There are five KPI’s risk appetite will be monitoring:
1. Will ‘MAGA’ shift the needle in terms of US long term potential growth?
A key issue for the US economy has been the downgrading of long-term trend or potential growth over the last 30 years. During the 1994-2006 period, trend growth forecasts stood above 3% but forecasts have declined to 1.8% (Congressional Budget Office forecasts) driven by lower labour force and productivity growth. A key measure of Trump 2.0 economic policy success is whether they deliver an upward inflection in these forecasts.
Exhibit 1: Can Trump 2.0 improve the US potential growth forecast trajectory?
2. Avoid concerns that tariffs and tax cuts will produce a sustained uptick in inflation expectations
During the first Trump administration the imposition of both import tariffs and tax cuts (fiscal expansion) saw import prices and inflation expectations (breakeven inflation) ratchet higher. This eventually forced the Fed into a tightening cycle. Exhibit 2 shows that the latest move in US breakevens is tracing the move witnessed back in 2016 through to inauguration in 2017.
Exhibit 2: Avoiding replay of the uptick in inflation expectations through to inauguration.
3. Prevent inflation concerns altering the Feds reaction function.
As markets started to price in a Trump administration from September, year-end 2025 interest rate forecasts increased 100bp from a low of 2.75% in August. This still means the markets are anticipating aggregate cuts in interest rates over the next 12 months but that the tempo of the cuts is being curtailed. A big test for risk appetite would be if the Fed change tone in response to rising inflationary expectations.
Exhibit 3: A curtailment in the ‘tempo’ of rate cuts to year-end 2025
4. Can Trump 2.0 deliver a repeat surge in corporate margins and profitability?
The first Trump administration oversaw a sustained uptick in corporate margins and profitability. This saw equities deliver a 48% return over the first three years of his tenure up to the Covid pandemic in early 2020.
Exhibit 4: Equities responded well to the uptick in corporate margins during Trump 1.0
5. Preventing the ‘Fed Model’ valuation turning negative?
The ‘Fed Valuation’ model measures the spread between the bond yield and the earning yield (inverse of the PE). Due to the recent rise in the bond yield and the 12M PE ratio, the spread is effectively at 0%. When the first Trump administration took office the spread was above 3% signaling equities carried a positive risk premium. The last time the spread turned negative was at the peak of the TMT bubble in the late 1990’s. There is a risk that any subsequent hike in bond yields could generate valuation anxiety and be seen as a negative for risk appetite.
Exhibit 5: Trump 2.0 is inheriting stretched ‘Fed Model’ valuations
Source: Wilshire Indexes, FactSet. Data as of November 18, 2024.
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