Thinking Ahead
My colleague, Paul Broughten, wrote last week about the market’s 26% advance this year, so investors have much to be thankful for this year. But what could go wrong? It’s a never-ending concern. Of course, there are plenty of potential pitfalls for investors, on the economic, political, or geopolitical fronts, aside from calamities like viruses, weather and who knows what else? No wonder pessimists have trouble sleeping. But even optimists like me have reason to be thoughtful. One of my fears is that inflation may re-ignite, preventing the Fed from lowering interest rates and creating a headwind to further stock gains.
Inflation has moderated considerably from its supply chain disrupted surge to roughly 9% a few years ago to less than 3% over the past year by any of several measures. That’s real progress. But it has flattened out over the past six months. Fed officials, including Fed Chair Jerome Powell expect it to continue to moderate, even if slowly. John Williams, President of the NY Fed, gave precisely that kind of forecast in the latest issue of Barron’s. I’m less sanguine for a number of reasons.
First, President-elect Trump plans to impose more tariffs on imports. Some tariffs may be a “punishment” for allowing illegal workers or illegal drugs to enter our country. Some tariffs may be to motivate firms to relocate critical manufacturing back home. Some may be to incentivize some firms to strengthen our domestic manufacturing base. Whatever the reason, prices of imported goods subject to such tariffs will increase. Firms simply cannot just take the entire hit in their profit margins. And when imported products go up in price, consumers will tend to shift their buying preferences to domestically produced products when they can, putting domestic product prices under upward pressure, as well. The size of this tariff induced price increase is indeterminant, as yet. Trump may trade off tariffs for something else he wants, since he is widely seen as highly transactional. But few people expect him to fail to follow through with some significant tariff levies.
Second, the economy continues to grow faster than the domestic labor supply can sustain. The domestic population adds about 75,000 new job seekers monthly, vastly below the rate of hiring. Such strong demand for labor would have boosted labor costs far more than the actual 4% rate of increase and forced firms to pass along the cost increases in the form of higher inflation if not for illegal immigration that served as a pressure relief valve, adding new workers to the domestic pool and enabling firms to hire the workers they needed. But in the past several months, President Biden has clamped down a bit on illegal immigration, which has coincided with a slight decline in the unemployment rate to 4.1%. As we all know, President-elect Trump plans to do so even more, including potentially forcing illegal workers to return home. The economic implications of such an action would be a rapid tightening of labor market conditions and a rise in labor cost pressures.
Third, Trump’s fiscal programs are also likely to be both expansionary and inflationary. Simply extending the tax cuts from his first term that are currently due to sunset at the end of 2025 is not very troublesome, even if it would worsen the deficit in the out years. Those tax rates are already in place. But new fiscal policies would likely increase the budget deficit and be both expansionary and inflationary. For example, Trump’s promise to end taxes on tips would boost household income and spending, along with the deficit, at a time when the labor market is already tight. He advocated for a number of such tax changes, but how much will he deliver? Trump may choose not to expend political capital for such costly fiscal programs, opting instead for something that matters more to him. And any tax proposals must gain approval from Congress, which is far from assured. Progressives and conservative budget hawks may band together to shoot down such initiatives.
Perhaps the three points above may not come to pass. I think that is wishful thinking and I strongly expect some unknown combination of these ideas will occur. That suggests to me there will be more inflation pressures in the economy than markets currently expect. Right now, futures prices imply that investors still expect another 25-basis point cut in policy rates by the Fed later this month and at least a few more in 2025. The Fed would be taking a significant risk if it follows the market with such rate cuts with the likely policy changes discussed above sure to be inflationary. So, while I am most grateful for the market’s strong performance in 2024, I am not inclined to take such an outcome for granted in 2025. Hopefully, economic growth and expanding corporate profits will provide a significant offset to these headwinds. But since hope is not a useful strategy, we will follow policy developments very closely and try to mitigate or take advantage of the conditions as they unfold.
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