Trumponomics 2.0

The eyes of the world were glued on the United States last week, and for once, the Federal Reserve’s policy meeting was completely overshadowed by other events.

In a conclusive victory, Donald Trump and the Republicans now have a mandate to implement their agenda over the next four years. Even so, slightly less than half the country will be very unhappy with the outcome. If the Democrats had squeezed out a win, the other half would be distraught. The deep political and social divisions are not getting any better, which is worrying since the US remains the world’s largest economy and most important military power.

For now, however, let’s focus on the investment implications. The initial market response was for the dollar to rally, US bonds to sell off (sending yields higher) and for equities to jump. Unlike in 2016, this election outcome did not come as a complete surprise and markets were broadly positioned for a Republican win. The speed with which the results were finalised was also positive. Markets hate uncertainty, and a drawn-out or contested result would have weighed on sentiment. In other words, while there were some notable market moves, all in all the past week does not stand out as being unusually volatile.

Tariffs, taxes and migrants
Looking ahead, Trumponomics has three broad policy elements. Firstly, he has promised tariffs on imports coming into the US, especially from China. Trump views importing from other countries as “losing”, in contrast to the orthodox economic view that trade benefits both parties. Moreover, high levels of US imports are not a sign of economic weakness any more than China’s export performance is an unambiguous sign of strength. China runs massive trade surpluses partly because domestic demand is suppressed, while the US trade deficit partly reflects strong domestic demand. The US consumer is still on a roll. And while the US imports goods from abroad, it sells financial assets to foreigners, running a capital account surplus. To oversimplify, the US imports Apple phones and Nike shoes, but sells Apple and Nike shares to the rest of the world. It is no surprise then that the trade deficit did not narrow during Trump’s first term, nor that it is hovering near record levels today.

Chart 1: US goods trade balance

Source: LSEG Datastream

The threat of big tariff hikes is likely partly a negotiation tactic to get concessions from trading partners, but some tariff increases are coming. The only question is who gets hit and by how much. China will likely be the main target, but Trump has spoken of across-the-board import tariffs, hitting friend and foe alike. The intention behind the tariffs will be to discourage imports and allow US manufacturers to compete, and also to avoid Chinese trade being re-routed through friendly countries such as Mexico and Vietnam. It should be noted that the tariffs Trump imposed on China in his first term were largely kept in place by Joe Biden, his successor, a rare bipartisan policy consensus.

Exchange rates are likely to adjust to partly offset the impact of new tariffs. So, for instance, if a 10% tariff is placed on Brazilian imports, we could expect the Brazilian real to weaken and the dollar to strengthen. However, it is hard to see China allowing its currency to weaken by 60%, the tariff rate Trump proposed. Therefore, the impact must be absorbed by producers in China in the form of price cuts, or by importers like Walmart or Target in the form of reduced margins. Otherwise, the end customer will be paying more at the till.

Where it gets interesting is that Trump also wants a weaker dollar to support American exports. The dollar is of course already strong. But he cannot have both. Widely implemented tariffs will probably push the dollar higher, unless some large-scale offsetting action is taken.

Secondly, he is anti-immigration. Immigration is a political hot potato the world over, including in South Africa. Practically speaking, it is going to be difficult to deport millions of undocumented immigrants as promised, but we should expect immigration rates to decline. The problem is that the US economy needs migrant workers, as the native-born labour force is not growing anymore. We could therefore see firms running out of workers in the years ahead, which can put upward pressure on wages and possibly inflation. Ironically, it might also give fresh impetus to shifting production to other countries where labour remains abundant and cheap, the exact opposite of what he wants. Similarly, some of Trump’s other proposed policies could also end up at cross purposes with one another, which means we need to be sceptical of people who claim to know exactly what will play out over the next four years.

Finally, he favours lower taxes and deregulation. His 2017 tax cuts were due to expire in 2025 and are now likely to be extended, while corporate tax rates might be lowered even further. Lower tax rates and deregulation are positive for company profitability, at least in the short run, and is therefore good for the stock market. Bank shares, in particular, surged last week on anticipation that onerous capital requirements will be eased, and more mergers and acquisitions will be approved.

Any additional tax cuts will have to be funded by additional borrowing, unless there are spending cuts, which seem unlikely. The federal government’s debt will therefore continue to rise, possibly by several trillion more on top of pre-Trump estimated trajectory. No surprise then that we’ve seen upward pressure on US bond yields.

The US economy is already growing faster than estimates of its long-term potential growth rate of around 2% and does not need additional fiscal stimulus today. However, since new tax cuts are only likely to arrive in 2026, much will depend on the state of the economy then. It might add some welcome oomph to an already cooling economy, or it could be the fuel that causes it to overheat. We’ll only know when we get there.

Then again, we should also remember that markets have a way of disciplining wayward politicians and moves in bond yields and/or the dollar could rein in Republican ambitions somewhat. Nothing is cast in stone today, and the old political saying of “campaign in poetry, govern in prose” could still apply.

Fed down, Fed up?
How does this impact monetary policy? Simply put, if the Fed fears that the inflation outlook will deteriorate due to tariffs pushing up prices or immigration restrictions lifting wages, it could be more circumspect in cutting interest rates. As with the tax cuts, the economic impact could take some time to materialise. For now, therefore, the Fed is still on a path to reducing rates. Market expectations for future rate cuts have been scaled back considerably, however. Following last week’s 25 basis point interest rate reduction, money markets are only pricing in slightly more than 100 basis points in additional cuts. This is almost 100 basis points less than was expected in late September, with the market now pricing in a Fed policy rate of 3.6% at the end of 2026.

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