It was a pretty solid week for the equity markets in the U.S., but beneath the surface there’s an interesting rotation going on. The big earnings news came from NVIDIA, and as usual, they posted stagging growth numbers. But interestingly, the stock was flat for the week. Two other members of the Magnificent Seven traded even worse – Amazon and Google lost -3% and -4% respectively.
Conversely, bank stocks managed to rally about +2% while small-caps stocks were up over +4%. Gold prices went up even though the dollar rallied (they typically move inversely to each other) and Bitcoin came close to tagging $100,000 on Friday.
If there’s a theme underlying all these gyrations it’s that investors are trying to position for the new administration. Banks are rallying because there’s a thought that the pending Basel III capital requirements will be abandoned early next year. Banks and brokers are also seen to benefit from an easier anti-Trust/M&A environment. But all of this sector rotation has something of a ‘clutching at straws’ feel to it because we simply don’t know what the focus of the new administration will be. From a broad market perspective, it’s hard to know what the fallout will be from policies that can and probably will work at cross purposes.
If the overall policy goal is full employment, for example, some of the initiatives listed above move in that direction, while others push against it. Furthermore, the above exhibit is too simplistic in that tariffs, for example, might be negative at first blush, but depending on the specific details of the plan and the reaction of other countries, it might go from being a clear negative to ‘much ado about nothing.’
Tariffs and Inflation – It’s a Bit Of a Headscratcher
There’s a lot of talk that whatever new tariffs the incoming administration rolls out, it’s bound to be inflationary and bad for bonds and maybe stocks. But even on this single issue, there’s a wide range of opinions. Let’s dig a bit deeper.
One notable feature of the last couple of weeks has been the move in the U.S. dollar. As soon as the election results were in the dollar took off to the upside, with the euro in particular showing weakness as it pushed closer to parity versus the dollar.
We saw something similar in 2016 after Trump was elected the first time. The market started to price in both fiscal easing and stronger growth and a widening in interest rate differentials between the U.S. and most other countries. The chart below overlays the current election cycle on the 2016 experience.
To quote Robin Brookes:
“The 2018 experience is instructive in this regard. Back then, the U.S. tariffed half of all imports from China at a 25% rate for an average tariff rate of 12.5%. The yuan fell around 10% against the dollar around then (chart below), in what was an almost one-for-one offset for the hit to competitiveness.”
What this means in practice is that even though the 2018 tariffs theoretically increased the prices of Chinese imports, the net effect was far more muted because the stronger dollar/weaker yuan offset much of the price shock. Hence, inflation during this period generally trended lower.
Now granted, the economy is awfully complex and there are untold moving parts, but it’s tricky to say that the last batch of tariffs triggered an inflation problem. That had to wait until 2020 and 2021 when fiscal spending took off and the government started mailing everyone a feel-good check.
So how do you model possible tariffs in 2025? It’s tricky because you have to answer the question of how will China
respond. Will they impose tariffs themselves, or will they allow their currency to depreciate versus the dollar to offset the impact of our tariffs?
Goldman took a stab at this analysis this week. What their model shows is that for every 1% increase in the effective tariff rate, core inflation might increase by +0.1% (right panel in the chart below).
As you can see from the left panel, a blanket 20% tariff on all Chinese imports works out to roughly a 3% increase in the effective tariff rate. So the inflationary impact will be about +0.3%. Universal tariffs will have a much bigger impact – about a +1% increase in core inflation.
Of course, we have to take all of this with a grain of salt. But it does help put things into context. And again, to the extent the yuan or the euro depreciates by more than the embedded assumptions in this model, the smaller the inflationary impact.
The chart below will be interesting to watch in 2025.
(Other) Charts We Found Interesting
- The dollar bull story rests in part on interest rate differentials between countries.
- Circling back to the outperformance of bank stocks, a secular change in lending growth could play a part in the upbeat story.
- It’s going to be hard to cut government spending much without tackling entitlement spending.
- It’s a similar story when it comes to cutting federal government employment. Most government employees are at the state and local level.
- The European Union is still (amazingly) importing natural gas from Russia.
- Seasonal weight gain in the U.S., Japan, and Germany. Some view this as a cautionary tale. Personally, I take this as a challenge to be above average!!
Have a good weekend
Charles Blankley
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