Our Variables – What do we need to manage around?
There aren’t many comparisons to be drawn between investing and quantum physics, but the policy cocktail in store for 2025 is one of them. There are three states of the world we could legitimately find ourselves in once the new administration’s economic agenda takes hold, and the only way of knowing with certainty which one we end up in is through observation. In the short-term, the constants laid out in the previous section are likely to keep baseline growth healthy.
1. The initial phase of decoupling and the infrastructure boom creates a demand shock that keeps inflation above target in an inflationary boom. In this environment it makes sense to own growth equities and real assets to capture upside and hedge against the erosion of value from higher inflation.
2. The optimal long-term outcome that this could transition to is a deflationary boom. This hinges on the productivity boost from AI materializing in a way that supplements labor and effectively lowers input costs. The range of estimates on the size of this boost is currently so wide that there is little to be gained by speculation until we see it in practice. Virtually all assets have the potential to perform well in this end state.
3. The risk scenario is that overly restrictive tariffs and a longer-than-expected timeline for AI to realize its potential create a stagflationary environment in which few assets can offer an attractive risk/return profile. With most of the risks being to higher inflation, and a strong foundation for growth, we believe we can take a deflationary bust outcome off the table.
Policy pronouncements since the election have skewed extreme, their actual implementation will likely take a more moderate shape. Take the 25% tariff proposal on Mexico and Canada as an example. Bilateral trade between the U.S. and Canada looks surprisingly symmetric for the largest categories of goods that flow across the border. 6.2% of the U.S.’ imports from Canada are cars, 5.5% of Canada’s imports from the U.S. are also cars. This isn’t a coincidence, U.S. automakers built cross-border supply chains under NAFTA. The parts and assembly process for a single car will cross the border multiple times. It follows that a blanket tariff on this flow would exceed the profit margin of U.S. automakers and almost certainly necessitate price increases. Such a policy looks unlikely to be implemented at face value and is more likely to be a negotiating tactic. We find it more productive to focus on the proposal to increase tariffs on China. As the United States’ main geopolitical adversary and less interdependence than with direct neighbors, we see this proposal as having a higher likelihood of passing. Whether it will be precisely targeted to minimize the effect on consumer prices, like those of the first Trump administration, or is more of a blanket policy is still unknown.
As we covered in detail in our last market insight, the government debt issue has the potential to become a major drag on markets and the economy at large. On average, the U.S. issues as much debt in a week as entire developed economies have outstanding in total. Policymakers will need to make outgrowing the debt a priority if we are to avoid a crisis that spirals out of control. The path for the Fed is an equally important input in bringing down the interest burden of the debt on discretionary government spending. They are dealing with the same set of uncertainties as the rest of us, data-dependence means they will also be watching and waiting. It’s entirely possible that we get four cuts this year and equally possible that we get none.
