Markets are priced to perfection on the Trump trade. Here’s why that could be a problem

Investors have been busy for at least the past several weeks bidding up prices in anticipation of what President-elect Donald Trump will do when he takes office. Expectations are running high that potential tariffs won’t lead to adverse outcomes, the 2017 tax cuts will be renewed and be accompanied by others, and deregulation will spur dealmaking on Wall Street and lead to lower energy prices. That, of course, raises the question: What if they’re wrong? More specifically, the anticipated course of lower taxes, less regulation and spending on energy and other initiatives has fueled a run in which the major averages have posted solid gains while prices for gold, silver and cryptocurrencies also have rallied. The S&P 500, for instance, is up about 3% over the past month, when bets started to accelerate that Trump would prevail. In some corners, there is concern that the market is pulling forward gains now and could pay the price later, particularly if the Trump initiatives not only boost growth but also aggravate inflation, as some economists fear. “The markets were on a roar coming into the election, and now they are on a postelection high, really trading on euphoria, lower taxes, the pro-business stance of this new administration,” Holly Newman Kroft, managing director at Neuberger Berman Private Wealth, said Tuesday on CNBC. “The market’s going to have to digest what the impact of this sort of tug-of-war between the pro-growth positioning of this administration and the risk of higher inflation.” Inflation wasn’t an issue the last time Trump took office in 2017, but it is now, even though it has drifted back toward the Federal Reserve’s 2% 12-month goal. October’s core consumer price index reading, excluding food and energy costs, came in at a 3.3% annual rate on Wednesday, far from the Fed’s desired target. While Trump’s stated intention to slap 10% across-the-board tariffs on imported goods might not in itself reignite price pressures, a full-blown global trade war could. It’s also a different policy environment from then.

Trump presidency — then and now

When Trump took office in 2016, not only was inflation tame but the Fed’s main policy rate also was anchored near zero. Now, it’s in target range of 4.5%-4.75%, a restrictive level as central bank policymakers seek to balance a relative easing on inflation against concerns that the labor market is weakening. The stock market could yet post more gains into the end of the year, “but we are not chasing trends aggressively into 2025,” said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. “For starters — this is not 2016 redux. Trump entered that year amid tailwinds related to an economy finally emerging from six years of secular stagnation with fed funds at zero,” Shalett said in a note. “While markets may be discounting policy certainty based on a monolithic view, our experience suggests that the current Trump policy agenda entails risks and contradictions that put a premium on sequencing and execution, even with strong congressional backing.” In other words, Trump’s full goals may not come to fruition, and even if they do the timing of their implementation is uncertain. The investing implications are important, though perhaps not so ominous, according to strategists such as Kroft and Shalett. Despite her caution, Shalett said Morgan Stanley is “not inclined to fundamentally revisit our asset allocation advice” and instead is simply advising clients not to overload on risk and focus on “broad balance and diversification.” Kroft also is recommending diversification and a focus on higher-quality names rather than chasing momentum. For instance, she said Neuberger Berman is underweight high-yield bonds and emerging market debt while taking an overweight position in small caps, which have performed well since the Trump victory.

The Fed question

There’s another significant wrinkle, though, in the investing landscape: If Trump’s agenda drives an uptick in economic growth and inflation, that could change decisions on policy. Indeed, futures markets in recent days have recalibrated their expectations lower for the pace of interest rate cuts next year, now seeing the federal funds rate settling in a range of 3.75%-4%, or about half a percentage point higher than just a few weeks ago. Trump favors lower interest rates and berated the Fed the last time he was in office for hiking in the face of economic weakness. While such uncertainty could be cause for concern, there’s also a case to be made that it’s a good thing. Market veteran Jim Paulsen, citing research on economic uncertainty, said markets actually are inversely correlated, meaning more uncertainty has led to higher stock prices. “Historically, when economic policy concerns have become as extreme as they are today … the negative fundamental fallout from excessive worries about the future direction of monetary and fiscal policies tend to be more than offset by support from a large Wall of Worry,” Paulsen, a former chief strategist for Wells Fargo, wrote in a Substack post. That doesn’t mean there can’t be some near-term volatility, and the past two days have shown some slowing in the Trump rally. “I don’t think we’re falling apart and I don’t think the market’s all that far ahead of itself so much as people think,” Paulsen said in an interview. “This is just a normal ebb and flow of the market. We’re ready for an ebb at some point.”