US election: impact on the economy and capital markets?

What could happen if Trump becomes US president again?

Executive Summary:

The USA's high level of debt actually requires a rational, growth-promoting policy. This is not to be expected from Trump, as he would weaken the US economy with new trade restrictions and a planned reduction in the supply of labor, while at the same time increasing the risk of inflation. The planned end to the independence of the US central bank would further increase inflation risks.

US equities are unlikely to benefit from this, as they are already heavily overvalued and any further corporate tax cuts that Trump would like to achieve would not be sustainable given the US government's financial problems. US residential real estate is a good hedge against the inflation risks that a Trump administration would trigger due to its high correlation to the consumer price index, but it is overvalued. The best protection against the consequences of Trump's policies is gold.

Anyone with very high levels of debt will have to put their finances back in order at some point by cutting costs. However, there are certain differences between companies and private households on the one hand and the state on the other. The former can severely restrict their expenditure without damaging their income. If you give up expensive vacations and new clothes for a few years, you may raise eyebrows among friends and acquaintances, but you probably won't lose your job. The state, on the other hand, cannot cut spending indefinitely because it weakens the economy by reducing investment and cutting civil servants' salaries or social benefits, thereby reducing tax revenues. In the US, not only government debt is very high, but also that of companies and private households (difference between red and orange line in chart 1); total US debt has been higher since the coronavirus crisis than ever before in US history (chart 1, debt was also low before 1947 as companies and households had little debt). This means that a recession would hit both the private sector and the state harder than before. When government debt was very low in the 1970s, government debt as a percentage of national income hardly rose at all (chart 2). Even in the three recessions between 1982 and 2002, debt growth remained moderate. However, during the financial crisis from 2008 and the brief coronavirus crisis in 2020, government debt rose very sharply. In view of the increasingly deteriorating geopolitical situation since 2020 (war in Ukraine, Gaza and Lebanon, dispute over Taiwan) and the growing number of elderly people who are dependent on state support, the next recession in the US is likely to lead to a renewed increase in government debt, especially as current deficits are already at 7% of national income even without a recession (source: US Federal Reserve St. Louis).

In democracies, politicians who save money also risk losing their jobs. Promoting economic growth is therefore a better alternative to saving. In the following, we will answer the question of which of the two candidates for the US presidency - Kamala Harris or Donald Trump - has a better recipe for the US economy.

The first point goes to Kamala Harris. Prof. Moritz Schularick, President of the Kiel Institute for the World Economy (IfW), calculated in a 2022 study that right-wing or left-wing populist governments (chart 3) pursue the wrong policies when it comes to promoting long-term economic growth; the average decline in economic output since a populist government took office was already over 8% after 6 years, and later well over 10% (chart 4). With his basic conviction ("I love the poorly educated", source: www.welt.de from 24.2.2016), Trump is a classic populist.

The results of the above-mentioned study can be made plausible by two simple calculations. If you look at the democracy index of the respected British business magazine The Economist (source: Wikipedia, keyword "Economist Democracy Index") and the corruption index of Transparency International in context, you can see that corruption is comparatively low in complete democracies (democracy index of 8 - 10) with an index value of a maximum of 40 (Figure 5). In contrast, the corruption index is much higher in countries that are less democratic or not democratic at all (democracy index below 6).

However, corruption is closely related to per capita income; countries with a low corruption index of no more than 40 have a high per capita income and vice versa. Since Trump not only talks about his view of the ideal voter ("uneducated"), but also about his anti-democratic plans ("Dictator for a day?": Source: www.tagesschau.de from 6.12.2023), it is reasonable to assume that the USA's democracy index will not improve under a President Trump.

At the same time, the future stability of US public finances is gradually being jeopardized by the increasingly irrational and unsustainable taxation of companies and top earners over the past 40 years.

