Bank of America Merrill Lynch macro outlook linking anti‑globalization trends to US fiscal policy

Introduction David Woo MLPF&S [email protected] First came Brexit, then Donald Trump’s election as the president of the most powerful country in the world. The world has changed. Possibly irrevocably so. These ground shifts have been brought on by a backlash to globalization, increasingly viewed as the culprit for wage stagnation (Chart 1), growing disparity of income and wealth between the rich and the poor (Chart 2), and the loss of national identity. We suspect the trend of anti-globalization is here to stay. Chart 1: US real median household income Chart 2: Income inequality and globalization 60,000 - 18 China entered 58,000 At a - 14 56,000 - 12 54,000 10 8 52,000 6 50,000 4 TMU MEY Dri MWD he DD eowwmnmnwmnwnm DD DD D ODD DD DDD DD DD ~ MW he DD oo oo Qo ooo o0 Oo NNN NNN 2013 2015 48,000 46,000 ——— share of aggregate income going to top 5 percentile (%, LHS) =< MMOnN Oar MOR Ruri MOR A WY MM SBSSSSSSSSSSSSSSSESS import/GDP (%, RHS ANNAN AAAA impor (%, ) Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Wide-ranging consequences for financial markets In our view, the anti-globalization theme will have at least seven major consequences for financial markets in 2017. 1. Monetary easing will give way to fiscal easing The history of populism is one of fiscal largesse. Furthermore, with limited scope for further monetary easing, fiscal easing is becoming the last and only resort for policymakers. It seems reasonable to assume that the combination of these two factors will soon usher in a period of easier fiscal policy. Nowhere will the impact of fiscal easing be felt more than the US in 2017, in our view. The GOP has achieved a rare clean sweep in the latest elections. During the 18 years that a single party controlled both the Presidency and Congress since 1965, US structural budget balance as a share of potential GDP deteriorated by O.4pp a year on average (Chart 3). In other words, history tells us that a clean sweep is usually a recipe for fiscal stimulus. The GOP has the additional incentive to use fiscal easing to boost economic growth ahead of the mid-term elections in 2018. The Republicans will need to pick up at least eight more seats in the Senate to accomplish their stated objectives of repealing Obamacare and Dodd-Frank (Chart 4). We think the Republican controlled Congress will use the reconciliation process (which has a deadline of 15 April} to pass most of its fiscal agenda into law. 2. Fiscal easing not yet priced into the belly of the curve Fiscal easing is unlikely to be kind to the Treasury market. For one thing, a bigger budget deficit would increase risk premium. And, fiscal easing at this late stage of the expansion would likely lead investors to demand higher inflation risk premium. Also, 2 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014732