Four More Years

Well, here we go, four more years. Regardless of your views or opinions of the election result, the market certainly has celebrated his victory. And it is safe to say politics will be more entertaining again, likely across multiple genres from comedy to drama to maybe even horror. In this post, we will talk a bit about the likely big policies but focus more on both potential economic and market impacts. Finally, how we think people should adjust – spoiler alert, we don’t think you should.

Tariffs – Obviously, the talk is lots of China tariffs, probably pretty quickly. The rest of the world, maybe. Of course, that would be rather inflationary, but who knows? The talk of tariffs will likely become a common occurrence. The world started to become more protectionist during Trump’s first term, and while tariffs were not the modus operandi for Biden, the protectionist trend did continue.

Economically, tariffs aren’t great, but free trade also has its issues. All else equal, tariffs would be inflationary for the US, a lift for the US dollar against most and have a negative economic growth impact for everyone. The inflation impact is very easy to see: things will cost more, and more production could be done domestically, which is likely a higher-cost jurisdiction. Higher inflation likely puts some upward pressure on shorter yields, which is a bit of a lift for the US dollar. Some USD strength is likely driven by weakness in currencies more heavily weighted to trade, such as Europe, China, etc. The economic growth implications are a bit more complex. It is likely a drag for all, with a larger drag for those who are more trade-oriented.

The impact may not be as significant as some expect. Global trade is fluid and changes over time. For instance, China used to represent about 50% of the US trade deficit, but it is much lower now. Previously imposed tariffs, geopolitical risk, and supply chain diversification are many reasons for this trend. Meanwhile, Mexico’s trade ballooned higher over the past decade. The point is that tariffs may not be as big a deal for economies or markets as they were during his first term.

The market doesn’t like surprises, and after decades of moving towards freer trade, it was a surprise when that trend reversed. We are not saying a bunch of tariffs won’t have an impact, but it’s kind of expected. The magnitude could be a surprise, but either way, the direction will not be. You can’t draw conclusions with a few days of data, but since the election, China’s equity market and a broad index of emerging markets have both been up.

Immigration – The border could be closed, and there could also be less legal immigration. The increase in the labour pool has helped on the inflation front and helped wage growth come down. Less labour, all else being equal, will put upward pressure on wages. It is possible that the tariffs discussion with Mexico and border control become intertwined. Less immigration, whether legal or not, could fuel inflation.

Fiscal spending/debt – Big deficits and rising debt were a foregone conclusion regardless of the election results. However, this will likely be incrementally worse, given the red sweep. Deficits typically run higher – and so do yields – when there is a sweep of all three branches, regardless of red or blue.

Yields will still move more on economic data, but it may be worth watching term premiums and how much higher yield investors require to own longer-term debt. The general mental model breaks down the yield curve. Two-year yields are most influenced by central bank policy and/or policy expectations. Five to eight-year yields are mostly influenced by the economy and economic expectations. Yields farther out, 15, 20 or even 30-year yields, are where concerns over the ability to pay would show up.

Less faith in the long-term fiscal ability to carry such large deficits and debt leads to higher yields. However, yields and term premiums have already been trending higher over the past few months. US economic growth has been improving for many months, and inflation has slowed or arrested its descent.

So, What to Do?

Pile into small caps? Sell all emerging markets? Buy gold? Or new gold? We would seriously caution drawing conclusions from term one and carrying them to term two. A common narrative from 2017 to 2018 was that Trump was positive for the markets. We wrote many times back then cautioning about drawing that conclusion because something else was going on. You see, following the 2008/09 recession, different economies struggled to return to growth. Europe fell back into a debt crisis in 2010-11 while the US & Asia were growing. Then, when Europe started to improve, Asia faltered. When Asia recovered, the US slowed. It was many years when the world’s biggest economies just couldn’t manage to grow at the same time… until mid-2016.

We believe markets behaved so well because we finally had global synchronized economic growth coinciding with Trump’s first term. He likely had a positive influence, with some negative as well, but the economy really mattered. We believe that will be the case this term as well. Policy matters, but the economy trumps policy (note lowercase ‘t’ in this trump usage).

Starting points matter – This is not 2016. In 2016, the S&P 500 was trading 17x forward earnings, with the expected earnings growth being really low. Today, the market is trading 22x forward earnings, which is already priced at 12% earnings growth. And yields are very differing. The Fed funds rate was a super accommodative 0.50%, QE was still flowing, and 10-year yields were below 2%. Today, we have QT. The overnight rate is 4.75% and 10-year yields are 4.3%. Lower valuations combined with accommodation were a great combination in 2016 for future returns. Today, expensive valuations with restrictive policies are a tougher combo. I’m not saying markets can’t go up; it will be more challenging.

Volatility – I know it is such filler to say markets will be volatile; that has been the case for all of history and will be for the future of markets. However, if you dig into market volatility, it most often comes down to uncertainty and surprises. The good news is that uncertainty has declined. Based on polls, this was supposed to be a close election. Most expected it to take days or weeks to be resolved, and many thought a contested election was likely. All that uncertainty disappeared last Tuesday night. Give the market clarity, and it most often reacts positively.

The challenge will be after the market celebration of the election results fades. There is no clue when that will be, but there are still many uncertainties for the markets, and based on President Trump’s first term, surprises could rise. The number of geopolitical conflicts remains high, and changes in responses to those from the US add uncertainty. The timing, size, and targets of tariffs are now uncertain and likely to change quickly. Tax policy, too. The debt ceiling could return as an uncertainty in 2025.

So, the uncertainty goes down initially but then rises. Given the sweep of all three branches of government, that, too, adds to uncertainty. Markets actually prefer a divided government because that limits policy changes, which means fewer surprises and greater certainty. A sweep, well, get ready for lots of policy changes and tweets.

Final Thoughts

The markets are enjoying the election results as a big piece of uncertainty has now been removed. This may well give way to greater uncertainty as the months roll by and the ‘surprises’ start to rise again, back on X. While the policy does matter, the economy tends to matter more for the longer-term trend. Policy changes or ‘talk’ will likely add greater noise around the trend. This could create opportunities at the margin, but the core of the portfolio should focus on the key building blocks of value – the economy and earnings. The good news is for now, inflation is improving, and the economy is doing well. At 22x forward earnings, much good news has already been priced in, making future gains more challenging.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

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Sources: Charts are sourced to Bloomberg L. P.

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