Business Insider recently caught up with Markus Schomer, the chief economist at PineBridge Investments, to help make sense of the state of the market and to talk about his outlook for 2017.
Schomer is a 20-year veteran of PineBridge, which has $82.6 billion under management.
Schomer discussed the sell-off in Treasurys, Fed rate hikes, and the geopolitical challenges of the year to come.
This interview has been edited for clarity and length.
Tina Wadhwa: The surprise election result has been traced back to how many Americans really felt about the economy. Are there any trends or indicators we perhaps did not pay enough attention to that we should now?
Markus Schomer: If you look at the election results, it’s quite difficult, isn’t it, because of the regionality of the system. On the one hand, almost 3 million more people voted for the Democratic candidate than for the Republican candidate, so if that was the only thing you knew, you would say that voters clearly voted overwhelmingly for the continuation of the current economic policy.
The reason it didn’t go that way and Trump won was because of a small part of the country where you could argue that some of the benefits of the Obama economy haven’t been felt sufficiently, and that’s of course the part where you could argue that we have seen a lot of the manufacturing jobs leaving and no new jobs being created. There’s an inequality between the jobs that have been lost in the old manufacturing hubs - places like Ohio, Pennsylvania, and Michigan - and they created them in places like California, where all the new tech jobs are. That’s an inequality the system has failed to address this time.
One of the reasons for that is the lingering problem in the housing market. Before the great financial market crisis, housing was always a very liquid asset. If you lose your job in Ohio, you sell your house and move to California, because that’s where all the jobs are. Because of the housing crisis, so many people have been so underwater with their mortgage that they couldn’t do that. For the past six years, that typical mobility that we had in the US, where people would go where the jobs are, has been lost. At the same time, the jobs being created aren’t the kind of jobs that everyone can do. The people who lose their jobs in one industry can no longer just transfer it easily to another industry. There’s a cyclical element here, which is the housing story, and a structural element, that the skill sets are not easily transferable anymore.
The problem is that we don’t have a policy to address this. That’s the one thing that was missing in the last administration. There was no policy to address the job shortfall in places like Pennsylvania and Ohio. Maybe it should be the state government that does that, but the federal government never developed a strategy.
That’s the message that’s coming out of the election, in my view. We need to have that strategy. The indicators I would look for is if mobility is picking up again, are workers moving out of the states that have higher unemployment rates to the states that have lower unemployment rates.
The last element is income inequality. Most of the income is going to the top income classes instead of the lower income classes. One way to address that is through change in tax policy. I’m not sure if the proposed changes in the Trump administration will address income equality - it will probably make it worse. Income quality is one thing to look at, and labor mobility is the other one. [Federal Reserve Board Chair] Janet Yellen sometimes talks about it, and I think it is part of this whole story that, yes, the unemployment rate is 4.6%, which is really low, but there still is an element of underemployment in the economy.
Wadhwa: What does a Trump victory and his Cabinet appointments mean for the global economy? Predictions seem to be for positive fiscal stimulus in the short term with more uncertainty over trade wars, immigration, and low GDP growth longer term. What’s your view?
Schomer: It’s interesting to look at the picks for different departments and try to infer what they could mean. I have to say, I’m of the opinion that we probably put too much weight on how impactful all of this is actually going to be. The government doesn’t have that much influence on the economy at the end of the day. The Fed, for example, matters a lot more.
But if you look at the people he’s chosen, a couple of themes are clear. He’s aware that he is only one of two sources in the way we do government in the US that initiates legislation. He can come up with an idea of what to do with taxes, but Congress can do that as well and will do that as well. And then he has to figure out to reconcile both of them. So when I talk about the impact of Trump’s fiscal policy on economic growth, it’s actually much less what Trump has been talking about and much more what the Republicans in Congress have been talking about for the last 10 years. They have a plan that’s more or less ready to go and Trump has a rough idea.
