14th November, 2024|By Rodney Sullivan, Executive Director for the Mayo Center of Asset Management, Darden School of Business, University of Virginia.
From taxes to tariffs, trade to regulations, change is coming for business and economic interests during the second presidency of Donald Trump. Rodney Sullivan, executive director of the Richard A. Mayo Center for Asset Management at the Darden School of Business, University of Virginia, addresses inflation risks and implications for investors.
Although inflation has been moderating this year driven by several tailwinds including increased productivity and an economic slowdown in China, risks to the inflation outlook have risen. The combination of the Federal Reserve continuing its aggressive easing path by lowering its key interest rate, along with a unified Republican government, warrant a review of the potential impacts on economic growth and inflation.
The commonly held view is that inflation has essentially been vanquished and will continue to move gradually downward to meet the Fed’s 2% annual inflation target. However, there are key risks to this view. First, it appears that US fiscal policy under Trump will focus on expansive tax cuts (for corporate and households). Such cuts, especially if not offset by spending reductions, could widen the fiscal deficit. Another policy proposal includes new import tariffs.
Trump’s goal is to reduce trade deficits and encourage domestic production, and he may very well achieve his intended outcome. However, retaliatory measures from trading partners could ignite a trade war, bringing inflationary consequences. Altogether, the combination of stimulative fiscal and monetary policy, alongside stiff import tariffs, may coalesce to push both economic growth and inflation higher.
The risk regarding monetary policy is that the Fed has declared “mission accomplished” too soon in the battle against inflation and the 0.75% rate cuts since September are overly aggressive and jeopardise the progress made on inflation.
It’s important to note that overall, the stimulative fiscal and monetary policies are a positive for nominal US GDP growth and US companies’ earnings. However, they are a negative for the US public deficit and debt trajectory. The bond market appears to have some concerns here as the benchmark 10-year Treasury yield has risen 55 basis points since early September to 4.3% currently.
So, while rising future inflation is not a given, the above suggests that we could see further progress on disinflation stall, causing the Fed to react. Higher deficits driven by lower tax rates, stiff import tariffs, and stimulative fiscal and monetary policy may be a policy elixir that leads to “echo-inflation” — another period of unexpected inflation. For now though, the US economy remains resilient, labour productivity gains driven by investments in AI are providing structural tailwinds that support economic growth while working to contain inflation.
Investment Implications
So, what are the implications for investors? Stock investors’ concerns about tariffs and larger budget deficits have been overshadowed by a regime change to a more pro-business climate promoting tax cuts and deregulation. The bond market, however, has not been cheering as evidenced by recent rising real yields driven by prospects for higher nominal economic growth and higher budget deficits. Expect some stock and bond market volatility in coming months as markets work to sort through the fog imparted by a coming policy regime shift.
A diversified portfolio should include assets that protect investors from unexpected inflation. Chief among these are Treasury inflation-protected bonds (TIPS), whose principal adjusts up (or down) to keep pace with changes in inflation while paying a fixed rate of interest. Though not assured to protect against inflation, other assets to consider might include commodities, real estate and stocks. Depending on the overall economic environment, the prices of these assets typically increase in value when inflation rises. However implemented, protecting against inflation should always be considered in portfolio construction.