Simultaneous record close at all-time-high levels for the Dow Jones Industrial Average (DJIA), the S&P 500 and the Nasdaq 100 was how equity investors reacted to Donald Trump’s win to become the 47th President of the US. With his positive comments on cryptos in the run-up to the elections, Bitcoin too hit a record.

But not all investors got to celebrate. Bond investors took a hit to the downside, while Gold took a breather after a fiery rally through the year.

How and why did each asset class react the way they did? And what is in store for the US stock markets under a new Trump Presidency? Trump takes over at a time when equity investor exuberance is as good as it can get and a strong AI boom, or what Sundar Pichai terms the Golden Age of American innovation, is underway. At the same time, these forces of optimism belie a few challenges that lie ahead for markets. As these opposing forces counteract, is there more upside in store or will the initial Trump rally fade away the way the rally in the shares of Trump’s own social media company Trump Media and Technology Group (Ticker - DJT) fizzled out a day after the election results?

 Read on to find out.

Prologue to Trump 2.0

Under Joe Biden, the DJIA, S&P 500 and Nasdaq 100 gave quite solid returns (returns from election day in 2020 to election day in 2024 considered), but not remarkably superior to the returns under Trump 1.0. In fact the Nasdaq 100 performance was even stronger under Trump 1.0 (see chart). Nevertheless, investors got it as good as it could get. This is because the Biden boost to equity markets came on top of an already exceptional four-year returns under Trump

But that was only when it comes to equity investors. When you shift focus to bond investors, it was a sea of red. For example, the Barclays iShares 20+ Year Treasury Bond ETF (invests in treasury bonds with maturities above 20 years) crashed 44 per cent in this period. The iShares 10-20 Year Treasury Bond ETF declined 37 per cent. The three-decade-long bull market in bonds, during which long-term bonds outperformed equities, peaked out in 2020 just as Biden won the elections. The bond market rout was an outcome of the high inflation during Biden’s term that pushed interest rates to the highest levels since 2007. Multi-decade-level high inflation during his Presidency took the sheen of what many say was strong economic performance in the last four years.

The pain of inflation is well captured in what is known as the Misery Index.

The misery index, conceived by economist Arthur Okun, is a measure of economic distress. A low measure implies low distress and vice-versa.  It is arrived at by adding up the monthly inflation rate and the unemployment rate. On the eve of the 2020 elections, the misery index was at 9.3. On the other hand, it is currently at 6.5. So, it has actually improved in the last four years, right? Optically yes, but in reality, it is a different take. In 2020, the index was distorted by temporarily-high unemployment due to the impact of lockdowns. Further fiscal stimulus during Covid-19 offset pain for many who were unemployed then.

More importantly, when you compare the average of the misery index, Trump’s first Presidency pulls ahead at 6.8 per cent vs 9.1 per cent under Biden. Thus, despite having amongst lowest unemployment rate in history during his tenure, high inflation resulted in an overall relatively-higher level of economic distress.

This resulted in what some economists term as two different economies in the US – one where those with high savings and investments feel the economy is doing great given the boom in equity and property prices, while those living pay-cheque to pay-cheque are not so happy about the economy and feeling left out. For many in the middle class, the boom in property prices, combined with very high interest rates, made purchasing a home out of reach.

As Trump takes over, this is a structural issue that will need to be addressed and there are no easy fixes.

Trump’s key agenda

Within Trump’s economic and political plan, three on the agenda – tariffs, tax cuts and deportation of migrants can have immediate economic implications.

Trump has said he wants to impose up to 20 per cent blanket tariffs on all imports and additional tariffs of 60-100 per cent on goods imported from China. Of course, what he actually implements may vary, but if you thought this was just election noise, hold your breath. Soon after Trump won the elections, Steve Mnuchin, who was the Treasury Secretary (similar to Finance Minister in India) for the four years during Trump 1.0, said that tariffs are critical to Trump’s agenda. This may be used as a ploy to bring counter parties to the table or implemented swiftly like he did in 2018 against China. Economists fear this may compound the US’ inflation problem by increasing the cost of imported components and goods.

When Trump implemented tariffs against many Chinese imports in 2018, the inflation impact was mitigated by the depreciation in the Chinese Yuan, which offset the net impact for Americans (while tariffs increased the cost, depreciation in Yuan made the cost of goods cheaper in dollar terms). How it plays this time is a ‘wait and watch’, but needless to say it will increase uncertainties; as unlike 2018, when deflation was the concern for US Fed, inflation is well entrenched today.

For the record, the tariff wars of 2018-19 hardly had any negative impact on markets, except for immediate knee-jerk negative reactions, following which there was a swift recovery.

