Global Capitalism’s Checks and Balances

By Tim Pierotti

“I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.” James Carville

In the wake of the recent “Red Wave” election results, one might be wondering if there are any restraints on the incoming administration. Republicans will control the White House and both the House and Senate. The Supreme Court is controlled by conservatives who have expressed an unprecedented view of the “Unitary Executive”. In some regards those concerns may be justified and we are likely to see a White House that is unrestrained relative to history. But when it comes to the economy, this administration will still have to answer to a higher authority: the bond market.

One of the unmistakable takes from the election is that inflation is a killer for incumbents. The resurgence of inflation, following decades of dormancy, has been a global phenomenon and so have been the election losses of incumbents. That reality will still be true for the next administration and their policy positions, many of which appear to me to be overwhelmingly inflationary. If inflation and inflation expectations move sharply higher from here, it is in our view likely that a recession and higher unemployment would be a result. To repeat one of our favorite economic oversimplifications, “Housing is the business cycle”. Should we see the US Ten-year Treasury rise toward or above 5%, we would see mortgage rates above 7.5%. In that scenario, we would envision a much weaker residential construction environment and job losses in residential construction, which stand at all-time highs despite already rising new home inventory.

President-elect Trump has campaigned on a few core platforms: Aggressive tariff policies, extending tax-cuts, and reversing the trend of higher legal and illegal immigration, which would include “millions of deportations”. Additionally, the incoming administration has expressed a view that the Fed should not be independent of the will of the President. Lastly, the incoming administration has rejected the Biden administrations efforts to impose constraints on Israel in that country’s ongoing and escalating war with Iran and Iran’s proxies. With all five of those distinct policies, the bond market may make any and all of those aspirations untenable. For instance, Trump may love the idea of 10% tariffs on all imports from all countries, but if that policy choice leads to untethered bond yields, there will be significant pressure to capitulate from his allies in Congress and his advisors looking out to the 2026 mid-terms.

Let’s look briefly at each one of those policies and consider the inflationary impact:

1. Tariffs – Tariffs are unambiguously inflationary. In some cases, in fairness, policy makers have no choice but to impose reciprocal tariffs or protections from the “dumping” of imported goods. But across the board tariffs for the purpose of creating a higher pricing umbrella to stimulate domestic production is, by definition, inflationary. We shall see, but I would be surprised to see a tariff policy anywhere near the campaign rhetoric.
2. Tax cuts – The extension of the 2017 Trump tax cuts that were set to “sunset” in 2025 now appears to be a given. Will there a “Truss moment” where US policymakers will find themselves in a position similar to what befell the former UK Prime Minister, and a crisis of confidence will be expressed in the bond market? I doubt it will be similarly violent, but there will be bond fund managers all over the world who will seek to lower their exposure to US longer duration debt as our fiscal credibility erodes.
3. Stagnant or even negative immigration growth – Food inflation is an election killer. If we start deporting the people who overwhelmingly provide labor in agriculture and protein processing, food prices will go higher. We are in a new world of secularly tight labor markets and without a steady flow of immigrants, we risk a wage price spiral across many industries beyond just food.
4. Fed independence – If the independence of the Fed is threatened and market participants come to see the Fed as no longer data dependent but politically motivated, there is obviously going to be a concern that the “price stability” mandate has become secondary.
5. Regime change in Iran – Oil prices and inflation expectations tend to be highly correlated. In our view, one of the reasons why the Biden administration failed to constrain Iranian exports was the fear of higher oil (gasoline) prices into an election. The Trump administration will also be loathe to see a conflict that shuts off not just Iranian exports but potentially all the Middle East oil that flows through the Persian Gulf and the Straits of Hormuz daily. If there is going to be regime change in Iran, the decimation of Iran’s oil infrastructure will likely be part of that effort. Should that happen, we would likely see oil prices move sharply higher.

We shall see. We have framed this election outcome as a mixed bag for the economy and markets. While equities are already showing the surge of “animal spirits”, those spirits will dissipate quickly if the incoming administration’s policy choices lead to an ugly bear market in bonds.

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