So the fact that he has appointed Steve Mnuchin, I’m not sure that has much of an impact of what Paul Ryan has been working on for the last 10 years. That will be presented to Congress and will land on his desk. There will be some talk, of course, between his people and the Republicans in Congress, but I’m not putting too much weight on some of the people he has chosen.
For example, on the trade-policy uncertainty you mentioned, the fact that he chose someone as ambassador to China who is almost, you could say, a friend of China, and chose a secretary of state who is a friend of Russia, is telling. He hasn’t chosen someone who is a friend of Mexico yet - that’s true.
It doesn’t sound like he is going to start massive trade wars with the rest of the world. It doesn’t look like it. I’m actually German, so the one thing that’s missing so far in the people he has chosen is someone who can extend a bridge to Europe. Interesting enough, I haven’t seen that yet, but he’s not going to start a trade war with the European Union. That’s not a part of the world he has insulted in any tweet so far. I think the risk of a trade war/protectionism is very overstated.
My argument has always been that if he does anything to make trade more difficult, or tries to disrupt some of the trade flows we have right now, he will hurt US businesses and he will hurt US consumers, and that doesn’t seem to be a very smart political strategy. There may be some blusters and some tweets, but I don’t believe there will be any significant policy changes that will result in lower trade or lower imports at the end of next year. I think it will be the opposite, in fact, that we will have more trade at the end of next year, because he’s stimulating investment spending in the US, and that is typically something that stimulates trade all around the world, like the global supply chain of manufacturing products. That is much more likely, in my view.
Wadhwa: What else forms your outlook for 2017?
Schomer: A major part of our outlook is the story in Europe with the elections. We never looked enough at elections, and the consequences of elections, but now everybody is completely and totally aware of it. We had Brexit, now Trump, and there are four, potentially five, major elections coming in Europe that could be hugely consequential and could have a very serious damaging impact on the European Union and the euro. I think markets will be very sensitive to that over the course of 2017.
There are elections in Germany, France, the Netherlands, and Italy, most likely. If just one of them goes wrong, there’s going to be another major, major euro crisis, that could be worse than the one in 2010 and could create another 2008. I think the risk is very, very high, and we need to pay very close attention to what’s happening in Europe. There are also a couple of other elections of importance geopolitically - Iran has presidential elections early next year, Russia is running elections in 2018, and I’m hearing that Putin is thinking about not running anymore, and that’s a big story. These may not be things that will change the trend for the global economy that much, but from a markets perspective, it will be very important, create a lot of volatility and make forecasting a lot more difficult.
Another story I’m telling is emerging markets. We’re not necessarily overweight on emerging markets, but we are seeing more and more countries starting this virtual reform cycle, where they vote for the right governments that implement reforms, which slows inflation, allows central banks to cut interest rates, which promotes growth, and stronger growth allows these governments to pass more reforms. We’re getting these virtuous cycles. For a long time it was just India, and India was everybody’s darling, but now we’re seeing that in more countries like Peru, Brazil, and Indonesia. To us, the spreading of this virtuous reform cycle in the emerging markets is also something that is changing in 2017 from just one country to more and more countries. To me, this is another trend that will become an investment story - how emerging markets more broadly could become more interesting again because they are doing the right thing, implementing economic reforms and boosting growth.
Wadhwa: Do you think the new administration will take a softer stance toward Russia with regards to the sanctions imposed after Crimea? And if so, do you see a lot of upside in Russia over the next year or two?
Schomer: I don’t have a lot of hard evidence or data to rely on, but I do think he will make it more likely that the sanction regime will crumble over the next year or so. There’s already quite a bit of pushback against the sanctions from Europe, from some Eastern Europe countries and from quite a lot of Western European businesses. The Western Europeans - the Germans in particular - are still supporting the sanctions, but I wouldn’t be surprised if we see, maybe not an official end to the sanctions, but a weakening of the sanction regime and on balance that will be positive for Russia and add to that the increase in oil prices, which is positive for Russia, so I think the economic outlook for that economy is actually quite good.