When it comes to taxes, under Tax Cuts and Jobs Act of 2017, while the corporate tax cuts were made permanent, some of the tax cuts for individuals are set to expire in 2025. Trump intends to extend these cuts and also wants to cut corporate taxes from the current 21 per cent to an even-lower 15 per cent for companies that manufacture their goods in the US. The flip side to this is that it will increase the US’ fiscal deficit, which has already been way too high in recent years. The fiscal deficit for FY24 is estimated at around 6.4 per cent, which in itself is high for a non-recession year. In the decades prior to Covid-19, fiscal deficit as a percentage of GDP had crossed 6 per cent only during times of recession.

On immigration, while it could be a huge challenge to implement, Trump’s agenda is for mass deportation of illegal immigrants in the US. This could have the economic impact of re-igniting inflation. According to some economists, the influx of illegal immigrants into the US labour force had helped keep wage inflation in check and consequently aided the decline in inflation towards the Fed’s target of 2 per cent in last two years.

Overall, while the above three agendas of Trump can be good for boosting manufacturing in the US and for job seekers, it comes with the risk of increasing fiscal deficit and inflation. This was the reason why while equities rallied, bonds slumped following the election verdict.

What is important here for equity investors to note is that what is initially not good for the bond markets, eventually turns out to be bad for the equity markets also in the longer term. With the US showing an incredible appetite for money printing and expansionary fiscal policies that support economic growth for now, what impact it will have on equities in the long term is, again, a wait and watch!

For example, the bond market rout there in recent years is a consequence of this. Typically, high bond yields are a dampener for equity valuations, but so far the trend has been bucked.

Inflation, interest rates and the Fed

US CPI inflation has moved down quite a lot from 9.1 per cent in June 2022 to 2.4 per cent now. However, in Fed’s own words, the battle is not yet won. In this week’s FOMC meet, while the Fed continued on the rate cut path by reducing short-term rates to a range of 4.5-4.75 per cent, in its statement it removed the words ‘gained greater confidence that inflation is moving sustainably toward 2 per cent’, which the statement for the FOMC meet in September had.  Further, Fed Chairman Jerome Powell alluded that while recent ‘inflation data wasn’t terrible’, it was ‘higher than expected’ and that ‘core inflation remains elevated.’

While nothing to get alarmed, this puts into doubt prior market expectations on the rate cut path ahead. Any upward surprises on inflation can result in a pause in the rate cut cycle. This is another factor that markets need to manoeuvre, as a good part of the optimism in equities is predicated on lower inflation and interest rates ahead.

This apart, the relationship between Trump and the US Fed also may need a watch. Towards the second half of Trump’s term, the relationship got a bit strained to such an extent that Trump in September 2019 posted on X (then Twitter) asking ‘My only question is, who is our bigger enemy, Jay Powell or Chairman Xi’, comparing the Fed Chairman with President Xi of China!

While it passed off without much impact last time, any such replay this time can impact investor confidence given the inflation problem.

Valuation

While few uncertainties and structural issues exist, what has worked in favour of markets has been a remarkably resilient US economy and the AI boom. In fact, consensus view was that US economy would endure a recession in 2023 which it defied. The probability was not low for 2024 as well, but the economy appears to have turned the tables on sceptics this year too, based on initial GDP estimates for the year so far.

These two factors combined with expectations of business-friendly policies of Trump have pushed not just the markets to all-time highs, but valuations, too, close to all-time-high levels barring a few exceptions in history.

As things stand today, the DJIA at PE of 23.8 times trades at a 41 per cent premium to its 20-year average, the S&P 500 at 26.3 times is trading at a 42 per cent premium, while the Nasdaq 100 at 34.5 times is trading at a 37 per cent premium. These are stretched valuations by any yardstick. Further, these valuations fall in the 95th percentile of historical valuations (last 20 years) in the case of DJIA and S&P 500, and 92ndth percentile in the case of Nasdaq 100. This implies valuations are as expensive as they have ever been historically. These valuations were previously exceeded only in 2020 and early-2021 when trailing earnings were distorted by Covid-19 and before that during the dot com boom

Thus, it is safe to conclude that the current valuations of the US markets do not give much room for comfort. This apart, other measurements like market cap to GDP at 212 per cent, too indicate extreme valuations in the US markets.

Veteran investor and fund manager John Hussman, who has analysed data going back to 1929, notes current valuations as the most speculative extreme in US history. At the same time, he also cautions that while valuations are informative about long-term cyclical outcomes, they are emphatically not useful indications of market outcomes over shorter horizons.

This view is echoed by David Kostin, the US Equity strategist of Goldman Sachs, who in a recent report while expecting decent returns from S&P 500 over the next one year, expects only 3 per cent returns in nominal returns per year over the next decade.

So could the exuberance in US markets be setting up for a lost decade, or can Trump and the AI theme keep pushing the markets even further for longer than usual? We shall see!