US markets embrace prospect of smaller government
Investors welcome deregulation under Trump 2.0
WITH the best post-election day performance for the S&P 500 in decades and a continued bid for stocks in the days after, investors are enthusiastic about the policies that may be put forth during a second Trump term.
Investors have particularly welcomed Donald Trump’s focus on deregulation and for the federal government to play a smaller role in the economy and financial markets.
The government has been a very large player
The purpose of capitalism is the allocation of societal resources by private markets. Instead of bureaucrats, capitalist systems prefer to allow the “wisdom of crowds” to determine what projects should be funded and where capital should be pulled from to drive societal growth.
How much has government been involved in this process? Since the global financial crisis (GFC) of 2008, the answer is – a lot.
The ratio of US government debt to GDP, for instance, has grown from 68 per cent before the GFC to an astonishing almost-130 per cent today.
Meanwhile, the US Federal Reserve’s balance sheet as a percentage of the economy has surged since the turn of the century. From its average of 5 per cent pre-GFC, it has ballooned to 25 per cent today. Twenty-five cents out of every dollar of GDP is held by the US central bank. Put in another way, the supply of money has exploded.
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Finally, Covid stimulus policies, from the CARES Act to the American Rescue Plan, resulted in over US$5 trillion being fed into the US economy, culminating in a fiscal deficit rivalling only wartime periods.
For those surprised that the US avoided recession in the last year or two, the explanation is simple: The economic soft landing the US is experiencing was purchased at great cost.
How did stocks fare during this period of exponential government growth? Starting at the beginning of the Obama administration to the end of October 2024, the S&P 500 returned 839 per cent for an annualised return of around 15 per cent. Whether under President Obama, Trump or Biden, stocks greatly exceeded normal historical returns and risk profiles.
Via monetary and fiscal policies, the US government’s involvement in the private sector effectively allowed for the privatisation of wealth in good times and for the socialisation of losses in bad ones.
This has reduced the ability of the private sector to efficiently price risk and allocate capital and resources under both Democratic and Republican administrations. So where might we go from here, with deregulation ahead, but also tariffs?
The look-ahead
While most (certainly me) welcome less regulation and intervention by policymakers, investors need to consider our starting point today. A look at the cyclically adjusted price-to-earnings ratio for US equities over the last 100 years may help.
While prices today aren’t as high as they were during the 1990s Internet bubble, given the historical returns of risk assets, we shouldn’t be too surprised to see that they compare to the levels of the late 1920s. However, I’m not suggesting a redux of October 1929, or another Great Depression, as there are too many differences between the periods.
While valuation is one similarity, valuation alone can be a dangerous investment signal. Importantly, investors need to consider the pathway of future earnings, the prime determinant of the prices investors will pay. Which brings me to one other similarity to the late 1920s: tariffs.
In 1929, investors began to discount the Republican Congress’ plans to tariff over 25,000 goods entering the US. This mattered to investors because, while tariffs make US goods more attractive to domestic buyers, they drive up costs for US producers sourcing goods outside the country as well as consumers. While there were other catalysts heading into October 1929, the prospects of the Smoot-Hawley tariffs were a factor that changed both how investors thought about future profits and what they were willing to pay.
To be fair, long before the 2024 election, input costs had risen as capital and labour costs jumped. But companies were largely able to offset those pressures by passing on higher prices to customers and cutting spending in non-mission critical areas. What has changed is consumers have begun substituting goods and services where necessary, driving prices and inflation down, and lowering corporate spending in unnecessary areas. With the low-hanging fruit already plucked, profit margin-protecting manoeuvres will be harder to achieve in the future, ushering in a new paradigm with far greater return dispersion in benchmarks.
In conclusion, less government involvement in the economy and markets is long overdue and welcome. But I think investors need to consider what a reduced government role may mean for the profitability of projects and businesses that cannot offset rising cost pressures. As a result, I think Trump 2.0, specifically smaller government, may upend the performance dominance of passive investing.
The writer is portfolio manager and global investment strategist at MFS Investment Management
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