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The long-awaited U.S. election has finally come and gone and there was none of the feared market volatility or disputed results that had been a risk for investors going in. The clear win for the White House by Trump and the Republican wins in both the House and Senate made for a trifecta of control that, in theory, should allow the incoming administration to carry out many of their election promises, including tighter border controls, a new global tariff regime, a substantially reduced regulatory environment, the extension of the 2017 tax cuts and streamlined government operations. Investors quickly got out their 2016 playbooks and jumped on all the trades that had worked in the last months of that year and most of 2017. The S&P500 surged to 5%+ monthly gain as did the Nasdaq Index, but the best accolades were kept for the previously lagging, domestically oriented small cap Russell2000 Index, which soared by over 10% in November.
But this is NOT ‘déjà vu 2016.’ A little relief certainly goes a long way. The small-cap rally was the most noticeable and a reflection that a more domestic-oriented agenda could get more of a pure benefit from protectionism. A corporate tax cut may also help small caps more directly. But while many investors dusted off their first-term playbooks as they prepared for Trump’s second term by buying financials, oil stocks, industrials, and small-caps, the sequel might not go as well. When Trump succeeded Obama in 2017, inflation was lower, with the core consumer price index near 2%. The federal deficit as a percentage of gross domestic product, now at 6.3%, was less than half that. The S&P 500 traded at undemanding 16.5 times earnings before the election in 2016, versus over 22 times now. Also, equity market positioning, sentiment and valuations at the time were light years away from where they are currently. Market Vane’s bullish sentiment was 60 then and is now at a ‘nosebleed’ of over 70. Every other valuation metric from price-to-earnings, price-to-sales, price-to-book, the Buffett Indicator (market cap-to-GDP) and the CAPE multiple are completely off the charts today – which was not the case in 2016. The American Association of Individual Investors sentiment survey shows bullishness near the highest levels all year, at 49% versus the historic average of 37%. U.S. households’ equity allocation as a share of total financial asset holdings has never been higher at almost 45%. While the 2016 playbook has worked so far post election 2024, we think that 2025 may not be another 2017 and could end up looking more like 2018. We are at vastly different starting points and almost all the potential good news from lessened regulatory environment, stimulated economic growth and tax cuts are already priced in while the risks (higher inflation, increased fiscal deficits, trade wars) have not really been considered.
There is an added constraint on fiscal finances which will make it much more difficult to increase spending and cut taxes, which are core to this reflation trade. Back in 2016, debt-servicing costs were absorbing just over 10% of the revenue pie. That interest expense ratio is double that today and even before Trump’s tax measures, that ratio is set to spiral to over 30% within three years. In 2016, the deficit-to-GDP ratio of 3% and federal debt-to-GDP ratio, of over 100%, were far less of a fiscal constraint on Trump’s fiscal ambitions then compared to today where the deficit tops 6% of GDP and the debt ratio is fast approaching 130%. This is a fiscal straight jacket that the market bulls may not be factoring in. The impact of this may all come to the forefront very soon as the decision to boost issuance of very short-term debt over the last four years means an unusually high amount of borrowing comes due next year. Latest estimates show $6.74 billion, about a quarter of the $28 trillion of total marketable U.S. government debt outstanding, will need to be re-financed in 2025, and at mostly higher rates than when they were issued. The spike in the cost of servicing U.S. debt is a primary reason why the federal budget deficit swelled to $1.8 trillion in the fiscal year just ended, or a lofty 7% of gross domestic product. The government’s net interest costs have more than doubled since 2020, to $882 billion in fiscal 2024 from $345 billion. It’s unlikely the incoming Treasury secretary will be able to reverse the trend.
Outside of the scale of U.S. fiscal deficits in the coming years, the big uncertainty relates to the President’s preparedness to use tariffs to extract concessions from trade partners. Canada and Mexico have already become ‘collateral damage’ in the ongoing U.S. protectionism towards China. While the U.S. trade deficit with Canada and Mexico has widened almost US$100 billion since Trump left office, our initial thoughts were that the U.S. was very dependent on Canada for oil (4 million barrels per day) and the auto industry was so integrated that we should not be the hardest target on the ‘tariff front.’ That hammer was most likely to fall harder on Europe and China. We have already been proven totally wrong on that point as Trump has proposed 25% tariffs on ALL goods from Canada and Mexico to stop the flow of illegal drugs and immigrants across both borders! That may just end up being a bargaining chip in negotiations given that the USMCA trade agreement comes up for renegotiation in 2026, but it was enough to cause a sharp selloff in many Canadian oil, auto and industrial products stocks. Just a sign of the volatility we can expect over the next few months (and years).
