To read the full article, see the Investment Strategy Quarterly publication linked below.
The results of the 2024 US election, which concluded with a Republican sweep, ended months of uncertainty regarding the next few years. Markets seem to have become very positive on the prospects of a unified government that should, potentially, take some of the typical uncertainties off the table, i.e., a non-contested extension of the debt ceiling, etc. Having more certainty is great for markets. Still, the Republican sweep opens other uncertainty avenues that could affect the prospects for economic growth, inflation, and interest rates going forward.
Economic growth
As has been the case for the last several years, economic growth continues to be on a strong footing, helped lately by very strong tailwinds created by the fiscal expansion provided by the CHIPS, IRA, and Infrastructure Acts as well as by a weakening but still relatively strong employment environment. The last several years have shown that, while important, the manufacturing sector's weakness should not prevent the US economy from continuing to show economic strength. As long as the new administration’s policies tend to keep this economic environment more or less unchanged, the US economy can continue to grow over the next several years. If that is not the case, then once we have the new policies implemented, we will assess the potential effects on economic growth.
Inflation
Strong growth during the last several years has not prevented inflation from decelerating after what happened in 2021 and 2022. The normalization of supply chains, the drawdown of excess savings over time together with the ‘revenge spending’ triggered by the end of the pandemic, as well as the Federal Reserve's (Fed) high interest rate policies have allowed inflation, finally, to approach the Fed’s target of 2.0%. However, the path to the 2.0% target rate has been slower than Fed officials would have liked as shelter costs have continued to remain uncharacteristically strong during this period compared to the past. Fed officials have been very lucky as energy prices have continued to support lower inflation. However, trusting energy prices to continue to behave in support of the Fed’s monetary policy objectives is not a sustainable (or even recommended) strategy.
Today, the Fed has to deal with the potentially inflationary consequences of the incoming administration’s policies, especially regarding tariffs as well as deportation of illegal aliens. Although there are still unknown details such as the depth, extent, and application of such policies, an analysis of the economic consequences points to potentially higher inflation going forward. As we have said in the past, it is not that we believe we will have higher inflation going forward—however, if there is the potential for inflation to move higher in the future, this will trigger a change in Fed monetary policy, which could include interest rates staying high for longer or even pushing the Fed to increase rates if the inflationary consequences of these new policies merit such a move.
Interest rates
Economic growth as well as inflation will determine the path of interest rates. This has been confirmed by markets, which are now expecting high interest rates to stay with us for a longer period of time. And we agree with markets at this junction. For now, elevated interest rates have not been a constraint on economic growth. High interest rates have not been binding for real nonresidential investment while they have been binding for real residential investment. However, as the effects of the fiscal expansion created by the CHIPS and IRA, and to a lesser extent, the Infrastructure Act, continue to fade away, interest rates are going to become a constraint on economic growth.
But perhaps the biggest risks for the US economy are higher interest rates from potentially higher inflation due to tariffs and the proposed deportation of millions of illegal migrants. While the impact on inflation from the curtailment of illegal immigration is going to take some time to feed into wages across the different industries affected, i.e., construction, agriculture, hospitality, etc. (see infographic on next page), and then into inflation, the effects of the imposition of tariffs on imports from the rest of the world is going to have an almost immediate impact.
