How will the divided US Congress impact the world economy?

This article first appeared in The Edge Financial Daily, on November 12, 2018.
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KUALA LUMPUR: The Democrats have seized control of the House, while the Republican party held onto the Senate last week after the US mid-term elections, delivering a split Congress and expectations of a legislative gridlock over the remaining two years of US President Donald Trump’s (pic) term.

The outcome was not surprising. It was pretty much in line with the past pattern.

The House of Representatives is the lower chamber of the US Congress, while the Senate is the upper chamber. Together they are the country’s principal decision-making bodies and approval from each is required to pass bills.

A divided Congress, however, will limit Trump’s ability to pass new legislations; a gridlock also means that politicians will not be able to do much to harm or undo some of the positive measures that are already in place that have helped lift the stock market, for instance.

Now, how would the divided US Congress affect the world?

 

Putting a brake on global growth

The positive earnings impact from Trump’s tax cut is likely to wane by the second half of next year, said a fund manager, and with Congress in gridlock, it is expected to be difficult for the Trump administration to pass any new fiscal stimulus measures to continue driving economic growth moving forward.

“If there is no room for stimulus amid the rising tension between the US and China, this will be negative for the global economy. The divided Congress also increases the risk of a debt ceiling fight next year,” the fund manager commented.

He did not rule out that the House Democrats might even push for a corporate tax hike as a condition for a higher debt ceiling. “This will definitely be bad for the stock market,” he said.

 

Oil prices

A divided Congress could lead to a change in Trump’s foreign policy in the Middle East, which may have a bearing on oil prices. This is because while the Senate is controlled by the Republicans, some of the senators are also critical and could break away from the White House on some of the foreign policies involving countries in the Middle East.

Among some of them are US sanctions against Iran as well as the US-Saudi Arabia relationship following the murder of journalist Jamal Khashoggi.

The House Democrats are expected to call for harsher measures to be taken against Saudi Arabia, which the Trump administration has been reluctant.

“There could be a negative impact on oil prices as there might be a push to revert to a more calibrated approach towards the sanctions against Iran.

“This might not be good for oil prices as the rise in the crude oil price has been partly due to the sanctions,” an oil and gas analyst told The Edge Financial Daily.

He, however, said oil prices had already encountered some downward pressures after the US granted sanction waivers to top buyers of Iranian oil.

The expectation of the Trump administration’s efforts to sanction Iran’s crude oil exports would lead to a shortage of supply has fuelled the Brent Crude price to climb to US$86.29 (RM360.69) — the highest level since October 2014, the year when the crude price collapsed. The Brent price had fallen 18% from the peak to US$70.43 per barrel as at the time of writing.

 

Chance of a stronger ringgit

Affin Hwang Investment Bank chief economist Alan Tan explained that with the lower chamber of Congress controlled by Democrats, it is likely that some of the fiscal stimulus measures proposed by the Trump administration would be rejected. If that happens, an overheating US economy is less likely, as a result the US Federal Reserve (Fed) may slow down on interest rate hikes moving forward.

Tan believes that with the expected US midterm election outcome and the interest rate hike cycle approaching its tail-end cycle, the strength of the US dollar could taper off towards the second half of 2019.

“I think that with the US mid-term elections, the US dollar strength would moderate. It is important to note that so far in 2018, much of the decline of the ringgit was due to the strength of the US dollar. In fact, the ringgit was one of the outperformers compared with other emerging-market currencies,” said Tan.

Rising expectations of a more gradual rate hike path in the US was the reason for the slight correction seen in the US dollar lately. Compared to a year ago, the ringgit has depreciated by 3.3% against the greenback. As of writing, it was trading at RM4.1785 against the US dollar. Tan also noted that foreign funds might return to emerging markets, including Malaysia, as the US dollar’s strength tapers off.

Last week, after the midterm elections, the Federal Open Market Committee kept its policy Fed Funds Target Rate (FFTR) unchanged at between 2% and 2.25% in a unanimous decision with a reiteration that “further gradual increases” in the FFTR are warranted.

The view of a gradual rate hike trajectory is maintained with the Fed on course to see a fourth rate hike this year next month.

UOB Group senior foreign exchange strategist Peter Chia said in his report last Friday that UOB Group had maintained its 2019 rate hike expectations at three 25-basis point hikes which imply that the Fed is set to exceed its long-run FFTR of 3% by mid-2019.

“Taking the balance sheet reduction into consideration, the implication is that the Fed will not add more rate hikes (beyond what is implied in the September 2018 dot-plot chart) unless we get a sharp inflation surprise,” he noted.

 

Ceasefire of US-China trade war?

UOB Group senior economist Alvin Liew and Chia said that a divided Congress could weaken Trump’s trade hawks and prevent further escalation of the US-China trade conflict.

The economists were of the view that Trump might soften his aggressiveness in imposing tariffs on imported products from China if the US economy is on a slower growth path as his administration is expected to face challenges to get the House of Representatives to pass any fresh economic stimulus measures to sustain gross domestic product growth.

The ease in trade tension may augur well for the global economy simply because any form of trade protectionism would deter world trade.

The investors will probably be getting a clearer indication of the Trump administration’s stance towards trade with China at the end of this month as Trump and China’s President Xi Jinping are scheduled to meet on the sidelines of the Group of Twenty summit at the end of the month.

Affin Hwang Asset Management portfolio manager Lim Chia Wei believes that the US-China trade talks would be more important to the outlook for emerging markets (EMs).

“If the two can strike a deal and come to some forms of compromise, the EMs could see a relief rebound. Though, with low expectations and if neither parties come to a deal, the EMs may see another leg of weakness as the trade spat gets protracted and the issue gets dragged on to 2019,” Lim said.

This is crucial because even though with the Democrats controlling the House and could challenge Trump in several areas such as military spending as well as his foreign business dealings, the US commander-in-chief still enjoys the executive power when it comes to trade policy. This means that while the outcome of the midterm elections could weaken Trump in his negotiations with Beijing, an escalation of the trade tension between the two largest economies in the world is still not off the table yet.