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Weekly Market Analysis - Post US Election Update: Driving Faster vs Going Farther
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Can Income Overcome Inflation in Trump 2.0?
The shift up in the cost of living during 2021-2022 defeated incumbents seeking reelection across the world. President-elect Trump’s success in economic management during the coming administration is highly likely to be judged on how strongly consumer incomes can outstrip inflation and for long enough to restore public optimism.
Trump Likely to Push for Faster, US-Centric Growth
As was the case in his first administration, Trump will look to “raise the speed limit” of the economy and avoid “leaking” the benefits of stronger US demand abroad.
However, depending on policy choices, the US economy might simply run “hotter,” without raising potential economic growth. Attracting legal immigrants is one tool US policymakers can control. The speed of technological change – and its impact on employment - is not.
Personnel Likely to Determine Policy in new US Cabinet
We have switched from uncertainty over election results, to great uncertainty over new-administration policy choices and the process of implementation. Observers suggest watching key personnel decisions of coming weeks most closely.
Summary
With remarkably close opinion polls, much of the world was shocked to see how quickly the US election outcome was resolved and how strongly the results favored Republicans. There were many issues for voters to consider – economic, social, geo-political. In our view, however, the sharp rise in consumer prices driven by pandemic-era impacts and policy has been the greatest driver of public dissatisfaction. The desire for change defeated incumbents in elections across the world.
A large share of consumer goods and services prices are sticky. Erasing the price gains of recent years cannot happen without a severe drop in demand. Such would likely be far more painful than adjusting to the new reality.
With this in mind, President-elect Trump’s success in economic management during the coming administration is likely to be judged on how strongly consumer incomes can outstrip inflation and for long enough to restore public optimism (see chart).
Portfolio considerations
Our asset allocation - overweight US equities across themes by 6% including overweights to small and mid-caps – benefited from Wednesday’s leap in US share prices. US large caps have gained 15% since we added an overweight on August 7. Looking forward - valuations have risen, and some US large caps are more vulnerable to tariff retaliation. Non-US shares have not dropped sharply enough for us to immediately reallocate to them, but global shares, including small and mid-caps look more attractive. An overweight to profitable US small- and mid-cap growth shares is likely to remain a focus of our US equity overweight even after the 2024 rally. They still trade 5% below their own historical valuation and 33% cheaper than large caps. More narrowly, financials could benefit from a steeper yield curve in the coming year.
Source: Haver Analytics, November 8, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Can Income Overcome Inflation in Trump 2.0?
As expected, in reducing interest rates further on Thursday, Fed Chair Powell refused to speculate on how White House and Congressional policies would impact monetary policy. He noted the great uncertainty around coming policy choices, the long road ahead to implementation, and the Fed’s posture to focus on today’s known challenges. This includes a slowing US labor market at a time when the Fed funds rate is still 4.50%-4.75%. This is still far above the Fed’s estimate of the long-run average policy rate of 2.9%.
Inflation measures are still poised to drop in early 2025, in our view. This will be driven by the strengthening US dollar, falling import prices and known lags between market prices and the CPI’s measures of shelter inflation (see FIGURE 6). The shelter measure of inflation is likely to continue declining, even if housing affordability weakens. This means that the Fed will likely hits its target of 2% inflation even on the core rate during the first half of next year.
The highly concentrated tariffs on Chinese imports in 2018 doubled US import duty revenue yet had remarkably little impact on the net inflation rate. Much larger tariffs and tax cuts would push back against the current disinflationary trend, but not before some further inflation progress is measured.
Trump Likely to Push for Faster, US-Centric Growth
The coming administration is likely to use expected tariff revenue increases and “dynamic scoring” of growth measures to drive some small net tax cuts in 2026. This is a far cry from the large tax increases that would take place at the start of 2026 under current law. It is also far from “eliminating the income tax,” an idea mentioned by Trump on the campaign trail. In essence, Congressional restraints on fiscal action means the US is very unlikely to see a radically different fiscal course. But even a mildly stimulative fiscal outlook, restraints on foreign supply, and an easing Fed should result in somewhat higher long-term yields.
With yields moving higher on stronger growth and inflation data recently – and the bond market pricing in higher odds of a “red sweep” in recent months - US yields did not rise markedly in the past week. The “short base” in the bond market has been deep for a long time, already bracing for higher yields. This makes further yield increases less likely in the short term.
Taking the many uncertain factors into account, we believe US 10-year yields will rise toward 4.75% by the end of 2025. This is high compared to global yields and somewhat higher than long-term drivers of growth – such as demographic trends – would suggest. Long-term high-quality bonds remain a key portfolio component, but these views remain consistent with our “neutral” allocation of long Treasuries and somewhat shorter-than-benchmark average portfolio duration across all fixed income assets.
Returns in fixed income in 2025 will be driven by taking the right credit risks, while earning coupons. As we saw just months ago in July/August, bonds will shine during the bursts of volatility in equities.
Personnel Likely to Determine Policy in new US Cabinet
Our uncertainty over election results has nearly ended but is replaced with great uncertainty over the coming administration’s policy emphasis and process of implementation. Our Global Investment Committee (GIC) overweight in US equities and slight underweight in non-equities – including overweights to small and mid-cap US growth shares - was well positioned for the market reaction to the election. As we noted last week, non-US shares trade at a mere 13.3X 2025 EPS estimates and look like a compelling value. But they did not drop significantly in US dollar terms as a prospective new investor might hope.
As our GIC meets in coming weeks, we will still consider the shifts in relative value occurring in global markets, including the sharp rally in the S&P 500. US small and mid-cap growth equities, on the other hand, are still trading about 5% lower in value than their long-term average and an historically large 33% below large cap growth shares. After several years of increasing market concentration in a few large cap tech firms – some with trade and regulatory risk – we believe suitable investors should consider broadening portfolio holdings to include “left behind” high quality growth equities.