Until 1982, both corporate taxes and top income tax rates in the US were raised in line with the national debt, e.g. until 1945 to finance the costs of World War II, or lowered again afterwards because the national debt as a percentage of national income was declining (charts 7 and 8). After 1982, this completely understandable logic disappeared from the US tax system. Since then, the national debt has risen sharply again, but the tax burden on companies and top earners has continued to be reduced to this day. Trump famously stages himself as the defender of the interests of the "common people" against the "elite", but during his first presidency from 2016 to 2020 he made policy for the "elite" by cutting corporate taxes from 28% to 21%, thereby further increasing the national debt, and is planning another cut in corporate taxes for his hoped-for second presidency, which he wants to finance with tariffs on all imported goods. This policy is certainly not in the interests of "ordinary people", as they will have to pay the price increase on all goods imported from abroad as a result of higher tariffs, while they will not benefit from the further reduction in corporate taxes. Businesses will be hurt by the tariffs in that domestic sales will fall due to the tariff-induced price increases and there is a risk of tariffs on US goods by foreign governments in retaliation, hurting US companies' export business. This policy is so nonsensical that, interestingly, even the boards of the 100 largest US companies do not want to support it (chart 9).

Charts 10 and 11 show the expected consequences of Trump's program for government debt. These will increase significantly more than if Kamala Harris had won the election.

As Trump's advisors are of course aware that this program is likely to lead to difficulties in future government financing, they are also bringing into play the abolition of the independence of the US central bank, which is not enshrined in law in the USA. There's no need to go on and on about this; chart 12 from a well-known 1993 study gives a clear answer to the consequences of removing the independence of a central bank.

Interim conclusion

• Trump's tariff policy is more likely to damage economic growth in the US. Imposing tariffs drives up inflation, reduces the purchasing power of US consumers and thus consumption, and creates the risk of foreign trade restrictions against US companies.
• Trump's planned recruitment ban for foreign skilled workers also has an inflationary effect, as the growing shortage of skilled workers leads to higher wages.
• A possible abolition of the independence of the US central bank has an inflationary effect.
• A higher government deficit due to tax cuts exacerbates the already problematic situation of US government finances and increases the need for government bond purchases by the US central bank in the next crisis in order to keep interest rates down as credit ratings weaken.
• A renewed presidency by Donald Trump is therefore likely to be another example of the negative influence of populist governments on a country's economic development (see chart 4).

The expectation of another sharp rise in government debt is based on the trend over the last 55 years. Chart 2 shows that in the periods of low government debt up to 1980, a recession had hardly any impact on new debt. Chart 13 shows the red figures in chart 2 as a bar chart, which illustrates the dramatic nature of the situation.

As the US government already needs a deficit of 8% to keep the economy running even without a recession, whereas a maximum deficit of 5% was achieved by 2020 before recessions (chart 14), it is to be expected that a coming recession with increased social spending for the unemployed and falling tax revenues from employees and companies will quickly push the deficit into the double-digit percentage range.

The following charts show that the leading economic indicators of the US forecasting institute The Conference Board (TCB) in all three major economic regions of the world - the USA (chart 15), China (chart 16) and the eurozone (chart 17) - have been on a downward trend for the past two years. This trend also continued in the current month (for the high hit rate of the TCB Leading Economic Indicators for the USA since the 1950s, see the June 2024 Capital Market Outlook, which you can find here ).

These deteriorating future prospects for the major economies are being ignored on the equity markets. The current narrative for equities is that a certain weakening of the economy and thus further interest rate cuts by central banks is certainly expected, but not a recession, as the interest rate cuts will soon accelerate economic development again.

However, this sequence of interest rate cuts and economic development has never taken place in this way in the US in the last 70 years. Chart 18 shows the timing of the start of interest rate cuts by the US central bank, which coincided with the start of the 7 recessions from 1953 to 1982. Thereafter, the rate cuts started a few months before the recession. The majority of interest rate cuts took place during the recession. Only once were there sharp interest rate cuts without a recession, namely in the mid-1980s. Before that, sharp interest rate hikes in the early 1980s had massively depressed double-digit inflation rates and the central bank was able to lower interest rates in a booming economy from 1982 onwards. This brutal fight against inflation with high double-digit interest rates under central bank president Paul Volcker was possible at the time because debt levels in the USA were far lower than they are today (chart 1). The 1980s cannot therefore be compared with today; the aforementioned narrative is ill-founded.

