WTF is going on with the Economy?! #129 - The economy since November 6th

This is a copy of our WTF is going on with the Economy?! Newsletter - the premiere source for people living abroad to learn about and understand trends shaping out global economy.

On November 6th, following Donald Trump’s presumed victory in the US Presidential election, financial markets and assets went into overdrive. Many in the financial media spoke about “The Trump Trade” as the driving force immediately following the election. But now, two weeks in, the rallies are continuing. Let’s quickly break down what’s happening.?

Stock markets rally?

Following Trump’s victory, US stock markets and indices all hit 12-month highs. A lot of the exuberance went down to expectations for how a future Trump administration would impact publicly-traded companies. Crucially, traders and investors believe that under Trump:?

• Taxes will continue to be low under Trump 2.0, which is good for profit margins. In his first term, Trump passed a tax cut lowering corporate and individual income tax rates. Normally, these cuts expire next year. However, it’s widely assumed that Trump and Congress (which the Republicans also control) will extend these cuts, giving a boost to share prices.
• There will be less regulatory scrutiny of mergers and acquisitions, which also boosts share prices. The Federal Trade Commission under Biden took a skeptical view towards mergers and acquisitions (M&A), fearing harm to consumers through less competition. Trump will likely be much more friendly towards M&A. When one company announces it will acquire or merge with another, the latter’s share price goes up. Investors like this as it allows them to take profit and exit an investment cleanly.??

Corporate debt and credit spreads

Stocks aren’t the only traditional financial asset gaining momentum. Companies borrow money by issuing bonds in what’s called the “corporate debt market.” Since Trump’s victory, companies have gone on a borrowing spree. At the same time, the difference between the interest rates companies and the US government borrows at is at its lowest since the late 1990s. We call this gap the “credit spread.”? There are a couple of reasons for this flurry of activity and credit-spread tightening:?

• Companies borrow money for M&A. If a company wants to acquire another, they’ll need to buy shares and pay investors. Sitting on piles of cash is poor asset management, so acquiring companies borrow money to fund M&A. As we wrote above, Trump should be more amenable to M&A which is why borrowing is up.
• Investors believe that Trump’s economy will be good for borrowers, making corporate debt more attractive. Government debt is the “risk-free rate of return” benchmark for investors. When the economy is bad or if investors are pessimistic about the near-term outlook (also known as bearish), then the difference between corporate and government borrowing rates increases. Now, investors think that the economy in the short-term will be good for businesses, making it less risky for them to lend money to companies.
• Interest rates might not go down as much in the future (or even go up) so borrowers are locking in rates now. Trump’s economic and social policies (like mass deportations) will almost certainly increase inflation. When inflation goes up, interest rates rise as central banks try to keep the economy from getting out of control.? Inflation and interest rates have been dropping recently, but many investors think that this trend won’t continue under Trump. If interest rates go back up in the future, borrowing costs for companies will, too, which is why companies are borrowing now to save on interest payments later.??

The US Dollar

If you’re a dollar watcher like my coworking desk mate who works remotely for a US company, you’ve likely seen the dollar rally to levels not seen in well over a year.? The main reason for the dollar going up is that investors want to get in on the action in the US. For them, they see:?

• US stocks and bonds are booming, which means they want to participate in the rally and hopefully gain from it. ?
• Interest rates remaining higher for longer, making dollar deposits more attractive. If Trump’s economic and social policies cause inflation to go up, then interest rates will rise, too. In that case, deposits on dollars will pay higher interest relative to other currencies.
• A more bearish global economic outlook. ?Since 2021, the US has been the economic performance outlier in the developed world (although the American electorate didn’t really capture this). While most countries experienced high(ish) inflation, the US economy is one of the few that is still firing on all cylinders. The European economy is in a weird spot right now (we’ll cover this soon!), and with globalization effectively ending, investors around the world are parking their assets in the US, which has traditionally been a safe-haven.?

What about the dollar? Will it hit parity with the euro??

Right now a lot of people (including my desk mate) are asking if the dollar will hit parity with the euro right now like it did in 2022. First, it’s impossible to predict. Second, a strong dollar is usually bad for the global economy. Energy prices still trade in USD, which means for us in Europe, buying natural gas and oil will become relatively more expensive. Second, many developing countries borrow in dollars. If the USD strengthens relative to their domestic currency, they’ll effectively pay more to service the debt. In turn, tax revenue would be diverted from social, infrastructure, and other economic programs to paying interest, harming their short and even long-term development.?

Crypto

Cryptocurrencies — particularly bitcoin (BTC) — have been one of the biggest winners of Trump’s victory. During the campaign, Trump promised to make the US a “crypto capital” and have bitcoin “made in America” (whatever that means). Crypto and decentralized finance (DeFi) investors bought the hype, and with Trump winning, it’s likely his administration will be much more friendly to the industry than Biden’s was.?

What does all of this mean and what happens next??

There’s a lot to make sense of from Trump’s victory,? particularly when it comes to the economy.? First, none of the fundamentals changed from November 5th to November 6th.? Biden was — and still is —? President that Wednesday morning. Neither companies nor the economy transformed magically overnight. Practically all of the market activity comes from investor excitement and expectations. What those actually are is anyone’s guess. In the past couple of days, markets have cooled off a bit. Perhaps some of the momentum is gone. More likely, many short term investors and traders took their profit, causing a small sell-off.?

We still have two months and one day until Trump takes over, and even then, it will take a while for the economy to feel the effects of his policies. The US Federal Reserve (the central bank) is likely cutting interest rates again in December, in line with their current forecasts, but it’s hard to say if they’ll continue down that path as Trump could fundamentally alter the economy.?

On that, his policies are the true X-factor. Trump campaigned on a contradictory economic and social policy. On the one hand, he claims he’ll lower inflation and the cost of living while bringing back manufacturing jobs (which have already been coming back thanks to investment from the Biden administration and Congress).? However, his stated policies will likely have the opposite effect.?

Tariffs are taxes on consumers which will cause prices to go up both on directly imported goods and on components brought in for the high level manufacturing more suited to the US labor market. Cutting taxes will only add more cash into the economy, which will increase activity and inflation. Deporting millions of workers who do low-level but crucial tasks like agriculture, construction and custodial services will cause prices to go up for food, housing, and rent.? If inflation goes up, interest rates will need to increase, too, driving up borrowing costs for Americans and companies alike.?

At the same time, he also wants to cut government spending by two trillion dollars through mass firings and reorganization of the civil service. Not only would this harm crucial functions in the economy, combined with his other measures, it could create stagflation; where the economy slows down but inflation doesn’t.

It’s really impossible to say right now what will happen (it always is). What we can say for investors is that in the most volatile decade in recent history, diversification and level-headiness is key. Having a plan is crucial, even if plans often change.?

(And if that fails, deep breaths and a good book to distract ourselves seem to work regardless).