The Trump honeymoon last week gave way to a more sobering evaluation of both the current economic environment and what the economic impact of the new Trump administration might look like. While Trump has made a long list of expected cabinet level nominations public, few had direct economic impact. The election seems to make clear that Americans were dissatisfied with the country’s direction and wanted change. Trump’s selections to date can be categorized by two words, loyalty and disruptive. Loyalty doesn’t require much explanation. Disruptive can be either good or bad depending on the outcome. Some nominations were more controversial than others. The approval process will sift out those unworthy to serve… hopefully. But for purposes of these letters, the focus will remain on the economic impact. So, let’s start there.
For the most part the economic choices haven’t been disclosed yet. Obviously, the most important will be Treasury Secretary and that will have to be someone acceptable to Wall Street. The major names mentioned so far would probably be well accepted but there are major sub-Secretary appointments that will also require approval. For now, I think we have to assume that given Trump’s focus on money with almost every step he takes, he isn’t going to be as disruptive with economic appointments as he has been with Justice, Defense, and HHS. We are sure to learn more this week. As for the media’s fascination with the future of Jerome Powell as head of the Fed, this doesn’t seem to be an ideal moment to pick a fight with the investor class. If investors lose confidence that the Fed will be allowed to act independently, financial markets are almost certain to react negatively, perhaps in a major way. If it’s a fight to pick, now isn’t the right moment.
So, we will move on.
Last week, key economic reports showed slowing retail sales activity and evidence that getting inflation down to 2% or lower isn’t going to be a slam dunk. With deficits now close to 7% of GDP and threatening to go higher, and yields on 10-year Treasuries on a slow climb toward 5% and beyond, markets brought the Trump honeymoon to a halt, if only for a week.
President Trump and his supporters believe Americans were tired of government spending growing in an unchecked way. Federal spending as a percentage of GDP has grown to levels not seen in decades. Deficits as a percentage of GDP are now at levels not see since World War II. Bureaucracy has expanded as new regulations choke the ability of government agencies to act. Approved infrastructure spending of over $1 trillion can’t be spent because of approval tie ups that take five years or more to traverse.
It sounds beautiful, therefore, to hear Musk talk about eliminating $2 trillion from the Federal budget or Gaetz saying he is going to shut down parts of the Justice Department or the FBI. But that isn’t the way government works. Change will take time. There will be some early benefits that can be achieved through Executive Order, but most structural changes will require Congressional approval. Granted that Republicans now control both chambers of Congress, but even so, change will take time.
It is also clear that some prescribed changes will create economic headwinds. We haven’t heard much about tariffs these past two weeks, but however they are implemented, they will likely be headwinds to growth, perhaps as much as a full percentage point. The other clear headwind, economically, will be limits on immigration and efforts to deport millions who have entered the US legally through asylum procedures allowed by the Biden administration, but not necessarily able to stay long term. Forget the talk of deporting 10-20 million. Even deporting 1 million and admitting 1-2 million fewer can also inhibit growth by as much as 1%. Thus, immigration and tariff policies alone can be a 1.5% growth headwind. To be sure, that could be overcome through greater efficiencies. Tax cuts would be helpful as well but they will have to be scored. Improving beyond a simple extension of Trump’s 2017 tax cuts can only happen if the Congressional Budget Office, which will score any tax legislation, says that such actions will not expand the budget deficits long term.
Over the past several decades, we have seen bold campaign promises fizzle into smaller realities. Obama didn’t get much done beyond the Affordable Care Act (which never was very affordable). Biden’s programs, passed in the wake of Covid, expanded inflation and the deficit more than they accelerated growth or increased economic well being for the lower and middle classes he sought to support. While the appetite for change today is probably greater than at any time since the Great Recession, it is unlikely that efforts will succeed to aspired levels.
If one looks at the markets by sector, the reactions to what we have heard to date also vary. Here are a few examples:
Energy – Freedom to drill will increase. But the willingness to drill will be tempered by price and the long-term outlook for fossil fuel use worldwide. While Trump will do his best to roll back green energy initiatives and allow for more oil drilling, oil companies have been and are increasingly focused on free cash flow. Oil prices are in decline not because of Trump policies, but because fall is seasonally a weak time for oil prices. Wait until May to reach any conclusions beyond the obvious; support for green energy initiatives will be reduced substantially in the months ahead.
