Unlock Editor’s Digest for free
Roula Khalaf, editor-in-chief of the FT, selects her favourite stories in this weekly newsletter.
The author is chief strategist at UBS Investment Bank
“Trump trades” have been on the move this year and have gained momentum recently. For example, amid strong gains in stocks, financial institutions in general, seen as beneficiaries of deregulation under a Republican president, have outperformed renewable energy, a sector that would benefit a Democrat in the White House.
The market appears to be using the template of Donald Trump’s first term to position itself for a potential second term. That would be a mistake. Today’s context could hardly be more different from the “red wave” of 2016.
First, the US economy is clearly in the later stages of the economic cycle, after being in the early to mid-cycle in 2016. From 2017 through mid-2019, both US GDP and S&P 500 earnings growth were consistently revised upward along a non-inflationary line.
It is unlikely that a strong economic expansion can be sustained today without triggering higher inflation and rates. There are some clear signs that growth and earnings upgrades are near their peak — a closing gap between actual and potential output in the economy, unemployment levels that are low but rising slowly, and a transition in consumption growth from extraordinary to pedestrian.
Second, the supply and demand for U.S. debt has completely changed, with major implications for Treasuries and the cost of capital for companies. U.S. debt held by the public has risen from 75.6 percent in 2016 to 97.3 percent of GDP. This $27 trillion debt stock is on track to nearly double over the next decade. That is, if the next president is a Democrat. If Trump’s 2017 tax cuts are fully extended, that increase could be another $3 trillion-$5 trillion.
Over the years of quantitative easing programs to shore up economies and markets after the financial crisis, a “savings glut” and central bank liquidity flooded debt markets, anchoring long-term interest rates. But central bank balance sheets are now shrinking. And compared with the mid-2000s, the weighted average savings rate of the OECD, East Asian and Middle Eastern countries has fallen from 14.9 percent to 10.2 percent of GDP. Demand for government debt is growing more slowly, while supply is growing. Former Fed Chairman Alan Greenspan once confessed that stable long-term bond yields in the face of higher Fed rates were a puzzle. Now the risk is the opposite: The Fed may cut rates, but long-term bond yields may not respond as strongly, keeping the cost of capital high for companies.
Third, it’s unclear whether continued lower taxes will incrementally boost GDP or earnings growth. Consensus pre- and post-tax earnings estimates show the market believes low tax rates will continue. S&P 500 profit margins are expected to rise from an already high 12.1 percent to 14.3 percent in 2026, just after Trump’s tax cuts expire. This isn’t just thanks to artificial intelligence and the Magnificent 7 tech companies that have dominated markets recently. Margins for the remaining 493 companies are also expected to rise to a new high of 12.6 percent. A red wave from Republicans in the November election would be closer to “no news” for the market. A blue wave, which could create a tax wall in 2026, would be the real surprise.
Fourth, a contraction in the risk premium priced into major markets was a key driver of returns during Trump 1.0. There is little room to contract further now. When Trump took office, U.S. high yield spreads narrowed from 5.10 percentage points versus benchmarks to 3 points, and the S&P 500’s forward price-earnings multiple was revalued from 16.1 to 18.6 times. Today, U.S. high yield spreads are already 3 percentage points wider, and the S&P 500 is valued at 21.5 times forward earnings — a level equivalent to the 93rd percentile over a 50-year history. There is little fuel left to fuel higher valuations.
The global backdrop is another key difference. In 2016, China had planted the seeds of a global boom when it spent money on redeveloping old homes. Today, China has neither the ability nor the willingness to spark another housing boom. And while China’s domestic stimulus in 2016 helped spur demand elsewhere, the export-driven push to boost the economy today could eat its lunch.
Muscle memory may mean that the market initially views a red wave as positive. But a worse mix of growth and inflation is the more likely legacy. In contrast, a blue wave may initially be viewed negatively by a market unprepared for higher taxes. The assumptions of high earnings expectations, high valuations and little fiscal space suggest a narrow path forward for high returns. A split US Congress, with the most extreme agendas of both parties watered down, may be the least bad outcome for markets.