The U.S. election has sent shock waves around the world just as in 2016 when Donald Trump pulled off an upset victory. The surprise this time was not that Donald Trump won, but rather that he built a multi-racial coalition of working-class voters and was able to garner the popular vote.
When Trump won the 2016 election, the stock market went on a tear as investors responded favorably to the prospect of tax cuts and widespread deregulation that were intended to boost economic growth. The initial reaction this time has been similar with the stock market posting its biggest weekly gain in two years.
It remains to be seen how long the honeymoon will last. John Authers of Bloomberg points out the only time the stock market was as expensive during a presidential election was in 1928. The final outcome will ultimately depend on how the economy performs in the next few years.
On the positive side, the economy is more robust than eight years ago, when it was in the midst of a sub-par recovery from the 2008 financial crisis. Since then, it has far outpaced other developed economies, and inflation is approaching the Fed’s 2 percent target after it surged during the COVID-19 pandemic. This has enabled the Fed to lower the fed funds rate by 75 basis points in the last two FOMC meetings.
One omen, however, is that Treasury yields have increased by about 80 basis points since the September meeting. This is partly because investors are concerned about the prospect of outsized budget deficits. Federal debt held by the public has ballooned by $15 trillion over the past eight years and it now stands at $35 trillion.
Looking ahead, the combination of tax cuts and tariff increases Donald Trump is contemplating could widen the federal budget deficit by $7.5 trillion or more over the next decade according to the Committee for a Responsible Federal Budget. Bond yields, therefore, will likely be considerably higher than during Trump’s first term.
Prior to the election, it was unclear what legislation could be enacted. Since then, the Republicans have gained control of the Senate by a comfortable margin and the House of Representatives by a narrow margin. This enhances the chances that they will succeed in extending provisions of the Tax Cut and Jobs Act that are set to expire next year and in modifying the tax code somewhat.
Beyond this, Republicans would be tempting fate that bondholders would accept the sweeping tax cuts that Trump campaigned on.
The main uncertainty now is whether Trump will follow through on his pledge to increase tariffs on goods from China by 60 percent and those on other imports by 10-20 percent. Economists have warned that such action could bring global trade to a standstill, but many investors view it as a negotiating tactic.
So, what signals should investors look for to have a better idea of what Trump will do?
My take is they should focus on the people Trump appoints as his principal economic advisers.
Robert Lighthizer, who served as Trump’s special trade representative in Trump’s first term, is expected to play a key role in shaping trade policy relating to both China and Europe. His stance on trade issues has hardened in the meantime, and CNBC cited a report that Lighthizer told investor groups that Trump could unveil his tariff proposals soon after taking office.
According to Politico, Lighthizer also advocates devaluing the U.S. dollar to improve the price competitiveness of U.S. companies.
Bloomberg reports that Trump’s Wall Street supporters are urging him to appoint someone with deep financial industry knowledge to serve as treasury secretary. The position is responsible for international economic policy and exchange rate policy, as well as fiscal policy.
The frontrunner is Scott Bessent, a billionaire hedge fund manager who is respected by the financial community. In a recent Wall Street Journal op-ed, Bessent hailed Trump’s economic policies and stated that allowing the private sector rather than the government to allocate capital is critical to growth. He also said that the only way to return a prudent borrowing strategy without upsetting financial markets is by “restoring faith in the economy and preserving the dollar’s global role.”
Bessent previously told CNBC he recommended that tariffs be “layered in gradually” so that any inflationary impact would emerge gradually and could be offset by deflationary policies, such as deregulation. He views Trump’s tariff stance as a negotiating tool to extract concessions from trading partners and believes tariffs should be phased in over time.
This could set up a battle in the White House between those who favor a tough stance on tariffs versus those who are pragmatic. The Washington Post reports that “The early skirmishes over personnel appointments pit Wall Street-friendly Republicans against trade hard-liners who back high tariffs.”
It is too early to tell which group will win out. However, I suspect Trump will listen to hardliners initially given his long-standing support for tariffs. If so, financial markets could wind up as the final arbiter about whether he has gone too far.
During his first term, Trump was compelled to resume trade talks with China in mid-2019 after the trade war caused a stock market sell-off. The market then rallied when an agreement was reached whereby China agreed to purchase an additional $200 billion in imports from the U.S. However, China failed to adhere to it, which is the primary reason that Trump is taking a much tougher stance on China now.
This also makes the stakes much higher today, and the markets’ response could be commensurately greater than in the first round of the trade war.
Nicholas Sargen, Ph.D. is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”
