Trump 2.0 would not play out like Trump 1.0 in markets

The writer is chief strategist at UBS Investment Bank

“Trump trades” have been stirring this year and have recently picked up pace. For example, amid strong gains in equities overall financials, seen as beneficiaries of deregulation under a Republican president, have outperformed renewables, a sector that a Democrat in the White House would favour.

The market seems to be using the template of Donald Trump’s first term to position for a potential second. This would be a mistake. The context today could scarcely be more different to 2016’s “red wave”.

First, the US economy is clearly in the later stages of the economic cycle, having been at an early to midpoint in 2016. From 2017 through to mid-2019, both US GDP and S&P 500 earnings growth were consistently revised higher along a non-inflationary runway.

It’s unlikely that strong economic expansion can be sustained today without triggering higher inflation and rates. There are some clear signs that growth and earnings upgrades are close to peaking — a closed gap between actual and potential output in the economy, unemployment levels that are low but creeping higher, and a transition in consumption growth from extraordinary to pedestrian.

Second, the supply and demand of US debt are utterly changed, with strong implications for Treasuries and companies’ cost of capital. US debt held by the public has risen to 97.3 per cent of GDP from 75.6 per cent in 2016. This debt stock of $27tn is on course to nearly double within the next decade. That’s if the next president is a Democrat. If Trump’s 2017 tax cuts are fully extended, the rise could be an additional $3tn-$5tn

Through the years of quantitative easing programmes to support economies and markets after the financial crisis, a “savings glut” and central bank liquidity had debt markets awash, anchoring long-end rates. But central banks’ balance sheets are shrinking now. And compared with the mid-2000s, weighted average savings rates of the OECD, East Asian and Middle Eastern countries have fallen from 14.9 per cent to 10.2 per cent of GDP. The demand pool for government debt is growing more slowly just as its supply is surging. Former Fed chair Alan Greenspan once confessed that steady long-term bond yields in the face of higher Fed rates were a conundrum. Now the risk is the opposite: the Fed may cut rates but long-end bond yields may not respond that strongly, keeping the cost of capital for companies high.

Third, it isn’t clear that continued lower taxes will incrementally buoy GDP or earnings growth. Consensus expectations of pre- and post-tax earnings show that the market believes low tax rates will persist. The profit margins of S&P 500 companies are seen rising from an already high 12.1 per cent presently to 14.3 per cent in 2026, just after Trump’s tax cuts are due to expire. This isn’t just down to artificial intelligence and the Magnificent 7 tech companies that dominated markets recently. Margins of the remaining 493 companies is also expected to rise to a new high of 12.6 per cent. A red wave by the Republicans in November’s election will be closer to “no news” for the market. A blue wave, which may make for a tax wall in 2026, would be the real surprise.

Fourth, a contraction in the risk premium priced into key markets was an important driver of returns during Trump 1.0. Now it has limited room to shrink further. As Trump assumed the presidency, US high yield spreads contracted from 5.10 percentage points over benchmarks to 3 points, and S&P 500’s forward price-earnings multiple revalued from 16.1 to 18.6 times. Today US high yield spreads are already at 3 percentage points, and the S&P 500 is valued at 21.5 times forward earnings — a level that is equivalent to the 93rd percentile of a 50-year history. There is little fuel left to drive higher valuations.

The global backdrop is another crucial difference. In 2016, China had laid the seeds of a global upturn as it spent to redevelop old housing. Today China has neither the ability nor the willingness to engineer another housing upturn. And while China’s 2016 domestic stimulus stoked demand in other countries, its exports-led push to boost the economy today could eat their lunch.

Muscle memory may mean the market initially regards a red wave positively. But a poorer growth-inflation mix is the more likely legacy. By contrast, a blue wave may initially be regarded negatively by a market unprepared for higher taxes. Starting points of high earnings expectations, high valuations and little fiscal room suggest a narrow path ahead for high returns. A split US Congress, where the most extreme of both parties’ agendas are diluted, may be the least-worst outcome for markets.