The year is nearly over and the U.S. will see Donald Trump in the White House in 2025. Ryan Detrick’s analysis of historical equity returns found that stocks historically do better in the first two years of a president who was re-elected versus a new president in office. The key question is whether Trump 2.0 represents a re-election or a new term.
I unpack that question by focusing on the economic effects of Trump’s key initiatives, namely the TCJA tax cut extension, tariffs and immigration.
Now that the Republicans have swept the White House, Senate and House, Trump is certain to push through legislation to extend the 2017 TCJA tax cuts that expire in 2025. He also made a series of tax cut promises on the campaign trail, such as no taxes on tips, overtime pay, social security benefits, car loan payments, and no federal taxes for police, fire fighters, military service members and veterans. As well, there is hope that the corporate tax rate would be cut further. At a minimum, the good news for CFOs is corporate tax rates are unlikely to rise.
The prospect of large increases in fiscal deficits is already rattling markets. Both the term premium (blue line), which is the spread investors demand to hold longer dated Treasuries, and inflation breakeven rates (red line) have risen.
The silver lining is that readings are near the top of historical ranges and inflationary expectations are not unanchored. Nevertheless, this is not good news for the bond market.
How inflationary are tariffs?
Trump campaigned on slapping 60% tariffs on all goods from China and 10% on all other countries. At first glance, such a proposal sounds highly inflationary, but the historical evidence indicates that tariffs may not be as inflationary as feared.
In 2018, the Trump Administration announced a 25% tariff on about half of the imports from China. The Chinese yuan fell about 10%, which roughly offsets all of the tariff effects. In effect, China absorbed the tariff increase through exchange rate depreciation.
A
Fed study found that the volume decline occurred in tariffed goods.
However, Trump’s efforts to re-shore production into the U.S. was unsuccessful. Imports shifted to other countries in response.
In a
different study, Fed economists modeled the effects of a tariff increase on economic activity and inflation in September 2018. To make a long story short, the study suggested that the Fed could decline to react to tariff-induced inflation under two key assumptions. First, inflation expectations have to stay anchored, and the pass-through of the cost shocks is short lived.
Undoubtedly, the Fed will be monitoring how the term premium and inflation breakeven rates evolve.
Stephen Miran, Senior Strategist at Hudson Bay Capital, made an intriguing proposal on how the Trump Administration could implement tariffs (see A User’s Guide to Restructuring the Global Trading System). He estimated that a 10% across-the-board tariff and a 10% appreciation of the USD as a currency offset would amount to a 0.3–0.6% increase in inflation.
Miran offered the following steps to mitigate tariff effects. First, he proposed a gradual tariff implementation policy, much like the steps taken during the 2018–2019 trade war. Tariff increases would be conditioned on “credible forward guidance, similar to what is used by the Federal Reserve across a range of policies, to guide expectations. The U.S. Government might announce a list of demands from Chinese policy—say, opening particular markets to American companies, an end to or reparations for intellectual property theft, purchases of agricultural commodities, currency appreciation, or more.”
In addition, he suggested forming a coalition of willing countries to create a trade wall around China by “putting countries into different groups based on their currency policies, the terms of bilateral trade agreements and security agreements, their values and more. Per Bessent (2024), these buckets can bear different tariff rates, and the government can lay out what actions a trade partner would need to undertake to move between the buckets.”
What about the strengthening USD, which makes U.S. exports less competitive?
Here, Miran suggested a Mar-a-Lago Agreement, in the manner of the Plaza Accord, to weaken the greenback. Participants would be encouraged to sell their Treasury assets to weaken the USD, offset by U.S. issuance of 100-year century bonds. This is the part of the proposal that sound the most dubious.
Immigration and deportation
Another key part of the Trump platform is restriction of immigration. In fact, he promised a mass deportation of undocumented immigrants from the U.S.
The Peterson Institute estimated the effects of Trump’s major promises in a
study. It modeled the effects on GDP and inflation of light (1.3 million people) and severe deportation (8.3 million), as well as different tariff rates and the revocation of Fed independence. Surprisingly, the largest effect on GDP was deportation. The magnitude of the effect of deportation is significantly higher than either tariffs or the revocation of Fed independence.
Axios reported that the two industries with the largest share of undocumented immigration employment are construction and agriculture. Deportation will create labour shortages, spark wage inflation and push up food prices.
For investors, mass deportation heightens the cyclical risk of the stability of the construction industry. Housing has been a key long-term indicator of economic health and any downturn could foreshadow a recession. Keep an eye on the relative performance of homebuilding stocks, which had been outperforming the S&P 500 in a choppy fashion since 2022. Elevated mortgage rates, which could be exacerbated by rising inflationary expectations that push up bond yields, along with rising labour costs from deportations, could sink this industry.
Investment conclusions
Looking to 2025, capital market returns are likely to be more uncertain than they have been in the past. The degree of dispersion in the range of forecasts is wider than usual. On one hand, Stephen Miran made the case that the effects of Trump tariffs could be relatively benign. On the other hand, Marketwatch reported that BCA Research set the probability of a U.S. recession at 75% in response to Trump’s victory.
There will be some losers, namely bonds, and construction stocks because of their sensitivity to both rising rates and heightened labour costs from deportation.
As for the stock market, the S&P 500 is trading at a forward P/E of 22, which is high relative to its own history and significantly higher than the level when Trump first took office in 2017. The good news is earnings estimates are rising and economic indicators don’t show significant recession risk. The bad news is earnings growth will have to bear most of the burden if stock prices were to advance.
Equity investors will have to weigh the balance of risks. Upside potential can be found in corporate tax cuts and deregulation. The sources of downside risk are trade wars and the negative effects of deportations on short run economic growth. For what it’s worth, the stock market may have a Trump Put in place. Various news outlets, such as the
NY Times, have reported that “Trump is seeking a Treasury secretary who will carry out his unconventional plans while still having the credibility to keep markets buoyant”. In other words, support his tariff plan and keep stock prices rising. Trump’s pick for Treasury, Scott Bessent, seems to fit that bill.
The illegal migrants issue is modeled as economically good but with social costs to be managed.
I think of it as substantially increasing legal immigration and reducing illegal immigrant population.
There are millions of vetted people waiting to legally immigrate and start anew without state support.
I hope this is how Trump 2.0 turns out with a win win solution.
US has been running a talent-based program the last 8 years which is not within the quota system of the current immigration policies. In fact several countries are running similar programs. There is a talent war going on. Let’s see how Trump implements his policies. You are right about the overall cost/benefit of illegal immigration. It is actually a big net negative with all factors considered. But when I say this people accused me of being racist and heartless. But numbers don’t lie. Calif is one prime example.