Prior to the Presidential election 23 Nobel Laureates for Economics collectively stated that Trump’s economic agenda would be bad for the economy. Obviously, markets since the election have disagreed. Today, I want to divide my note into three segments; what was the message of the election, what has been the message of the market so far, and how might the ultimate outcomes be different from what markets believe today.
The message of the election was fairly positive. Compared to Joe Biden four years earlier, Kamala Harris lost ground among both men and women, across most ethnic divides, and across the economic middle class. The only slices of the electorate where she gained ground was among women with college degrees and seniors. It’s no accident that these groups get most of their news from the mainstream media. Harris did particularly poorly among young voters. Clearly, the Democratic push to the left didn’t resonate among voters.
Rehashing the past only has benefit if it changes future behavior. It’s too early to judge future changes, but one that almost certainly will occur is for Democrats to tack to the center politically. The Old Guard of Pelosi, Sanders and Warren will gradually cede control to a younger generation that will want to appeal to the sectors of the voting population that have been driven from Democrats to Republicans.
Obviously, the Republicans have changed as well. The old image of Wall Street bankers with their pressed 3-piece suits has given way to a much more populist image that clearly resonates and broadens the appeal of the party. But with that said, there is plenty of overlap between the Old Guard Republicans and the new populists. Most of that overlap is economic. Republicans old and new don’t want government to tell them what to do. Capital allocation largely belongs in the private sector according to their vision. A corollary to letting the private sector allocate is to reduce the regulatory barriers put in place over the past two decades.
Thus, the electorate embraced better capital allocation and less regulation in addition to immigration reform that will stifle the flow of undocumented and illegal immigrants. One final message embraced by voters is using political pressure and tariffs, along with tax cuts and other adjustments to tax policy to improve our nation’s competitive stance. While details are only beginning to emerge, it is clear that Trump wants to move as quickly as possible to put his agenda into motion. While many steps require Congressional action, tariffs to some degree can be done by Executive Order. Similarly, while Trump cannot seal the border, he can slow the flow of immigrants across our southern border significantly while accelerating deportations of undesirables.
Thus, we know voters want to move toward the political center or even a bit right of center. Such a move is consistent with more freedom for capital allocators (i.e., the private sector) to invest, merge and otherwise take steps to improve economic efficiency. One measure of GDP growth is the product of productivity improvement times changes in population. U.S. birth rates today are at multi-decade lows. Deporting more people than you let in will hinder growth. Estimates vary but there are as many as 10 million undocumented persons currently living in the U.S. While Trump’s campaign rhetoric talked of deporting as many as 20 million people, no one sees that as either feasible or sensible. With that said, there will be a big difference between deporting one million and deporting five million. The devil is always in the details.
If there is one other clear message from the Trump team early on it is that we should brace ourselves for an overload of disruptive changes. Not all changes will be well received. Some will have to be modified. Stating a goal to reduce Federal bureaucracy by $2 trillion is an aspiration. But cuts of that size will mean reducing headcounts substantially. Those people that lose their jobs won’t be happy campers two years from now in the mid-term elections. History shows that both Democrats and Republicans like to spend to covet voters. But any significant attempt to rein in bureaucracy will be a positive.
Markets so far buy into this game plan. Soon gone will be Federal subsidies for green initiatives, at least in the form that exists today, i.e., government handouts. It’s too early to evaluate how the tax law changes that expire at the end of 2025 will be modified or extended. But the game plan is obvious. Tax less, offset part of the lost revenue with tariffs, and hope that improved productivity fills in the balance.
I mentioned fewer green initiatives. But there are other changes coming that should eliminate distortions. Barriers to drilling for oil and gas will disappear. That doesn’t mean “drill baby drill” as some suggest. Those days are long gone. Wall Street transformed the oil and gas industry to concentrate on delivering free cash flow, not maximizing production. But if the U.S. is less dependent on foreign oil, it strengthens our government’s ability to stand up to bad actors in the world like Russia and Iran.
There is another distortion that Treasury will have to deal with. When yields on 10-year Treasuries rose to 5% a year ago and fears of crowding out accelerated, Secretary Yellen shifted the duration of Treasuries issued away from 10-year bonds toward very short maturities. This was yet another example of government trying to manipulate financial markets. It worked in the short term but now has set up an enormous amount of refunding in addition to new deficits that have to be funded. Will a resetting of duration likely result in higher 10-year yields? That’s clearly a risk that will have to be addressed.
Now, let’s look ahead. As noted, markets like what they see for the most part. Obviously, some companies will be affected by higher tariffs more than others. Banks have reacted positively as the yield curve shows signs of steepening. Less regulation and a friendlier FTC and Justice Department should accelerate merger and investment banking activity. Prospects of reshoring of manufacturing have lifted the stock prices of most industrials. Dollar strength will induce more foreign investment in the U.S.
But what looks great on paper doesn’t always translate as expected. Trump’s tariffs on aluminum and steel hardly ended up rejuvenating our U.S. industries. Tariffs on Chinese goods may move some production to the United States but more likely will shift the great bulk to other Asian nations. Simply said, the U.S. is not the low-cost producer of many goods. Greater productivity will help but won’t be a complete offset. Trump focuses on balance of payments. Our greatest imbalances are with China, Europe and Mexico. That’s where his tariffs will focus. But will they work? They didn’t the last time around. Will Trump start with 60% tariffs on Chinese goods, 20% on European goods, and 200% on Mexican items? Probably not. He’s a deal maker and will try to use the threats to his advantage. Will the cost of tariffs, offset by tax cuts and extensions create more growth? While markets say yes today, reality will almost certainly adjust judgments going forward.
The other real question markets must face and haven’t faced so far is the future path of inflation. During Trump’s first term, inflation was largely dormant as plenty of slack remained from the Great Recession. Today is different. Labor unions have won large contracts with Boeing, UPS, and the auto industry. The dockworkers strike was postponed until at least January 20, Inauguration Day. Add rising wage rates to the impact of tariffs, inflationary pressures from an economy growing at a faster pace, and the impact of mass deportations, and you have the ingredients for some acceleration of inflation.
If there is one indicator of the future success of the Trump economic agenda, it will be the yield on 10-year Treasury bonds. Markets can accept rates pushing 5% if growth accelerates, but if accelerating growth is accompanied by higher inflation, they will have to adjust. Last week, the S&P 500 crossed the 6000 barrier briefly. Estimated earnings next year center around $260, yielding a P/E of almost 23 times. That suggests markets are embracing a lot of optimism. I don’t expect that to dissipate before year end. But as the calendar moves past Inauguration Day and words become actions, it is unlikely that all the reaction will be positive. I see no reason to change one’s asset allocation based on what we know so far, although I would keep fixed income duration extremely short. With that said, a spike in one’s equity values may require some shifts to maintain one’s asset allocation. Good long-term investing requires discipline. Taxable investors notably don’t want to realize capital gains just before year end. Thus, the honeymoon can continue for several more weeks. But all the current euphoria has to be backed up by economic performance if the rally is to continue far into 2025.
Today, Jon Batiste is 38. Leonardo DiCaprio is 50. Demi Moore turns 62. Stanley Tucci is 64.
James M. Meyer, CFA 610-260-2220