Against this backdrop, the current record highs on many major stock markets are dangerous. The US economy will weaken significantly as soon as the debt doping ends, the eurozone is barely growing and in China the government is already being forced to support the financial and real estate market through regulatory relief for banks and interest rate cuts for existing mortgage loans and short-term loans (source: Trading Economics, Sept. 2024). However, as China is in a balance sheet recession (the Chinese only want to pay off their debts but not take out new loans, no matter how low the interest rate is), these measures may stimulate the stock market in the short term (price gains of around 10% in the last few days), but will not generate sustainable growth.

Never before have share prices risen sharply in an environment in which the Leading Economic Indicators have been falling sharply for two years (USA, eurozone) or nine months (China) (charts 19 to 21, red oval). This is also not sustainable.

If the bull market in equities since autumn 2022 has been driven by hopes of massive interest rate cuts, the disappointment will be that for decades these have only been implemented during recessions (chart 18). In recessions, however, share prices tend to fall initially despite interest rate cuts (chart 22). The question of whether share price losses are high or low at the beginning of a recession is answered by the valuation. When US equities with dividend yields of 3.5% to 6% were cheap (the 6 points at the top right of chart 23), the subsequent price losses remained moderate. When stocks were highly valued (dividend yields below 3.2%), price losses averaged 42%. With a current dividend yield of 1.28%, the risks to share prices from a recession are considerable.

Trump's policy mix, which tends to weaken the economy and increase inflation risks, thus making interest rate cuts more difficult, does not improve this unfavorable starting position.

Given this uncertain environment, the record-high optimism of US private investors for the US equity market (chart 24) is difficult to understand and easy to shake: High optimism is also associated with weak future returns for US equities (chart 25).

Equities are therefore not the most attractive asset class due to the high level of optimism in the US, especially if Donald Trump becomes president.

The situation is somewhat better for US residential real estate, which, with a very high correlation of 0.98 (the correlation can fluctuate between -1 and +1), has almost always moved in parallel with the consumer price index since 1900 and would therefore benefit from higher inflation (chart 26). However, residential real estate in the US is not cheap; the feasibility index for home purchases in the US is currently very low because prices are high, American incomes are low and interest rates are not yet low again (chart 27).

The best insurance against a Trump-led US government is gold. Its price has also shown a high correlation of 0.91 with the US consumer price index for over 220 years (chart 28). However, unlike US residential real estate and despite the current record high prices, gold is not overvalued but undervalued. When the red line in chart 29 is high, e.g. in 1980, gold is very expensive compared to US equities, because at that time one ounce of gold (31.1035 grams) could buy five times the US S&P-500 equity index. The orange line was very low in 1980; gold lost over 4% p.a. in the following 10 years. Currently, 1 ounce of gold buys 0.46 times the S&P 500 index, so gold is cheap and stocks are very expensive.

‍Conclusion:

Trump's election program is in line with historical findings about populist or undemocratic governments whose policies have significantly damaged the economy of the country concerned. Trump's election program is also likely to weigh on the economy and drive up inflation rates. Trump therefore offers no advantages for US equities, which are already highly valued; these should remain underweighted in the portfolio.

US residential real estate is not ideal either. Although it offers an extremely high correlation to the consumer price index, it tends to be overvalued. Gold, on the other hand, is not overvalued, also has a high correlation to the consumer price index and is therefore a suitable protection for the portfolio against the effects of the planned Trump policy. This also applies to investors from the eurozone, as an inflationary US economic policy weakens the dollar and also the global economy, meaning that stronger demand for gold can be expected worldwide.

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As usual, we will repeat the key messages of our capital market outlook from three years ago so that you can get a feel for our long-term forecasts.

You can find the capital market outlook from September 2021 here. Three years ago, we pointed out the growing inflation risks due to the then corona-related expansion of the money supply, the increasingly deteriorating demographics, the deglobalization accelerated by corona and the energy transition.

We also calculated the suitability of various forms of investment to generate long-term returns above the inflation rate. The result: equities beat inflation by a particularly wide margin, but residential real estate and gold also achieve this goal.

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You can also download the capital market outlook here.