Retail – Neither tariffs nor uncertainty are good for retail. Ideas like capping credit card rates sound good in a campaign but will never happen. Tariffs will hurt especially low-end retailers in two ways. First, it will raise the prices of what they can buy and, second, it will weigh on its customers who will have to bear a higher share of the tariff burden because they live hand to mouth and will be forced to buy less than what they have.
Healthcare – Perhaps no sector faces greater uncertainty than this one. Prospective HHS head Robert Kennedy Jr. has issued one controversial thought after another over the years, although he has tempered some, perhaps in order to gain approval in the Senate. But the targets, from vaccines, to food nutrition, to new drug development, etc. right now raise more questions than answers. What is clear is that America spends more per capita on medical care than any other developed nation. It is the goal of Kennedy, Trump and Musk to change that. It’s hard to see how that creates a brighter economic future for any company focused on health care than before.
Technology – Both the current and prospective future administration have concerns about the concentration of power at the top of the technology pyramid. To a large extent, that concern is echoed in Europe. At the same time, regulations and legal challenges have choked the private equity and venture capital industries so important to the development of new technologies. Add in the protectionism aspects of dealing with the Chinese and there are lots of cross currents facing the technology sector. But with all of that said, to overcome the lack of population growth and the headwinds of tariffs, a significant improvement in productivity is needed. That can only happen with a big investment in technology, specifically AI and advanced semiconductors. Any effort to stifle growth in improved technological productivity will deflate much of Trump’s overall economic program. And make no mistake about Donald Trump. He is obsessed with numbers. Wall Street is his report card. If profits are squeezed, if inflation soars, or if the stock market crashes, Trump’s support will wane. And he knows that.
Finance – We can talk about less regulation, more freedom for banks to lend or raise dividends, but the big number for the banks is going to be the 10-year bond yield. If that number is too high, then the Fed Funds rate can’t come down. If the rates along the curve are too high, interest on the Federal debt will choke the budget. Inflation is a function of monetary policy. If the economy is too strong or supply is too small (as in the Covid crisis when supply chains shrunk supply), inflation rises. Trump can’t control inflation nor can he control the nation’s debt service requirements. The 10-year Treasury yield will be the arbiter of his economic success or failure.
Small Caps – They have boomed lately but largely they are small banks and small manufacturing businesses. They have limited access to capital markets. Small businesses rely on banks to support their activity and small banks need a strong economy to foster loan demand. Small businesses don’t borrow at the Fed Funds rate; they borrow at the Prime rate or higher, often much higher. Small banks only flourish in a strong economy.
So, will the economy be stronger or weaker a year from now? That probably doesn’t depend on whether Matt Goetz or Pete Hegseth get their nominations approved. Right now, the economy is solid. But it shows mixed signs. Early Trump administration attempts to ease the regulatory burden should help although specifically not in the green energy or healthcare segments. Sealing the southern border or introducing broad tariffs will be less helpful. With that said, monetary policy will probably matter the most. Look for a slow decline in the 10-year Treasury rate assuming inflation stays well below 3%. If it starts to rebound, both the Fed and Wall Street will take a skeptical view. Tax cuts are likely to pass this year but it will likely take several months for the package to take shape. Uncertainty may have some short-term negative consequences.
In sum, the initial rally may have run most of its course. In the first quarter, the rubber meets the road. It may take several months to measure any consequences. Again, watch the 10-year yield like a hawk. There are plenty of reasons for both optimism and pessimism. But all will agree that the current state of affairs, where deficits are 7% of GDP and climbing is unsustainable. There is plenty of room for efficiency within the Federal government. But much of that requires Congressional action. And Congress equates spending cuts with head count reductions that mean fewer votes. Turning bold campaign promises into bold action takes courage not only in the White House but also on Capital Hill. The public says, “go for it!”. Let’s see if Congress is ready.
Attempts to be disruptive aren’t always successful. That doesn’t make them bad; it’s part of a process. Hopefully, some of the nominees that may be too disruptive give way to better choices. But investors shouldn’t let the media’s obsession with the more controversial names lose sight of the long-term opportunity to make significant productivity gains. One thing is certain. There is going to be a Republican in the White House, and Republican control of both chambers of Congress. If things go right, they will have every reason to celebrate. If they go wrong, they will have no one to blame but themselves. That should be a powerful incentive.
Today, Owen Wilson is 56. Actress Linda Evans is 82.
James M. Meyer, CFA 610-260-2220