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Occasionally, something big – or something very big – affects the markets. This month it was the U.S. elections.
The Republican Party, headed by president-elect Donald Trump, has secured a grip on the levers of power in Washington unparalleled in U.S. postwar history. In 2025, Republicans will control the White House, the Senate, and the House of Representatives (the House majority is still to be confirmed, but a near certainty). Republican appointees already represent a majority on the U.S. Supreme Court and heavily populate the federal judiciary. And it is highly probable that Republican political appointees will more widely and deeply populate agencies that make up the federal regulatory apparatus than has ever been the case before.
Such political dominance is rare. History suggests that when one party wields vast power, big changes ensue. In 1933, President Roosevelt used expansive powers to usher in The New Deal. In 1965, President Johnson worked with Congressional majorities to introduce the most significant changes in U.S. public policy and politics since the Civil War, passing legislation to establish Medicare and Medicaid and to enact landmark law via the Voting Rights Act and Civil Rights Act.
No president since, not even Ronald Reagan, has had the opportunity to enact his agenda now available to incoming President Trump.
Investors should take note. This was no ordinary election, and the ramifications for financial markets and investment portfolios are likely to be extraordinary as well.
The U.S. equity market jumped 3-4 percentage points on the Wednesday after the news of the Republican “clean sweep.” The removal of uncertainty (primarily in the form of a contested election) was one reason. But the more important driver, we believe, was that the U.S. business sector will soon welcome a party willing to cut statutory and effective corporate income tax rates and deregulate swathes of industry and services. And it has the power to do so without restraint from a viable opposition party or from within the regulatory agencies that implement policy.
Over the next half year and perhaps longer, U.S. equities appear to us to have the potential of delivering double-digit returns. The impetus will come from stronger economic growth and hence upside revisions to earnings, courtesy of fiscal stimulus (tax cuts without corresponding expenditure reductions), and stronger business investment spending unleashed by what we anticipate will be a more favorable tax and regulatory environment.
The sectors and styles most likely to benefit include mid- and small-capitalization stocks, value, fossil fuels, financial services, and pharmaceuticals. In short, the U.S. market will advance based on rotation away from the handful of stocks most responsible for the market gains of recent years to a broader set of companies and industries. And while momentum and investor enthusiasm almost always push bull markets to extremes, the shift in market leadership we anticipate will be underpinned, we believe, by tangible earnings improvement. That should, in our view, allow investors to enjoy strong returns at least into the first half of 2025.
In contrast, the outlook for fixed income looks more challenging and will require investors to carefully select exposures within the asset class.
To see why, consider the starting point, which is a U.S. economy at full employment. The economy will likely soon experience a significant increase in total spending (aggregate demand), stemming from tax cuts and a surge in business investment outlays.
As a result, we believe the Federal Reserve (Fed) will not be able to cut interest rates as much as we had anticipated prior to the surprising election outcome. Accelerating growth amid an economy operating near full capacity warrants some monetary restraint. Investors have already pared back their expectations for future Fed rate cuts, and bond yields are on the rise.
Should a stronger economy nearing capacity constraints create an uptick in inflation, the Fed will not just slow rate cuts, it may stop the cuts altogether. It could even be in position to hike interest rates next year.
That outcome becomes more likely if, as promised, president-elect Trump introduces new tariffs on imports or cracks down on immigration. Both are akin to negative supply shocks, which, against the backdrop of accelerating growth, would likely lead to higher inflation.
Accordingly, we think it would be prudent for investors to reduce exposures to long-term bonds (to duration, or interest-rate sensitivity). But not all parts of fixed income will be undermined by a stronger economy. Companies with weaker balance sheets or cash flows should see their financial position improve, suggesting to us that shorter-duration credit markets and private credit now offer investors an attractive income alternative to longer-duration government and corporate bonds.
The prospect of stronger U.S. growth, rising equity prices and higher interest rates will likely act as a magnet to draw capital from abroad into the United States. Inflows into public and private equity and credit markets are likely to increase if, as we expect, U.S. returns across most asset classes improve relative to those in other regions of the world. The consequence, of course, will be a stronger U.S. dollar.
While this newsletter is focused on U.S. markets, global markets will also be affected. We expect reactions from other countries as the United States changes policy regarding tariffs, in particular, but also with respect to regulations that might encourage companies to consider relocating to the United States. We will cover this issue in more detail in future articles. For now, we think the U.S. equity market is likely to continue its leadership position.
Investors, therefore, have much to like about the near-term prospects for portfolio returns as asset prices adjust to the policies of lower taxes and less regulation. And we strongly suspect that returns in the period ahead will be robust and will endure for long enough for investors to still benefit from the “Trump trade.”
With that said, we remind readers that high returns are typically accompanied, at some point, by higher risk. And within the unfolding dynamic we have described above are embedded risks that investors would be wise to consider and monitor in the months ahead.
The more the Trump administration raises tariffs – whether for economic or national security reasons – the more those measures restrict supply and increase prices, thereby potentially stoking inflation in an economy that will be bursting at the seams. Higher tariffs will also raise intermediate prices for some industries (e.g., manufacturing), which could crimp their profitability.
The same is true with regard to immigration and, potentially, deportation. Immigration has been a key source of U.S. labor supply in recent years, without which employment costs in a variety of industries would have been higher. Food prices could prove to be especially sensitive to significant shifts in immigrant labor supply.
But of all the risks to markets, the most worrisome may be the potential for conflict between the White House and the Fed. As noted, the likely impacts of lower taxes and stronger business investment spending in the next few years will be an economy that risks overheating, implying higher interest rates and a stronger U.S. dollar.
Those are not outcomes most presidents like to see, and particularly not President Trump. Already, there are concerns about a potential clash. At November’s Federal Open Market Committee post-meeting press conference, for example, Fed Chair Jerome Powell faced questions about his future under a Trump administration.
Investors rely on institutions, and none is more important than an independent central bank tasked with steering the economy toward full employment and stable prices. Investors also count on an independent central bank to act decisively when financial instability emerges.
Investors are only loyal to returns and the foundations upon which they rest. The ambitious agenda of the Republican clean sweep portends strong returns immediately ahead. But sustaining and extending those gains will require continued investor faith that even the strongest ambitions must respect boundaries.
Investors welcome strong growth, lower taxes, unfettered business, and rising profits. Markets are now embracing those prospects. And we suspect they will continue to do so for at least a bit longer.
Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter, Investing This Week. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.
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What are the risks? All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
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