Welcome back to the world of “America First” — a phrase that, in this case, signifies heavy fiscal muscle, contentious trade wars, and perhaps a bit of political chest-pounding. President Trump's re-election and the republican government sweep signifies tangible economic changes, including heightened tariffs, increased fiscal deficits, and a transformed market landscape.
DAte
Nov 26, 2024
Branding
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12 Min
Investors are facing a combination of opportunities and challenges, with U.S. equities appearing buoyant in the near term and bonds under pressure. However, the lurking risks of inflation and dollar appreciation should not be overlooked. Let's have a closer look into the details with the help of our Chief (AI) Strategist NINA.
Prefer listening over reading? Listen to the podcast version where we discuss this article.
1. Macro: The Fiscal Party’s Back, But at What Cost?
Fueling the Economic Engine….with Dirty Diesel?
Trump's second term heralds a clear shift towards expansionary fiscal policy. According to NINA, our agentic investment system, deficit spending is expected to be about 0.5-0.6% of GDP in the base case. This isn't just a gentle nudge for growth—it's a spending-fueled boost that could initially push GDP upwards, but has a less rosy medium-term impact, potentially shaving off roughly 20-30 basis points of GDP by Q3 2025.
Historically, fiscal expansion injects cash directly into the economy through, for example, military spending, subsidies, or tax cuts. This surge typically elevates GDP as consumer and business confidence rises. It’s like boosting an economy on an energy drink: short-term zing, but watch for the crash.
Inflation and the Fed’s Tightrope Walk
Now, it would be great if fiscal expansion came with no side effects, but economics rarely works that way. This push for growth brings back an uninvited guest: inflation. Increased government spending drives up costs, rippling across prices. As more dollars chase a limited number of goods, inflation begins its upward climb. And with Trump's immigration policies tightening labor markets, inflation gets a second wind as fewer workers are available to meet rising demand.
Here's the silver lining: inflation can be self-regulating if central banks respond appropriately, especially from a monetarist perspective. We don't anticipate an expansionary monetary policy to accompany Trump's spending plans. NINA estimates fewer rate cuts, which should help keep the M2 money supply in check.
Why M2?
NINA pinpoints this as a critical economic relationship affected by Trump's policies and the Fed's balancing act. M2 emerged as one of the key players from the large set of hypotheses the system is built out of. The importance of a hypothesis is estimated through rigorous quantitative testing, with causal associations baked in.
In the chart below we depict the relationship between the year-on-year change in core PCE inflation and the acceleration of the M2 Money supply. It is clear that with a lag the M2 money supply acceleration seems to be an important driver of inflation. Think of it as one of inflation’s secret best friends, which is not new to the monetarist readers out there.
A Quick Sidebar on M2 and Core PCE
M2 Money Supply: This is a measure of the money supply. In simple terms, M2 reflects the amount of money available in both cash and savings that can be easily accessed and spent. It’s adjusted for seasonal factors to give a more accurate picture of money trends.
Core PCE Price Index: The Federal Reserve's preferred inflation gauge. Think of Core PCE and Core CPI as two different ways to measure how prices are changing. They're like two people shopping at the same store, but with different shopping lists and ways of adding up their bills. Core PCE is like a shopper who looks at everything in the store and changes their list often based on what's popular. They also include things their friends might buy for them. Core CPI is more like a shopper who sticks to a specific list of items they always buy themselves, focusing more on housing costs. Because they shop differently, they might come back with different ideas about how prices are changing. The Federal Reserve prefers to look at Core PCE because of its potential to paint a better overall picture of price changes in the economy.
As said, the expectation is that expansionary fiscal policy without monetary accommodation should keep inflationary pressures in check.
Immigration Policies and the Labor Market
Trump's stringent immigration policies are a double-edged sword. Initially, the reduced labor supply could lower unemployment rates. But those pesky second-order effects can't be ignored. Over time, a slower-growing labor force may mean less investment, which eventually chips away at economic growth.
Our estimate? We anticipate an inflation effect between 0.3% and 0.5%, of which a significant portion is coming from the expected tariffs discussed below.
NINA’s projections suggest the Fed may cut rates at most three times in 2025, a delicate dance as fiscal policies continue to push inflation around. Just remember, NINA’s numbers change daily with new data—so consider this a snapshot rather than a prophecy.