Wadhwa: Trump has adopted what can be seen as a pretty confrontational tone toward China, speaking with Taiwan and threatening to declare China a currency manipulator and impose tariffs. How do you see this playing out? When does it start to hurt China, and is there a retaliation we should be prepared for?
Schomer: Well, if he were to do all of these things you listed, I think that could be a problem. The problem is, so much has been said and been rolled back or reversed. It’s hard to really know what will become policy. There obviously was a phone call, but it’s unclear who initiated it and it’s unclear if that was designed as a policy signal, which I doubt, or just as something you do if you don’t exactly know what you got yourself into. That’s more likely what happened, in my view.
Could he declare China a currency manipulator? That is something that I believe will be the hallmark of his new administration. I think it is possible that he would do that, because that’s also something you don’t need Congress for - the Treasury department does that. I think he will declare China a currency manipulator, but without any consequences. It would be exactly the kind of thing I would expect for the next four years - where President Trump can show success and action in that he did exactly what he promised his voters he would do, but it would have basically zero consequences.
I bet he will build a piece of the wall, but it will have no consequences. He will replace the fence with a wall, but no economic consequence will come out of it.
Same story with the wall. I bet he will build a piece of the wall but it will have no consequences. He will replace the fence with a wall, but no economic consequence will come out of it.
And I expect the same thing with China. He may adopt a different way of talking to China - for example, his reaction right now to the capture of that naval drone - but I don’t think there will be a significant policy change that will disrupt the very lucrative economic relationship between China and the US.
Wadhwa: Larry Kudlow and Steve Mnuchin are talking about a 4% growth rate over President-elect Trump’s first term. With the unemployment rate at a low level, would growth at these levels spur significant inflation?
Schomer: I don’t think a 4% real growth rate over the course of one or two years is attainable now. Productivity is too weak, and that’s the main driver of economic growth. It’s going to take a long time to get our productivity numbers up again and thereby raise that underlying growth potential. Many estimates of the potential growth rate right now are below 2%.
Donald Trump is talking about a major increase in debt finance growth, but most of us forecasters believe that only some of that will go through Congress and not in the amount that Trump is talking about. So I think a 4% real growth rate is out of the question. I wouldn’t be surprised if they switched that target to a nominal growth rate, which is easily attainable and can be exceeded easily. I wouldn’t be surprised if when they talk about 4% that at some stage they are going to show us a chart of the nominal GDP growth rate and say how beautifully they have exceeded the 4% growth rate, which is of course only possible because inflation numbers are going up as well.
Wadhwa: In your opinion, what warranted the Fed’s upgrade from two to three rate hikes? Was it based on higher growth, higher inflation, or just a rebalanced Fed interpreting the same economic data in a more hawkish fashion?
Schomer: I think what warranted that was not necessarily the fact that the view has changed at the Fed. If you look at their forecast, not much has changed. I was actually quite amazed that they only raised their growth forecast for next year from 2%, which is really quite low, to 2.1%. That’s kind of amazing. Our forecast is at 2.5%, which is significantly more optimistic for growth. The fact that they raised it from two to three was a confidence move and not driven by the idea that everything now has changed because of Trump. They are just more confident in their forecast so they believe they can go to three, but we think that’s too much.
Wadhwa: What is your view on rate hikes during 2017?
Schomer: We expect two rate hikes in 2017.
That’s less than what the Fed is expecting. The Fed just raised their expectations from two rate hikes to three rate hikes in 2017, at the last meeting, but we think that we have had two years now where we have had fairly low unemployment but also still fairly low inflation and that warranted a pace of one rate hike per year. Now we are going to a period where there is still very low unemployment but inflation will be close to target or even a little higher, and a pace of two rate hikes given the uncertainty in other parts of the world and the fact that the US is still the only Central Bank raising rates, that only warrants a two-rate-hikes-per-year pace.