Could we see the outbreak of a trade war like what occurred after the U.S. adopted the Smoot-Hawley tariff in June 1930? After those tariffs were introduced, U.S. trade partners initially protested the sweeping tariff legislation, with many eventually choosing to retaliate by increasing their tariffs on imports from the United States. The Smoot-Hawley Tariff Act did not cause the Great Depression; however, it worsened conditions during that time. The Act increased tariffs, which further stressed struggling nations—including those in debt to the U.S.—and caused other nations to retaliate by imposing their own tariffs. It raised the price of imports to the point that they became unaffordable for all but the wealthy, and it dramatically decreased the amount of exported goods, thus contributing to bank failures, particularly in agricultural regions. While most of the rhetoric around tariffs have been about the retaliatory, inflationary and economic impacts, there should also be increased awareness by investors of the corporate profit impacts. This is particularly key if China indeed becomes the biggest focus of those tariffs. China is the destination for a large chunk of technology and basic material exports and those would be most at risk from retaliatory tariffs. But China is really the ‘world’s factory’ when it comes to the production of most consumer goods. A significant rise in those prices due to tariffs will be taken straight off the bottom lines of Walmart, Costco, Home Depot and other major retailers unless they could pass those tariffs on to their customers which, of course, would add to inflationary pressures.
With third quarter earnings officially ‘in the books’ we saw some notable changes that markets are ignoring, specifically the earnings downgrades outside of the ‘Magnificent Seven’ group. In the past three months (shown in the table below), 2025 earnings expectations for the S&P500 have come off by -1.8%, by -2.7% for the other 493 names, and by -11% for the Russell 2000, while the Magnificent 7 have experienced a +4.8% upgrade. This tells us that the price rally may be broadening out, but the fundamental backdrop continues to narrow. Small caps have been one of the strongest groups since the election, with regional banks helping the Russell2000 Index rise by over 10% in November on optimism that the incoming administration’s policies will lift domestic earnings more than the rest of the market, and domestic companies have a much higher representation in the Russell2000. But the optimism might be premature since there is still a lot of ‘heavy lifting’ to do in the small cap stocks, where earnings over the past year are DOWN 7%, while S&P500 earnings are up 5% and big tech earnings have gained over 20%! Bottom line, as shown in the table below, while the S&P500 Index has risen by over 30% in the past year, earnings growth has been 8.6%, but only 2.3% excluding the ‘Mag 7’. That means that over 75% of the rise in the stock market over the past year has been due to increased valuations. Nice, but probably not sustainable!
The unsustainable positive feedback loop that keeps the U.S. economy strong and the stock market rising. The U.S. stock market and economy continue to lead all others globally and much of this has been attributed to “U.S. exceptionalism.” We would argue that there are other factors at place, most of which are not sustainable in the longer term. One of the biggest lifts to U.S. growth over probably the past eight years has been the unheralded level of fiscal stimulus. While the pandemic necessitated much of this spending just to keep the economy moving and businesses solvent, the deficit as a percentage of GDP has been increasing since 2017 and is now running at over a 7% rate. That is an unprecedented level for an economy that is not in recession, which is what is was for only two quarters in 2020. But an even bigger stimulus to consumer spending has been the ‘wealth effect,’ which we believe is completely underestimated by most economic analysts. In the booming economy of the 1980’s, the value of the stock market was about 40% of GDP. Today it is over 150%, or almost four times the value four decades ago. Fifteen years of near-zero interest rates lead to a surge in the value of financial assets as well as real estate. That made the upper income earners in the economy feel wealthier and encouraged higher spending. An economy should grow because of higher employment levels and greater corporate profit reinvestment, not due to inflating the values of financial assets and then using that to support spending. It has also lead to a ‘bifurcated economy’ where the wealthier cohort who have stock market holdings and real estate have been supporting the overall growth numbers. The lower income cohort has been more negatively impacted by inflation and rising prices for most food and other ‘essentials’ that cut into real incomes. That can be seen by the fact that the bulk of sustainable spending has been in the services sector, where ‘experiences’ such as travel, concerts and restaurants have seen the biggest surge in spending while lower income consumers have cut back on spending on goods. Retail earnings commentary is showing this economic divergence. While Walmart beat expectations on their pure value focus, we have seen a raft of disappointments in the past week including Kohls, Target, Best Buy, Lowes, Starbucks and Dick’s Sporting Goods. These recent quotes from this week’s earnings reports support this cautious outlook:
