a looser regulatory stance, reduce its portfolio of assets and potentially encounter unprecedented oversight by the executive branch. Taken together, these shifts in direction will provide an important reminder that while the US central bank is “independent within government”, as it is often described, it is not “independent from government”.

Existing legislation empowers Mr Trump to appoint Fed governors who favour policy adjustments that are in line with his administration’s goals – and he will certainly have several opportunities to do so. By stacking the Fed’s Board with like-minded governors, Mr Trump can weaken the Treasury-Federal Reserve Accord of 1951, which freed the central bank to formulate monetary policy regardless of the wishes of the president.

At the same time, the Fed’s independence from political interference will not be entirely eroded. The Fed will likely take symbolic actions that add to the transparency of its operations, and unless new legislation is enacted, there should not be meaningful changes to the structure of the Fed system.

Investment implications of the new Fed

  1. Faster and higher interest-rate hikes. New Fed governors will likely resemble other Trump administration officials – for example, business executives who dislike excessive regulation. We also expect the next Fed Chair to favour a strict, rules-based approach to monetary policy formulation and implementation. This is a marked departure from the view of current Fed Chair Janet Yellen, who vigorously opposes such an approach. Given that most of the current 17 members of the Federal Open Market Committee believe US interest rates are too low to stimulate enough real economic activity, a newly revamped Fed may elevate rates as quickly as economic conditions allow. Rules-based models suggest that the FOMC could feasibly raise interest rates to 4 per cent soon. Investors may want to consider factoring this forecast into their asset allocations – particularly given that many bonds lose value as interest rates rise.

  2. A shrinking Fed balance sheet with limited market disruption. The weighted average maturity of the Fed’s balance sheet has shrunk considerably since its peak in January 2013. Although it is unlikely that the Fed’s portfolio will be reduced to its pre-financial crisis levels, we expect the Fed will begin unwinding its positions later this year as the federal funds rate approaches its target level. Recent hints by FOMC members suggest that they will reduce holdings of both Treasuries and mortgage-backed securities. Investors may be reassured by the fact that because the Fed has preannounced its intentions, it is unlikely that these portfolio reductions will significantly disrupt the markets or have an outsize effect on interest rates.

  3. Reduced regulatory burdens to spur growth. The resignation of Governor Daniel Tarullo, the Fed’s head of supervision and regulation, enables President Trump to nominate a successor who will relax enforcement of existing regulations, roll back others and, perhaps, guide the withdrawal of the US from some international banking standards. Look for the Fed to either withdraw from Basel IV capital standards negotiations or, at least, to attempt to impose US-favoured rules. Other international standards covering leverage, solvency and liquidity could be modified or put at risk. This may mean that small regional and community banks can look forward to diminished regulatory burdens. This could give them more scope to lend money to local businesses, which could in turn spur some economic growth.

For more information, read “The End of the Fed as We Know It?” on allianzgi.com

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Investments in smaller companies may be more volatile and less liquid than investments in larger companies.

Investments in emerging markets may be more volatile than investments in more developed markets. Dividends are not guaranteed. Bonds are subject to interest rate risk and the credit risk of the issuer. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

146059

Expert-Image

Steven Malin

Investment Strategist, US Capital Markets Research & Strategy
Steven Malin is an investment strategist and a director with Allianz Global Investors, which he joined in 2013. As a member of the US Capital Markets Research & Strategy team, he is responsible for making weekly US and global asset-allocation recommendations. Steven’s responsibilities also include analyzing global economic, financial, political and regulatory developments; and briefing institutional, retail and retirement clients. Before joining the firm, he was the director of research at Wealthstream Advisors, a private wealth management firm; and an advisor to Aronson Johnson & Ortiz, a quant-based institutional equity manager. Earlier, Steven was a senior portfolio manager at AllianceBernstein, serving institutional, sub-advisory, Taft-Hartley and private clients throughout North America. He also worked at the Federal Reserve Bank of New York for more than 16 years, and during this time he was an officer who held several senior position. Before that, he was the senior economist, founder and director of the regional economics center at The Conference Board. Steven has a B.A. in economics from Queens College and a Ph.D. in economics from the Graduate Center of the City University of New York.
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