A New Government in Focus

Growth initiatives associated with deregulation are largely welcome by corporate America, where some have felt hamstrung in recent years. This is ”growth positive,” as it could unlock pent-up strategic merger and acquisition activity and alleviate costly administrative requirements. A potential reduction in the capital gains tax rate is also a growth tailwind — not only for GDP but also for corporate earnings. That said, some of the policies on President elect Trump’s platform could be growth headwinds; specifically, tighter immigration controls and the widespread implementation of tariffs. However, the balance of these policies affirms our confidence in an economic soft landing, where growth hovers near a longer-term potential of 2%.

Where our outlook has changed a bit is on the inflation front. We have two risk cases that reflect a potential halt in disinflationary progress. One of these cases revolves around tariffs, which lead to higher costs (and lower growth), and the other is a reflation scenario, where the policy mix has a stimulative impact on growth in an economy already running near full employment —  which also is inflationary. While our base case remains that inflation will continue to make progress toward the 2% target, a halt in progress would likely lead to at least a pause — or potentially a reversal — in the Federal Reserve’s intended rate-cutting cycle.  

Investors have been more focused on inflation recently, with 5- and 10-year inflation breakevens moving up decisively over the past few weeks to Spring 2024 levels. This comes after a notable downshift in inflation expectations over the summer and into the fall, as the economic data seemed to affirm that inflation was indeed moving toward the thus-far elusive 2% policy target. Since bottoming in September, however, inflation is back on the map of potential concerns. Some of the increase in market-based inflation expectations had been a function of the growing probability of a Trump presidency and a potential “red wave,” which could usher in a set of inflationary policies. Some of the move also is based on the actual economic data, which continues to reflect inflation progress on pause: This week’s CPI and PPI data did little to assuage these concerns.

U.S. Treasury yields have responded to both the politics and the data. Yields continued to climb this week, with the 2-year and 10-year Treasury yields rising 8 and 13 basis points, respectively. The yield on the 2-year note — which is the tenor most sensitive to changes in monetary policy around the federal funds rate — rose in particular on Thursday. Moreover, Fed Chair Powell equivocated about the future path of interest rates, highlighting his data dependence. In some ways, this hyper focus on data, and not on a forward view or framework for decision making, has put the Fed in a difficult and reactive position.  

Some have called this election a “vibes election,” where voters responded less to data and more to the perception that conditions are unfavorable. The post-election market environment also seems influenced by vibes, as investors focus on an America-first agenda and embrace the pro-growth narrative. Animal spirits have risen substantially, and bullish sentiment, as measured by the American Association of Individual Investors (AAII) survey, has jumped to nearly 50% from just 40% at the end of October.

Stretched U.S. equity valuations are one fairly persistent area of concern, however: They seem to reflect a lot of the potential good news to come, and more market pundits have referenced them as a risk. While we concur that high valuations leave the market susceptible to negative news, we would characterize today’s elevated valuations as more of a headwind to forward returns than a downside risk. After two years of exceptionally strong U.S. equity markets, we are unlikely to see a “threepeat” in 2025.  

The market has woken up —  a bit — to the upside risk of inflation. This, along with the obvious risk of high U.S. debt issuance required to fund the deficit, will likely keep a floor under longer-term interest rates and may drive more bond volatility along the way. In short, the range of potential outcomes for rates and inflation is simply wider. However, as the economic implications of the Trump administration become clearer, bond investors may find calmer seas, but a still-elevated sea level.

For equities, U.S. exceptionalism continues to dominate financial markets with the seeming perpetual underperformance of non-U.S. markets —  now exacerbated by the recent strength of the U.S. dollar. Following Treasury yields higher, the trade-weighted U.S. dollar has gained 3% since the election. In particular, the U.S. dollar’s nearly 4% advance against the euro has provided a meaningful headwind to European equity investments held by U.S. investors.