U.S. equities rallied to new highs after Donald Trump’s election, with equity investors wanting to believe that fiscal stimulus, tax cuts and a lighter regulatory touch will boost the economy. Bond markets moved in the opposite direction, with interest rates rising in response to expectations that reflationary policies will create a stronger economic recovery and higher inflation. Ten-year Treasury yields rose to 2.6%, up sharply from the 2016 low of 1.36% reached in the post-Brexit turmoil. Longer-term government bonds, municipal bonds and investment-grade corporate bonds were among the victims of the bond market rout. Bond proxies that were winners earlier in the year, such as utilities and real estate investment trusts, also lost ground post-election.
“I Want to Believe”
Investors are anticipating that the “pragmatic and market-friendly” economic version of Donald Trump will prevail over the “anti-growth and protectionist” version of Trump who often appears in late night Twitter rants.Investors are enthusiastic about economic growth under Trump and bullish about the prospects for equities, while demonstrating considerably less enthusiasm about the prospects for bonds.
Following are some observations about what may actually occur during Mr. Trump’s presidency.
“Curb Your Enthusiasm”
Investors may have unrealistic expectations about economic growth, and may need to temper their enthusiasm; Trump’s tax and spending proposals will face significant obstacles in Congress. Although Republicans control both houses of Congress, Tea Party members in the House of Representatives may object to measures that dramatically increase the Federal budget deficit. Trump’s thin margin in the Senate may also force compromise over certain issues.
Tax reform will create winners and losers, with special interest groups fighting hard to protect deductions and subsidies that favor their constituents. Trump’s spending plans sound promising, but a shortage of “shovel-ready projects” and the complexity of his public-private partnership initiatives may cause fiscal stimulus to have a greater impact in 2018 than in 2017.
U.S. economic growth was 3.2% in the third quarter, and is expected to be reasonably strong to end the year. Unemployment continues to decline and wages are rising, though the relatively low labor force participation rate reflects an aging population and a high level of discouraged workers who have left the workforce.
The Fed “dot plot” signals plans for three rate increases in 2017, though Fed Chair Janet Yellen has signaled that she is open to having the economy run a little “hot” and to allow inflation to rise above the Fed’s 2% target rate. Some analysts speculate that the inner circle of the Fed – Yellen, Vice Chair Stanley Fischer and New York Fed President William Dudley – are expecting to raise rates only twice in 2017.
If Fed tightening leads to a strong dollar, the Fed may not need to raise interest rates too much to cool the economy. Ultimately, the three “D’s” — debt, demographics and the dollar — may impair economic momentum despite Trump’s best intentions.
“Dude, Where’s My Drone?”
Events beyond the bubble of Washington may disrupt Trump’s economic agenda. China’s seizure of a drone may be the first in a series of “proportionate” reactions to perceived provocations from Trump.
Concerns about China’s militarization of the South China Sea may be an early test of Trump’s foreign policy reactions, as will increasingly close ties between China and countries such as the Philippines that were historic allies of the United States. It seems inevitable that North Korea will “act out” soon after the inauguration, testing Trump while South Korea is in a state of political chaos.
Vladimir Putin is also likely to explore how friendly Trump will be toward Russian interests, a test for Trump and his non-traditional selection for Secretary of State, Rex Tillerson.