Mr. Trump’s economic policies cannot be described as Republican orthodoxy. He has advocated for a major increase in spending focused on infrastructure, especially public works projects, and national defense. He has also put forth a policy for major tax cuts. As yet, there have been no announcements of any compensatory spending cuts. If these proposals were to be made to a Republican Congress by a Democratic president, they would be met with resistance. But Mr. Trump is, of course not a Democrat, but rather a Republican. Could it be that, just as Richard Nixon was able to open up relations with China because of his long-standing reputation as an opponent of Communism, so Mr. Trump will be able to launch a radical economic agenda in the first 100 days of his presidency?
Bear in mind that since the global financial crisis began in 2008, there has been a contrast between fiscal and monetary policy across the developed world. While the monetary policy of central banks has been very expansionary, to varying degrees fiscal policy has emphasized austerity and paying down debt. Economists will be debating for years whether that was the right mix of policies for the crisis, but in recent months there has been a discernable change in attitude toward fiscal policy. Such non-partisan luminaries as Larry Fink of Blackrock and Mohamed El-Erian of Allianz have argued for new fiscal stimulus, emphasizing investment in infrastructure to raise demand and increase the sluggish rate of growth we have had since the Great Recession.
This brings us back to the market. If the market thought that new fiscal stimulus was good for US economic growth and that a President Trump would be able to make it happen, then we should observe a couple of things. The first is that equities most closely tied to US economic growth would benefit the most in this situation. The following chart shows that is precisely what happened. The US small cap Russell 2000 Index jumped 9% in the first six trading days after the election. The large cap Russell 1000 Index also increased, but at a more modest 2% over the same period. The smaller cap stocks tend to be less multinational and more directly tied to the US economy. At the same time, we saw that non-US equities did not fare so well. Some of that was the strengthening of the dollar, to be sure, but only some of it. For example, the FTSE Developed ex US Index in euros was flat over that period.
The second thing we should observe in this situation is that inflation expectations should increase, as deficit financed fiscal spending is typically inflationary. The 10-year Treasury rate did jump 45 basis points from 1.88% to 2.33% over the first four trading days after the election. To see whether any of that came down to inflation expectations, we can calculate the implied inflation between the 10-year Treasury yield and the yield on inflation-indexed 10-year Treasury Inflation Protected Securities (TIPS). The next chart shows that indeed it did pick up.
Of course these conjectures skate over a number of complicating issues, such as Mr.Trump’s proposals on trade, immigration and regulation, all of which may have some impact on market movements. We have only looked at the very short term in this analysis but it is going to be interesting to see how it all plays out.
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