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“A wise and frugal government, which shall restrain men from injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvement and shall not take from the mouth of labor the bread it has earned — this is the sum of good government.”
Now that the US presidential election is over and we are gaining clarity on voting patterns, it is clear that economy — most importantly high prices — was one of the main reasons for the Republican sweep of the White House and both chambers of the US Congress. The result was likely surprising for many Democrats, as wages for US workers have largely kept up with rising costs, gas prices (which are paramount to US consumers) are at multiyear lows, and headline inflation is at pre-COVID levels. But in my view, what explains the election outcome has more to do with which prices remain high, rather than how much overall price levels may have stabilized or fallen.
Figure 1 shows the relative change in core components of the Consumer Price Index (CPI), through September 2024. The dark blue line represents the price level for core goods commodities exempting food and energy, including apparel, cars, alcohol, tobacco, and so forth. The light blue line represents the price level for services, including shelter, education, health care, travel & leisure, etc. Services inflation, which has been growing at a much higher rate than goods inflation for decades, continued to rise steeply after the pandemic.
There are a few reasons why core goods prices have risen more slowly than core services. First, because manufacturing is more productive than services, prices should be expected to fall (or at least be disinflationary) in the long run. The cost of a high-quality flat-screen television today, for instance, is far lower than it was 10 years ago. Second, globalization and constructive trade agreements have allowed US companies to import goods from abroad at low prices, taking advantage of a cheaper global labor force.
As for core services, to me, the reason those prices have grown so dramatically is because of the sensational performance of US equity markets over the last few decades. While there are many contributors to market appreciation over time, I would attribute much of the rise in corporate profits to substantial ongoing fiscal deficits and the monetization of those deficits during COVID, when the economy was already growing above potential. Figure 2 shows the exceptional US growth, relative to other countries, and how closely related it has been to fiscal spending.
Let’s take the largest component of core services — housing. Low interest rates coupled with quantitative easing during the pandemic drove mortgage rates to historic lows. Affordable mortgages enabled more consumers to purchase homes, which dramatically drove up housing prices in an already supply-constrained market. A few years on, amid rising rates, elevated prices, and a continued housing shortage, affordability is close to all-time lows. In other words, it has arguably never been cheaper to buy a flat-screen TV and never more expensive to buy a house to put it in. This is why, even though inflation has eased, it remains top of mind for frustrated US voters.
So, what can investors expect next? The Trump administration’s economic policy focus can be broadly encapsulated as tariffs, immigration reform, and tax cuts, all of which have different impacts on inflation. These policies will also likely entail different responses from the US Federal Reserve (Fed), which, as I noted last month, is focused mainly on inflation that stems from the labor market.
Tariffs may initially boost core goods inflation. Many in the incoming administration acknowledge this and argue that the jump in prices is worth the competitiveness that can be gained from onshoring or reshoring manufacturing capacity to the US. The Fed will probably look past the impact of tariffs on price levels, as it would view the effects as one-off increases, albeit with some potential negative impact on consumer spending.
Immigration reform, if it creates a truncated labor supply, would heighten domestic wage pressures — and this is something the Fed does act upon. The impact would not be immediate, however. Instead, I would expect to first see lower, if not negative, monthly payrolls, which might cause the Fed to be more dovish. It is also possible that lower-income workers would experience nominal wage increases before inflation has an impact and erodes real purchasing power.
This brings us to tax cuts. The Tax Cuts and Jobs Act (TCJA) was passed in 2017 by the first Trump administration. Several of its provisions, most notably individual tax cuts, are set to expire at the end of 2025. Given Republican control of the executive and the legislative branches, these tax cuts will likely be extended. Extending them will not mean that fiscal stimulus is being added, however, just that current fiscal policy is not contracting.
As I noted above, one of the main reasons for above-trend US growth and the odious core services inflation of the last few years has been reckless fiscal spending. The Trump administration is surely aware of this and the degree to which consumer angst contributed to its reelection, so it is not surprising to hear key administration officials discuss the need for spending cuts, even as they extend the TCJA.
Even following sweep elections like this one, incoming administrations need to prioritize which policies they pursue for two reasons. One, Washington, DC moves at a snail’s pace; and two, the incumbent party typically loses control in the midterm election. What this administration chooses to pursue in its first term will be extremely important for the trajectory of the US economy and markets. On the heels of the 2004 Republican sweep, for example, President George W. Bush chose to pursue Social Security reform, even though there was little appetite for that policy domestically. Unfortunately, the war in Iraq ended up monopolizing policy for the remainder of Bush’s term, and his plan for Social Security was killed when Democrats gained control of Congress in the midterms of 2006. Similarly, in 2008, President Obama chose to focus on health care reform during his first two years in office, leaving little capacity to focus on other domestic priorities (apart from, of course, GFC stimulus and rescue plans).
My sense is that the Trump administration will focus on tariffs and immigration reform to a greater extent than tax cuts or additional fiscal stimulus, given the latter’s propensity for further increasing core services inflation. As of this writing, the US stock market has had blistering performance since the election, largely on the hopes of further corporate tax cuts and fiscal stimulus. The reality of governing a restive population, however, and the trade-offs between further stimulus (which market participants would welcome) and inflation (which consumers would not) might leave many equity market participants wanting.
The US equity and credit markets have priced in a “goldilocks” economic environment of strong growth with decelerating inflation. This optimism ignores at least one major red flag: The Trump administration might be serious about severely cutting fiscal spending that has propelled US asset prices to new highs (in part via the proposed Department of Government Efficiency). At the same time, long-end Treasuries are pricing in significant term premia (compensation for investing farther along the yield curve), mainly because of fears about continued profligate fiscal spending. As of this writing, the 10-year forward 10-year Treasury yield is 5.15%, 150 basis points above the market pricing for the Fed in three years — a historically wide spread. If fiscal spending contracts from the breakneck pace of the past few years, the Trump administration could be — ironically — positive for long-dated Treasuries.
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By
Andrew Heiskell
Nicolas Wylenzek