Donald Trump’s election victory comes at an interesting time for the US economy, and for its financial markets. On the back of strong growth and incredible stock market gains, America is increasingly viewed as the only game in town. Nonetheless, the nation has handed the real estate and casino mogul a mandate to ‘make America great again’. Given lingering inflationary pressures, record levels of government debt, and sky-high equity valuations, the stakes are high, and it is far from certain that the odds are in his favour.
The resilience of the US economy in the face of high interest rates has been remarkable. Propped up by a staggering $10.8 trillion of federal deficit spending over the past five years, and fuelled by free-spending consumers, US real gross domestic product (GDP, adjusted for inflation) is now more than 11% higher than it was pre-pandemic – a rate of growth that is the envy of all other developed markets. Meanwhile, driven by a select group of technology stocks, the US stock market has been surfing a wave of euphoria that has left global competitors trailing in its wake. These dynamics have given rise to a growing conviction in ‘American exceptionalism’ – the idea that the outperformance of America’s economy and stock market are structural, inevitable and persistent.
Though recognising some of the advantages of the US economy, we maintain that fault lines have been increasingly visible beneath the surface. First and foremost, unemployment has risen meaningfully from its low in early 2023. While companies have so far proved reluctant to release employees, the number of new jobs being created has slowed appreciably, and those who have lost their jobs are finding it increasingly hard to re-enter the workforce. Meanwhile, delinquencies on consumer loans and corporate bankruptcies have both been rising. Perhaps most indicative of the pressures facing the domestic economy, the profits earned by listed smaller companies peaked in late 2022 and have since fallen more than 20%.
That the US economy is starting to fray at the edges should come as no surprise. The Federal Reserve may have cut interest rates by 1% since September, but yields on bonds issued by the US government and corporations have risen, not fallen, over this period. Meanwhile, the small businesses surveyed by the National Federation of Independent Businesses report average rates of interest of 8.8% on their short-term borrowing. At such levels, we would expect interest rates to continue to bear down on economic activity.
From an economic perspective, then, Donald Trump’s return to the White House comes at an interesting time. Vowing to cut taxes, slash regulation and use aggressive trade policy to protect and promote domestic production, the Trump administration is betting that it can not only extend the period of US economic and stock market exceptionalism, but amplify it. However, it is far from clear that the odds lie in its favour.
Though the incoming Trump administration is widely considered “pro growth”, there are as yet few details on the scale and reach of its economic agenda. Furthermore, if we take various campaign promises and post-election announcements at face value, parts of the new administration’s economic agenda appear contradictory. This has important implications for the chances that the bet pays off.
In our view, the most challenging contradictions lie in the reconciliation of the growth agenda, the towering budget deficit, and the pledge that inflation and interest rates will fall.
For example, it seems likely that in an effort to stimulate investment, corporate tax cuts implemented during the first Trump presidency will be extended, rather than expiring at the end of 2025 as previously planned. Additional promises of reduced and restructured corporate and personal tax rates are likely to be more challenging to deliver. Nonetheless, the Congressional Budget Office estimates that even the extension of the existing tax breaks will add an extra $4.6 trillion to the federal budget deficit over the next ten years.
While positive for growth, deficit spending is typically inflationary. If married to trade policy designed to protect and promote domestic production over cheaper imports, or immigration policy that restricts the supply of willing, low cost labour to key industries such as housing and agriculture, it is reasonable to expect significant upward pressure on prices. Not only would this be politically unpopular, it would also encourage the Federal Reserve to apply the economic brakes by raising interest rates.
This brings us back to the budget deficit. At 120% of GDP, total public federal debt is already close to surpassing the level reached during World War II (Fig.1). Annual federal interest payments now exceed the Defence Department’s military spending for the first time on record and are forecast to exceed $1 trillion in 2025. Higher interest rates would make the burden of servicing the colossal debt pile more onerous still. With this doubtless in mind – and with questions already beginning to be asked about the sustainability of government debt levels – Scott Bessent, nominee to head the Treasury, has pledged to more than halve the annual deficit to around 3% of GDP. Given a reduced revenue from taxes, this implies a sharp reduction in government spending, which – irrespective of its feasibility – would present a significant headwind to economic growth.
Equity investors, though, have tremendous reserves of optimism. Despite the tendency for falling interest rates to be accompanied by recession, the first rate cut in a cycle has all too often elicited a positive market response. For example, exactly 17 years to the day before this month’s move, the Federal Reserve also cut rates by ½%. Back then, the decision prompted the biggest one-day gain in four years with a certain investment bank, Lehman Brothers, rising nearly 10%. Needless to say, this enthusiasm proved hopelessly misplaced. The US stock market peaked just three weeks later while the economy had tipped into recession by January 2008. Importantly, some investors saw the writing on the wall, trusting to foresight and reducing equity allocations in advance of a stock market decline which measured 56% from peak to trough.
Despite engaging in an exercise that is inherently forward-looking, the investment industry has a remarkable propensity to find comfort in the status quo, and a will to believe in narratives – however fanciful – that might help it endure. We think this tendency explains how investors can, in aggregate, get it as demonstrably wrong as they did in 2007 and why we suspect they are making a similar mistake today.
Given these challenges, we suspect the odds do not bode well for the long-term, with resurgent – or even simply stubborn – inflation a potential joker in the pack. However, we recognise the possibility that the Trump administration may, in the near-term, enjoy a few more winning hands. Firstly, Trump’s election win has, in aggregate, been warmly received by executives, small business owners and consumers. Optimism can itself give rise to increased investment and consumption, at least temporarily. Secondly, he may succeed in using the threat of tariffs to extract concessions from the US’s trade partners, most likely in the form of capital investment in the US. How should investors assess the possibility of a winning streak, especially if it may prove short-lived?
Firstly, we would warn against diving headlong into the ‘American exceptionalism’ consensus. We have highlighted some of the challenges faced by US policymakers, and believe further detail is necessary before their chances of success can be truly reckoned. More immediately, the consensus is by now very well established. This is reflected in signs of irrational exuberance that should give investors pause for thought.
US large cap equities trade at valuations seldom seen before. With stock market indices increasingly concentrated in a small number of technology companies that have embarked on an AI arms race, provoking hundreds of billions of dollars of investment in an unproven technology with little evidence of near-term profitability, our wariness is only increasing. Furthermore, we suspect the resilience of the US consumer to date is at least partially attributable to the wealth created by the surging stock market: an equity market correction could well send this dynamic into reverse, precipitating a recession, as it did when the dot-com bubble burst.
Unlike their large cap counterparts, indices tracking mid-sized US companies currently trade at valuations that are merely in line with their long-term averages. If economic growth fails to accelerate, these reasonable valuations should confer a degree of defensiveness. In addition, should the economic slowdown we have long anticipated finally materialise, we would expect the associated exposure to the US dollar to benefit sterling- based investors. Meanwhile, earnings forecasts for mid-sized companies are also only average: after two challenging years, there is scope for earnings – typically more sensitive to the condition of the domestic economy and more beholden to statutory tax rates than those of larger companies – to exceed these forecasts should Donald Trump’s economic gamble pay off. Where appropriate, we have therefore switched a portion of the European equity allocation into US mid caps within model portfolios.