If we get to a point where there’s more synchronized global growth and other central banks are raising rates, which means the consequences of US rate hikes are mitigated by the fact that other central banks are following the same path, that’s when we can go to three or maybe four rate hikes a year, but we are not there yet for the next two years.
Wadhwa: The sell-off in Treasurys after Trump’s election win has been pretty significant. Is this being driven by the market taking a more bullish view on economic growth or greater inflation expectations going forward?
Schomer: I think the sell-off is probably driven by both of those arguments, plus maybe a third one. After Trump’s election, most of us economists went through our numbers, and even though we didn’t have any details of policy changes, we should expect some kind of fiscal stimulus through tax cuts and increased spending on the military and infrastructure, so that should add to economic growth.
Post-Trump growth outlooks are a little bit stronger, and as a result of that, and debt finance, inflation will also be a little bit stronger, so on bounds those two drivers of Treasury yields would have suggested that yields should have gone up a little bit.
But if you look at the sharp reaction in the market, there’s a third element here. Treasury yields have been very gradually rising since July, but at a very slow rate. I think what the Trump election also did was remove some of the uncertainty and some of that lingering pessimism that growth will always be weak and that inflation will always be low. And that led to a one-time reevaluation of the Treasury market, and now we are a level that is more commensurate with the expectation of growth and inflation that we have.
So it’s three things: It is stronger growth and inflation expectations but also this one-time reevaluation once Trump removed this lingering pessimism that was still in the market.
Wadhwa: How will geopolitical uncertainty in 2017 affect Treasury yields?
Schomer: We actually think Treasury yields will remain range-bound for most of the year. Now that we have seen that reevaluation, I think on the one hand there are some forces that could push Treasury yields up further, which is just the outright acceleration in US growth numbers. Much of that is priced in, but it’s never fully priced. If we actually were to see stronger growth coming through in the first half of the year, that could push Treasury yields up.
On the other hand, there is still an enormous amount of QE going on in the eurozone and in Japan, which will keep bond yields low in those countries and therefore make US Treasury yields very attractive for overseas investors - that has always served as an anchor to prevent US yields from going up too quickly.
We have an enormous amount of uncertainty in many parts of the world. For example, look at the electoral calendar in Europe. We believe it’s a really big deal this year. That will mean a fairly frequent spike in market volatility every time one of these elections comes up, and it’s almost on a monthly basis. In each of these instances, it’s quite likely that we will see a sell-off in equity markets and a move back to safe haven assets - and the big safe-haven asset is the US. That’s why we think the market is fairly volatile but could be range-bound for most of the year.
Wadhwa: As an investor, given all of this geopolitical uncertainty, how do you protect yourself?
Schomer: There’s two ways we do that here at Pinebridge. On the one hand, we are fundamental investors. We try not to get sidetracked by those stories that do not have fundamental consequences. What we look for is fundamental investment stories. We have a more intermediate-term time horizon when we invest. We’re not traders, so we look at the world in a nine-to-18-month time horizon. We look at what the world is going to look like in 2018. That’s what we target in our fundamental analysis, and we try to find investment vehicles or asset classes that can get us to that fundamental view for 2018.
And then we are diversified. If there’s a lot of political risk in parts of the world, it also creates a lot of opportunities. All through this year, I’ve been talking to our clients and our portfolio managers about how serious this list of upcoming elections are. I’m now starting to switch and look at Europe as a potential for significant opportunities. The French, for example - it’s possible that we actually get a very business-friendly new government in France, which could be a significant game changer. We haven’t had that in a long, long time. It could start to drive the eurozone to a much better place in terms of economic reforms. That’s a new story that nobody’s looking at. I’m looking for more evidence on if this is becoming more likely, and those are the things that we try to play in our portfolios and our asset allocations at Pinebridge.
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