“Our sales performance was impacted by overall softer than forecasted customer demand during September and October. We attribute this to a combination of overall ongoing macro uncertainty, customers waiting for deals and sales, and distraction during the run-up to the election, particularly in non-essential categories. We expected lower demand between sales events, but the impact was even steeper than we estimated.” — Best Buy
“We are approaching our financial outlook for the year more conservatively, given the third-quarter underperformance and our expectation for a highly competitive holiday season.” — Kohl’s
“We did want to be appropriately cautious, given the uncertain macroeconomic environment.” — Dick’s Sporting Goods
The result of all of this is that the rise in stocks and home values keeps spending strong and then feeds into stronger corporate profits, which feeds back into higher stock prices and the feedback loop continues. This has pushed stock valuations back very close to the record highs we see at the peak of the ‘tech bubble’ in 2000. Meanwhile, investor allocations to stocks continues to rise as U.S. households’ equity allocation as a share of total financial asset holdings has never been higher. The household sector financial mix was over 70% in stocks. This took out the bubble peaks in both 2000 and 2007. While this ‘feedback loop’ could conceivably go on indefinitely, the risk is that the return to the median valuations is a much bigger drop, particularly so in a market where ‘quantitative’ and ‘algorithmic’ trading programs means more immediate adjustments to prior levels. The gap between stock market performance and earnings has continued to widen this year as the S&P500 has continued to make new highs even with analyst earnings revisions for 2025 having peaked and year-over-year earnings growth only in the single digit range. The result is that the equity risk premium (the excess return that investing in the stock market provides over a risk-free rate) has dropped to a mere 50 basis points, versus the historical norm of around 300 basis points. Only two other times in recorded history have valuations been as excessive as today: 1929 and 1999! In other words, ‘look out below’ if this euphoric scenario begins to unwind!
Investors and speculators don’t like bonds! But that might ultimately present a great opportunity to buy. While there is far more that we don’t know than we do know about the incoming Trump administration, the one thing seems to be clear is that almost all of his election promises (extend 2018 tax cuts, corporate tax down to 15%, no taxes on tips, punitive global tariffs, mass deportation which reduces workforce) would tend to be both expansionary and inflationary. That probably means less room for the Federal Reserve to cut interest rates than stock market investors currently anticipate. While we had seen the ultimate destination of short-term interest rates (the ‘neutral rate’) to be in the 2.75-3.00% range, we now see this target range as being 3.25-3.50% due to higher expected nominal economic growth and more stubborn inflation. We also think the path to these ultimate rate targets could be slower. The sudden reversal of sentiment on the path of interest rates has made investors more wary about the bond market. The chart below shows the positioning of traders in the futures markets for the 10-year Treasury Bond in the U.S. The ‘net short’ position of over 1.2 million contracts, by far the most bearish positioning on record, suggests that investors fear the 10-year yield could be headed back to the 5% level that it almost reached in late 2023. While the incoming administration has certainly lifted inflationary risks due to expectations of expansionary policies in an economy that is already growing, believe that 5% would be an absolute ceiling on those rates since they would ultimately slow down the economy and thus ‘self-correct.’ While we have not yet added back to long bond positions in the U.S., we see yields for 10–30-year bonds above 4.5% as a very attractive re-entry point with very little downside risk. It also provides an income cushion and is a good hedge against any potential correction in stock prices.
If you need any further evidence that the post-election surge in equity prices was overdone, take a look at what insiders are doing. The Financial Times reported that record numbers of U.S. executives (in two decades of tracking) are cashing in their shares and options in their own companies. When the managers and other insiders of Goldman Sachs, Nvidia and Tesla are taking profits and locking in their gains, that’s a strong signal the rest of us should be thinking along the same lines!