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The author is chief strategist at UBS investment bank.
The “Trump trade” has been gaining momentum this year and has recently gained momentum: Amid a big rally in the overall stock market, for example, the financial sector, which would benefit from deregulation under a Republican president, has outperformed the renewable energy sector, which a Democrat would favor.
Markets seem to be using the template of Donald Trump’s first term to prepare for a possible second term. This would be a mistake. The situation today is very similar to the 2016 “Red Wave.”
first, U.S. Economy While 2016 was in the early to mid-cycle, we are now clearly in the later stages of the cycle. From 2017 through mid-2019, U.S. GDP and S&P 500 earnings growth were consistently revised upward along non-inflationary trajectories.
It is unlikely that a strong economic expansion could be sustained today without causing rising inflation and interest rates. There are some clear signs that economic growth and income gains are nearing their peak: the gap between the economy’s actual and potential output is narrowing, unemployment is low but gradually rising, and consumption growth has shifted from extraordinary to mediocre.
Second, the demand and supply of U.S. Treasury debt has completely changed, with strong implications for the cost of capital for government debt and corporations. Public ownership of U.S. Treasury debt has risen from 75.6% in 2016 to 97.3%. This $27 trillion debt is expected to nearly double within the next decade, assuming the next president is a Democrat. A full extension of Trump’s 2017 tax cuts could add another $3-5 trillion.
During the years of quantitative easing to support economies and markets after the financial crisis, bond markets were flooded with a “savings glut” and central bank liquidity, which pegged long-term interest rates. But central bank balance sheets are now shrinking. Also, compared to the mid-2000s, the weighted average savings rate in OECD, East Asian and Middle Eastern countries has fallen from 14.9% of GDP to 10.2%. The demand pool for government debt is growing slower while supply is surging. Former Fed Chairman Alan Greenspan once confessed that it was a challenge to stabilize long-term bond yields in the face of Fed interest rate hikes. Now, the risk is the opposite: the Fed may lower interest rates, but long-term bond yields may not react as strongly, and corporate capital costs may remain high.
Third, it is not clear whether continued tax cuts will gradually boost GDP or profit growth. The consensus forecasts for pre-tax and after-tax profits indicate that the market believes low tax rates will continue. S&P 500 profit margins are expected to rise from an already high 12.1% today to 14.3% in 2026, just after President Trump’s tax cuts expire. This is not just due to artificial intelligence and the Magnificent 7 technology companies that have dominated the market recently. The remaining 493 companies’ profit margins are also expected to rise to a record high of 12.6%. A Republican victory in the November elections is tantamount to “no news” for the market. A Democratic victory with a possible tax wall in 2026 would be the real surprise.
Fourth, the narrowing of risk premiums priced into major markets was a key driver of returns during Trump 1.0. There is now limited room for risk premiums to narrow further. When Trump took office, U.S. high-yield spreads narrowed from 5.10 percentage points to 3 percentage points versus the benchmark, and the S&P 500 revalued from 16.1x forward earnings to 18.6x forward earnings. Today, U.S. high-yield spreads are already at 3 percentage points and the S&P 500 is valued at 21.5x forward earnings, a level that corresponds to the 93rd percentile of its 50-year history. There is little fuel left to push valuations further.
The global picture is also a crucial difference. In 2016, China was sowing the seeds of a global recovery by investing in the redevelopment of old housing. Now China has neither the ability nor the desire to repeat the housing recovery. And while China’s domestic stimulus in 2016 spurred demand elsewhere, today’s export-led stimulus could hurt other countries.
Due to muscle memory, markets may initially view a red wave favorably, but it would more likely leave a worse mix of growth and inflation in its wake. In contrast, a blue wave may initially be viewed negatively by markets that are not prepared for higher taxes. A starting point of high earnings expectations, high valuations, and little fiscal space suggests a narrow path to high returns. A divided U.S. Congress, in which the most extreme policies of both parties are weakened, may not be the worst outcome for markets.
