Remember Trump’s proposed USD1 trillion infrastructure fund? You can read the brief details of the plan here. Now as many people are saying, there are not much details on how this package is going to get funded. Trump has merely used the wording of “financed through public and private capital”. But the wording of “public” plays a big role in how capital flows will be determined across the world.
Let’s take a step back and consider what it means by “financed by public capital”. This means infrastructure projects are financed by
- Tax Revenue
- Proceeds from bond issuance
What is of interest here is the second method of financing, which is funding from government bond issues. The US Treasury regularly issues T-Bills and government securities to finance their operating expenditure and fiscal policy requirements. One of the options for Trump would be to issue large amounts of T-bills to finance its USD1 trillion fund.
So from an economics point of view, what does this mean? Issuing of T-bills are tantamount to what economists called an expansionary fiscal policy. Fiscal policy is when government spends in stimulating the economy, by investing in infrastructure and such. This works through the “economy multiplier” if you believe the effect of it ( I honestly doubt this trickle down economics effectiveness ). A dollar spent by the government would flow through firms, suppliers, and individuals, meaning every value chain gets a boost from government spending.
What happens when the Treasury wants to issue bonds? Lets take the example of the T-bills which are zero coupon bonds. Take a T-bill bond with a face value of USD100 and a nominal value of USD99, meaning the interest rate would be 1%. The T-bill can be traded in the market so it will be intuitive to think about it in terms of demand and supply. The price of the T-bill would now fluctuate based on this. The higher the price of the T-bill, the lower the interest rate and vice versa.
So what determines the supply of T-bills? The decision by the Treasury to issue T-bills. An issuance of T-bills would increase the supply of US government securities in the market and cause the price of T-bills to decrease ( shift of supply curve from S1 to S2 ). As price decrease, the interest rates on T-bills would increase (shift of IS1 to IS2). Think about it this way, if you want to issue more T-bills, you would have to make it cheaper (nominal value lower than face value) and offer a higher interest rate than current rates to attract investors.
For those not familiar with the IS-LM graph, its enough to understand that an issuance of bonds to fund infrastructure projects would increase government spending, and thus increase output (GDP).
Now, how would this impact Malaysia’s capital flows? Let’s say hypothetically US T-bill interest rate ( “r(US)” ) is currently 1.25% and Malaysia’s MGS interest rate ( “r(MY)” ) is also 1.25%. An increase in supply of T-bills to fund the infrastructure fund would cause r(US) to increase to 1.5% making T-bills more attractive compared to r(MY) of 1.25%. Funds would now flow from MGS to T-bills to capitalise on the higher returns.
These trends would happen if investors capitalise on T-bills higher returns.
- MYR would depreciate against the USD. More demand for USD.
- Outflow of funds from local MGS market to T-bills, pushing MGS prices down.
- Outflow of funds from local stock market, pushing stock prices down.
So ordinary investors should take note of the short term impact of Trump’s USD1 trillion infrastructure fund where Malaysia’s bond and stock market are expected to trend downwards with foreign investors taking advantage of higher returns in the US. In the medium to long term however, there are potential upsides to this, as the US remains one of Malaysia’s biggest trading partner. These infrastructure projects are expected to stimulate economic activity, which increases economic growth. Malaysia is expected to benefit in terms of increased exports to the US ( and with a depreciated MYR making Malaysian goods more affordable ). Investors should take note of companies with extensive involvement in the commodities sector supplying materials to the US, or intermediate goods to other countries that would take an interest in the infrastructure projects in the US. Chinese, Korean and Japanese infrastructure companies would stand to benefit from this and Malaysian investors could capitalise on this by investing directly into these companies or investing in local companies that supply commodities to them.
There is a serious implication of this policy by the US to how Bank Negara Malaysia would approach its monetary policy though. One, depreciation would cause imported inflation in the forms of imports becoming more expensive to local consumers and companies. BNM has a mandate to conduct monetary policy with a target to maintaining stable inflation. If inflation becomes uncomfortably high because of imported inflation, BNM might increase interest rates to keep inflation down. This will cause economic activity to decline, as consumers find it more attractive to save rather than spend, and companies face higher loan and investment cost. History has proven that central banks are very effective in driving stock markets trend, Ex the FED in the 1930s on how it burst the stock market bubble.
How should you as an investor approach this fiscal policy by Trump if it happens?
- If you are holders of MGS and Malaysian stocks, sell all and buy T-bills.
- After MGS securities and stocks are at lowered favorable prices, enter back into MGS and stocks.
- Take positions in companies with extensive exporting profiles to the US or infrastructure based companies.
- Pay close attention to the inflation numbers and BNM’s monetary stance. If BNM is critical in its assessment of inflation, it would be the time to engage in profit taking activities by selling Malaysian stocks and going into the bond markets where yields would be higher if BNM decides to raise interest rates.