What will a second Trump presidency mean for markets?

Donald Trump’s 2024 presidential election victory has had a profound impact on financial markets. The most notable impacts have been to the performance of U.S. small-cap stocks relative to large-caps, of U.S. stocks relative to non-U.S. stocks, and of U.S. stocks relative to U.S. bonds.

We have seen gradual divergences in these asset class pairs recently, particularly over the period beginning October 9—the date that election prediction markets began to tilt in Trump’s favor.  Not surprisingly, that is also when financial markets began to reflect the potential impacts of a second Trump presidency.

Since then, small-cap stocks have outperformed large-cap stocks by just over 2 percent (which is a significant departure from recent history), U.S. stocks have outperformed non-U.S. stocks by almost 8 percent, and U.S. stocks have outperformed U.S. bonds by nearly 5 percent.

Some of the reasons behind these trends are obvious.  Non-U.S. stocks have sold off due to concerns about the impact that higher tariffs on imported goods would have on U.S. trading partners if Trump delivers on his campaign promise to significantly raise tariff rates upon taking office.

Meanwhile, U.S. bonds have sold off because two of Trump’s most prominent campaign promises are expected to increase inflation.  Higher tariffs likely would mean higher prices on imported goods—costs that typically are passed along to consumers.  Stricter immigration policies would likely result in tighter labor markets, leading to higher wages and upward pressure on prices.

Pent-up economic activity could be released

Despite the broadly held view by economists that higher tariffs and tighter immigration policies would be bad for the U.S. economy, growth expectations have been rising recently. This reflects a belief that significant pent-up economic activity might be released now that election uncertainty has been removed. Additionally, many business owners—particularly small business owners—are likely to become more optimistic, as they expect Republicans to enact more business-friendly policies.

Data from the NFIB—the National Federation of Independent Business—illustrates the potential for a release of pent-up economic activity. The NFIB’s index of small business optimism is currently at a historically low level, which appears to have had a dampening impact on business activities such as capital expenditures and inventory levels.

Notably, the last time the index rose sharply was from September 2016 to December 2016, when Trump was previously elected president. Many investors anticipate seeing a similar improvement in that measure in the coming months. Presumably, a sharp rise in optimism would lead to stronger business activity.

Regulatory policies should be business-friendly

Potential reasons for optimism about U.S. stocks also include the regulatory environment and the outlook for corporate taxes.

Regulatory burdens are expected to be cut back sharply under the Trump administration. Again, we can look back to the first Trump presidency to see the reasons for this optimism.

In 2017, Trump’s first year in office, the total number of pages in the Federal Register, which tracks the flow of government regulations, fell from over 97,000 to under 62,000. Such declines are considered business-friendly, because compliance with regulation tends to be costly and time consuming. These burdens are even more pronounced for small businesses, which have less resources to commit toward compliance.

Less regulation is also likely to make merger and acquisition, or M&A, deals easier and less costly. This could mean a rebound in M&A activity, which has fallen sharply over the past three years. M&A deals are often an important driver of small-cap stock performance.

Lastly, there is a chance that corporate tax rates will be lowered, as they were during Trump’s first term in office. However, there is more investor skepticism about this potential outcome, given the already-elevated federal budget deficit and the need for congressional support for any proposed tax changes.

Inflation concerns

Despite the potential positives, much of the Trump-driven optimism for U.S. stocks ultimately could be upended by rising inflation concerns.  As noted earlier, higher tariffs and tighter immigration policies are expected to put upward pressure on costs and prices.

This is in stark contrast to the inflation environment that Trump encountered the last time he took office. In 2017, inflation expectations not only were extremely low, they had been low for the previous nine years. In fact, the U.S. Federal Reserve’s target for its key federal funds rate had been held near zero since December 2008 in an effort to keep inflation from getting too low. So the rise in inflation expectations that accompanied Trump’s victory in 2016 was actually a welcome development.

That’s very clearly not the case this time. Inflation expectations have been elevated for over four years. The federal funds rate is now over 4.5%, and the Fed is currently in the midst of a rate-cutting cycle that many investors, businesses, and consumers hope will bring further relief from interest costs well into 2026.

But an abrupt rise in inflation now could lead Fed officials to stop cutting—or even force them to begin raising rates again. Such a scenario could generate significant market volatility, including a potential sell-off in both stocks and bonds—as was the case when the Fed began hiking rates in 2022.

Conclusion

The market optimism engendered by Trump’s election victory is well supported by the potential impacts on business activity, particularly small business.  However, Trump’s promised policies carry the risk of reigniting inflation concerns that ultimately could derail the optimistic scenario many investors seem to envision.

Given the positive near-term outlook, our Asset Allocation Committee is maintaining an overweight position in stocks. However, the committee is also keeping an overweight position in real assets equities, which historically have been an effective hedge against rising inflation. Additionally, we will carefully monitor the economic landscape for any signs that inflation once again will become a significant problem.

January 2000 to October 2024.
Source: Macrobond/National Federation of Independent Business.

Weekly, January 1, 2010, to November 15, 2024.
Source: Bloomberg Finance L.P. Data analysis by T. Rowe Price.
¹Two-year inflation expectations = breakeven yield on the 2-year Treasury inflation protected security (TIPS).