How can investors separate the policy changes that are likely to really matter for the economy from those that get a lot of press but may not have the most traction?
November 21, 2024
By Atul Bhatia, CFA
With the incoming Trump administration discussing a raft of potential policy initiatives, we think it’s worthwhile to discuss how to approach analysing these measures. Rather than delve into the details of any specific idea, we want to offer a framework for thinking about the potential short-term economic consequences of policy moves.
In general, we think it’s helpful to break down proposals on three general lines. How much of the economy does the proposal touch, both directly and indirectly? What sort of change is being proposed – is it so radically different from current policies that estimating its impact could be difficult, or is it just a difference in degree from what we’ve already done? Finally – and perhaps most importantly – how durable is the impact? Are there potential countervailing forces? Is the administration able and willing to modify policy parameters based on the policy’s effect?
When looked at through these prisms, it seems to us that many of the proposals that get the biggest headlines – such as tax cuts and tariffs – may not be that consequential. Others, meanwhile – such as the Department of Government Efficiency (DOGE) and immigration policies – could have a bigger short-term economic bite.
President-elect Donald Trump’s proposed tariff regimes are certainly broad: they will likely apply to every import into America. Retaliation by trading counterparts means that U.S. exports will likely be impacted as well, so tariffs are certainly meaningful in scope.
But they’re hardly new; tariffs in America pre-date the country’s founding. At its core, a tariff is just a tax designed to change consumer behaviour. Anyone who has ever bought a pack of cigarettes or a bottle of wine is quite familiar with the concept. The difference between a tariff and other forms of behaviour-modification taxes is simply the political goal – import substitution versus public health.
Nor are any changes likely to be written in stone. Even on the campaign trail, Trump was floating wide-ranging tariff proposals. Since Republicans control the machinery of lawmaking, it strikes us as very likely that the White House will have both the ability and willingness to modify tariff levels as conditions change on the ground. So, in our framework, tariffs don’t appear that risky – they’re a well-known tool that is easy to modify, offsetting the breadth of their application.
Debt-funded tax cuts are a similar case. Yes, higher budget deficits are very likely to add to inflation in the near term, and unlike tariff levels, tax rates are difficult to change on the fly. But no one can seriously contend that a budget deficit is something new for the U.S. economy.
More importantly, fiscal policy doesn’t exist in isolation. The U.S. Federal Reserve can help offset any inflation with higher interest rates, and the U.S. economy also dynamically adjusts to rising prices, with consumers and producers changing behaviour in response. These adjustments won’t be painless for the economy or investors, but they are part of the normal evolution of background macroeconomic conditions. Because of familiarity and ease of offset, we think budget deficits are likely manageable.
Two areas of policy change that look potentially more challenging in the short term are immigration and the DOGE.
If the Trump administration reduces the undocumented population of the U.S., it wouldn’t be unprecedented. Pew Research Center estimates show multiple years of decline in the recent past. But the largest prior episode coincided with declining U.S. labour demand because of the global financial crisis. Policies that prioritise immigration enforcement over labour supply are rare, particularly at a time of approximately four percent unemployment.
Source – RBC Wealth Management, U.S. Census Bureau 2022 American Community Survey
There are also few natural economic offsets if the administration were to dramatically reduce the roughly five percent of the workforce that is undocumented. Given the existing lack of available workers, wages would likely rise, an important inflationary precursor. And with nearly 18 percent of the construction and agricultural supply chain workforce lacking work authorisation, according to U.S. Census Bureau data, there are risks of disruptions in the housing and grocery sectors.
Policy responses are limited, in our view. Fed interest rate hikes could help with some of the wage-driven inflation, but they are largely ineffective against supply-driven price hikes. It would be politically difficult, we believe, for the administration to reverse course. All in all, this makes immigration an area to watch for investors under our framework – a novel proposal, with high impact on key sectors, and with limited available course corrections.
If the DOGE succeeds in increasing government efficiency – achieving the same outcomes using fewer resources – that’s almost certainly both a long- and short-term economic win, as we see it. There are few economic concepts more powerful than efficiency.
Based on public comments, however, it strikes us that the DOGE may not be looking to keep outcomes constant and is instead looking to cut government programmes and employees. Whether that will pay off in the long run depends on the details, but in the short term, it looks to be an area for investors to watch. Large cuts to government services, if that is what happens, are rare in the U.S., and they would touch a sector that directly contributes roughly 20 percent of U.S. GDP and indirectly impacts most of the economy. Depending on exactly what the DOGE does, we believe it could be difficult to make midstream course corrections.
Even within the Trump administration’s likely policy mix, there are forces that could pull in different directions. Shrinking the government is likely, in our opinion, to limit short-term growth and could help with inflation, while debt-funded tax cuts likely provide a fillip to economic activity.
More broadly, we see the new administration as likely to propose and execute on a wide range of different policies. As investors, we think a useful framework to approach these changes is looking at the magnitude, novelty, and durability of their impacts, as a way of distinguishing the potential game changers from the normal give-and-take of macroeconomic conditions.
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