2. Global Trade and Tariff Turbulence
Trade Wars: The Sequel
If you thought the first Trump term was tough on global trade, brace yourself for round two. Trump 2.0 proposes even higher tariffs, with China in the crosshairs and the EU, Mexico, and Vietnam not far behind. U.S. trade policies under this administration could push weighted average tariffs on Chinese goods up to 22%, with an 8% total tariff possible for other countries according to NINA. It's like upping the stakes in a high-stakes poker game where everyone's bluffing and nobody wants to fold. But, clearly the coming administration firmly beliefs that this will be a source of income to reduce the budget deficit, with all the tax reductions planned ahead.
Tariffs Fueling Inflation?
Inflation rises when tariffs make imports costlier, leading to price increases for goods sourced from overseas. With additional fiscal stimulus pumping more disposable income into the economy, demand surges, further pushing up prices. NINA estimates that tariffs alone are expected to boost inflation by about 0.3 percentage points—a short-term effect but enough to make CFOs have another look at their pricing strategies.
Elon Musk: The Wildcard
The agentic analysts brought up an intriguing wildcard: Elon Musk. Having played a pivotal role in the elections and now a key ally of Trump, Musk adds an unpredictable element to the equation. With substantial business interests in China, he might serve as an informal mediator between the two superpowers. We already know he and Vivek Ramaswamy will run the new government agency DOGE. Could he be the bridge over troubled waters, or will his tweets create more waves? It's a subplot worth watching.
Source: The New York Times
3. Dollar Strength and Its Economic Impacts
The dollar has strengthened by a couple of percentage points in recent weeks, and expectations are that it will maintain this momentum due to the chain of favorable economic fundamentals, including fiscal expansion and higher Treasury yields. While this can benefit importers, it poses challenges for U.S. exporters as their goods become less competitive overseas.
A stronger dollar often correlates with capital inflows into the U.S., driven by higher interest rates and economic optimism. However, these same forces can exert downward pressure on growth. Moreover, for S&P 500 companies, more than 40% of aggregate earnings come from non-dollar buyers. As witnessed in 2022, a strong dollar can weigh on earnings. Additionally, a robust dollar places downward pressure on dollar-denominated commodities, impacting industries tied to raw materials, which in turn somewhat dampens inflation pressures.
For our Argan Agentic Fund, significant USD/EUR exposure is a double-edged sword. While a strengthening dollar boosts portfolio returns from our U.S. holdings, it negatively affects some of those same portfolio companies' earnings. As of this week, NINA estimates the euro to remain between the 1.05 and 1.09 levels on the medium-term. For a broader set of outcomes, see the graph below.
So, What Does This All Mean?
A Trump-Driven S&P 500 Rally
Trump's re-election is anticipated to drive another round of equity market exuberance, fueled by deregulation and favorable tax policies. NINA suggests a potential 10-15% return for the S&P 500 by mid-2025 from the current levels, based on a snapshot base case price-to-earnings ratio of 26.5x and an EPS of $253. Lower regulation and tax relief are expected to boost investor confidence and fundamentals, although underlying risks remain. These risks can derail the base case, especially as we are still in an environment of inflation volatility. The effects ripple through bond volatility, higher for longer/less rate cuts, and ultimately lower risk premia.
With inflation expectations volatile, an expansionary fiscal stance, and a rising budget deficit that could bite the economy in the long term, bonds may present stormy waters yet again. And for those who were waiting for the return of the 60/40 portfolio with a vengeance, the wait continues. Sectors like technology, energy and financials, as well as small to mid-sized businesses, stand to gain from deregulation and fiscal stimulus. Meanwhile, short-duration bonds and scarce assets can offer some safety against inflation volatility. Though remember gold loses its gleam in periods of accelerating growth and real yields, albeit short-lived and manufactured. I would not be surprised to see Treasury yields climb another 20 basis points in the near term before policy impacts the growth picture negatively.
The strong dollar calls for caution in commodities and emerging market investments, where currency effects could weigh heavily on returns.
As always, agility is key. In these dynamic markets, staying nimble could make all the difference.
Starting May of this year, the strategy derived from NINA for the Argan Agentic Fund went live and has returned 23%. Our older system, prior to NINA, has a model portfolio going back to 2021. Including its performance would put the YTD results at 35% with an overall annualized vol of 10.4%.
At Argan.ai, our philosophy is straightforward: we put our money where our insights are. We're not just observers; we're participants in the markets we analyze.
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