As the US election approaches, market strategists and pundits are falling over themselves to offer guidance on what the outcome will mean for investors.
And the common refrain is: Not much.
The conventional wisdom, spanning almost every investment bank and asset management research team, is that ‘the fundamentals’—not politics—are decisive for medium-term stock, bond, and currency market performance. Armed with reams of statistics and charts, Wall Street argues that financial market performance is typically invariant to who is the occupant of the White House or which party enjoys a majority in Congress.
The message is as clear as it is uniform: Don’t sweat the election.
That is right. Until it isn’t.
For reasons we come to shortly, now is one of those times when ‘don’t sweat it’ might be wrong. As I outline below, a Trump presidency poses significant investment risk. And that risk is nowhere to be seen in prevailing asset prices or in consensus market commentary.
But first, let’s explain why the mainstream view is so complacent.
It is correct that, on average, stock and bond market performance is determined by economic growth, inflation, interest rates, and corporate profits. It is also correct that, on average, politics influences those fundamentals less than politicians would like us to believe.
A casual look at the data, for example, demonstrates that stock and bond markets have done well with Republican and Democrat presidents, in times when one party controlled the White House and both houses of Congress, as well as in times when divided government prevailed. Equally, corrections, bear markets, periods of market stagnation, and other financial setbacks have occurred under all possible combinations of US federal government.
Perhaps the only surprise, at least for some readers, is that US equity markets have generally delivered higher returns over the postwar era when a Democrat occupied the White House.
Yet even that little acknowledged fact is not germane to what follows.
Instead, sometimes we must suspend ‘the average’ and focus on the particular. Saying things that are generally true, such as the observation that market outcomes are invariant to the party in power, blinds us to the possibility that sometimes it is different.
Look, ‘stuff’ happens. And when it does, history is clear: Investors get stuffed.
Crucially, in almost all those instances neither markets nor the consensus of so-called experts sees it coming.
As the historian Niall Ferguson has shown, on the eve of the outbreak of World War I in 1914, financial markets were oblivious to the consequences of what was unfolding. The devastating impact of that war on free enterprise, profits, default rates, and currency values—to say nothing of the toll it would take on lives, nation states, empires, and politics—were utterly absent from prevailing stock, bond, and currency prices as war arrived.
Equally, the risk of stock market crashes, for example in 1929 or 1987, was nowhere to be seen in market prices or in most Wall Street opinions prior to those calamities. The economic and financial risks of France or the UK adhering to the gold standard for too long in the 1930s, or the debilitating consequences of US tariffs or Federal Reserve mistakes in 1932 were similarly unappreciated by most contemporaries and the investing public.
In more recent memory, while some economists warned of growing imbalances in US credit and housing markets in the early 2000s, markets were oblivious. Many more investors were dancing alongside Chuck Prince as the music played than were girding for the financial devastation that ensued in 2008.
Here’s the rub. While it may be true that, on average, market performance is invariant to politics and policy, occasionally truly dreadful policies, including war, currency mismanagement, tariffs, or policymakers’ inability to see emergent discontinuities are decisive. Occasionally, who runs the government and makes policy is the only thing that matters for markets.
That could become the case if Donald Trump is elected president.
To see why, it is important to point out the fundamental contradictions in Trump economic policy. Essentially, Trump wants to cut taxes, but not government spending, deregulate swathes of the economy, stop immigration, deport undocumented immigrants, and impose tariffs on foe and friend alike to reduce the trade deficit.
Any one of those policies might make sense, at least in mere political terms. But in combination they represent a massive contradiction, one which could imperil the US and global financial markets.
To see why, it is important to recognize a few basic economic concepts regarding savings, investment, government deficits, and the trade balance, as well as their impacts on inflation and interest rates.
It is an accounting truism, for example, that the government budget balance, together with the gap between business investment spending and private sector savings must equal the trade balance. Knowing that, if Trump becomes president and enacts his policy wish list, the result will almost certainly lead to a massive trade deficit.
Say what? I thought Trump hated trade deficits.
He may, but a growing gap between US imports and exports flows inescapably from his other policies, namely the desire to cut taxes but not government spending, which will lead to larger fiscal deficits, as well as to slash corporate taxes and regulations, which will boost business investment relative to savings.
The mathematics are simple—the trade deficit must expand.
But it gets more interesting. In stimulating the economy via tax cuts and an investment boom, while at the same time reducing the supply of labor (closed borders, deportations) and imposing tariffs, a Trump administration will boost inflation. Accordingly, the Federal Reserve will have no choice but to stop cutting interest rates. It will probably raise them instead. Among others, the result will be a soaring US dollar on the world’s foreign exchange markets, exacerbating the US trade deficit.
So far, none of this is the stuff of a market crisis. It is merely pulling back the curtain to reveal the gross inconsistencies of Trump economic policy.
The genuine risk, instead, is what ensues.
Trump concedes nothing to no one. He cannot countenance dissent nor disagreement. Accordingly, what comes next is highly probable and surely more so than markets now reckon. Trump will degrade the last institution in Washington, DC that still enjoys the confidence of the public and standing in the markets, namely the Federal Reserve.
Why? Because Trump will rail against high interest rates and an appreciating US dollar, and will blame the Federal Reserve, rather than his own policies, for having caused them.
Trump has already called for his views to be heard at the Fed when it deliberates monetary policy. Does anyone doubt that his calls to influence Fed policy will grow louder as a soaring US dollar hurts US competitiveness and surging interest rates make it difficult for Americans to buy homes and cars on credit?
The risk that markets utterly disregard on the eve of this election is the inevitable collision between Trump and the Fed. And at some point—and history suggests that point will not be anticipated—when bond markets realize the Fed’s policy independence is in jeopardy, the ensuing bond market crash will rival any in history.
All of which begs the question, why are markets so complacent today? What is the risk they do not perceive?
Perhaps, as Niall Ferguson and others have pointed out, it is because investors are preternaturally biased toward averages and excessively discount extremes. Or maybe it is because investors are not able to see the inconsistencies in Trump policies that point in the direction of calamity. Or perhaps investors cling to the belief that no one, not even Donald Trump, could be foolish enough to take on the bond market.
Let’s hope it is the latter. Let’s hope that, if elected, Trump’s irrepressible ego stops at the bond market. Because, if not, the inescapable conclusion is that just like in 1914, 1929, 1932, 1987 or 2008, a bit too much dancing to the music is happening today on Wall Street.
