Stock Markets Are Soaring on the Back of the Republican Wave, but for How Long?

While economic indicators remain mixed in most of the world's major economies, the election of a new president to the White House has shaken things up and forced us to revise the outlook for growth. The deregulation and tax cuts proposed by Donald Trump could juice up US and global growth as early as 2025. Investor optimism and soaring markets could fuel growth even before the president-elect takes office. But all of the new policies he’s proposed could have an inflationary effect, which is already being reflected by sharply rising bond yields. New tariffs on imports and a reduction in the number of immigrants to the US could also hit medium-term growth, both in the US and abroad.

Unsurprisingly, the Federal Reserve (Fed) went ahead with a 25-basis-point cut to the federal funds rate on November 7. Although the meeting was held after the outcome of the presidential race was announced, it seems clear that the election’s result did not influence the Fed’s messaging. The risks to both sides of the Fed’s dual mandate (employment and inflation) seem to be more in balance, which will allow the central bank to increase its focus on normalizing monetary policy over the coming months. Investors quickly revised their key rate expectations for 2025 after Trump’s electoral victory. The Fed may very well have to slow the pace of its rate reductions to offset the inflationary effects of the policies that will be implemented by the new administration.

The Canadian economy still isn’t giving off many positive signals, even though the Bank of Canada (BoC) has cut rates several times since the summer began. Real GDP stayed flat in August, which suggests annualized growth will amount to less than 1.0% for the third quarter. The employment market also cooled in October, with just 15,000 new jobs added. This left the unemployment rate unchanged at 6.5% (graph 1). The good news is that more sustained US short-term growth could also push up demand in Canada. However, the negative effects of uncertainty over trade policy and potential tariffs could hit the Canadian economy later on.

One of the biggest impacts of the election of the new US president will be greater divergence between the Canadian and US economies. While new tariffs could adversely affect both countries, the hit to Canada could be bigger. Given the current weakness of Canada’s economy, the BoC is expected to keep its key rate on a downward path, despite the political change in the US. Rates may have to fall even further after 2025 to offset the adverse effects of US policies (graph 2).

Canadian government bond yields recently started following US yields back up (graph 3). And yet the weakness of the Canadian economy suggests that the BoC should keep cutting rates. These opposing trends have narrowed the spreads on products across the yield curve, making variable-rate loans an increasingly better deal for borrowers. Once the recent rebound has ended, bond yields should start ticking back down, but at a slower pace than variable rates, which will keep the latter more attractive than fixed rates.

The US dollar has been romping higher since the beginning of October, appreciating broadly against other currencies (graph 4). This upsurge is closely related to the recent rise in bond yields. Improved economic data in the United States helped push US bond yields upward, widening yield spreads with other countries and giving the US dollar an advantage (graph 5). Donald Trump's election has amplified this effect. Yield spreads have kept widening in anticipation of more inflationary policies, which is sustaining the US dollar’s momentum.

Economic literature generally shows that countries that raise tariffs see their currencies appreciate. Essentially, there’s no way to game international trade in a floating exchange rate regime. Exchange rates will tend to adjust to offset any economic advantage a country might try to gain over the rest of the world. Tariffs would also fuel inflation, which is sending projected interest rates for the US higher than for other countries, while also driving up the US dollar.

The Canadian dollar has lost nearly 3% of its value since October began. It’s now close to CAN$1.40/US$ (approximately US$0.715), a level that it hasn’t hit since the first wave of the COVID-19 pandemic back in May 2020. The Canadian economy may pick up over the short term, especially if US businesses accelerate their imports before new tariffs come into effect. The Canadian dollar and other currencies could enjoy some respite in the first half of 2025, especially if US bond yields slide. But the longer-term economic prospects look gloomier, and we have revised our forecast for the Canadian dollar significantly downward. The loonie should end up around CAN$1.42/US$ (US$0.71) by the close of 2025, rather than appreciating against the dollar as we previously expected.

US stock market indexes ripped higher after Donald Trump's victory was announced, while investors turned away from government bonds (graph 6). The Republicans have won both houses of Congress, which means the president-elect will be able to quickly introduce tax cuts that should boost corporate profits. Investors have therefore focused on the positive effects that these measures will have on businesses, while choosing to ignore the risks associated with tariffs and reduced immigration for now. But, despite the above, they have acknowledged the potential inflationary impact of Trump’s proposals, leading them to revise their expectations regarding key rates. 

While the market's response to the election of Donald Trump may seem disproportionate at first glance, investor optimism may make more sense once we look at what happened during his previous term as president. It was marked by initially strong market gains and a period of rapid earnings growth driven by cuts to corporate taxes (graph 7). Now that equity market valuations have reached record highs while economic growth is expected to be modest, profit-boosting measures may be just what’s needed to justify further market gains, at least over the short term.

Although we can expect market-friendly measures during the first few months of Trump’s term, the outlook could dim later on. Heated trade negotiations with several countries and the imposition of tariffs on US imports could sap investor confidence and penalize certain businesses. Canadian companies wouldn’t be protected from these tariffs, and even if they weren't enforced, the threat of tariffs could discourage investment. Although the S&P/TSX will likely be buoyed by renewed optimism and measures that will provide short-term stimulus, its gains may be smaller and more easily reversed than its US equivalent’s. That said, the steep rise in the US market probably won’t last either, and the medium-term outlook remains more muted.

The risks related to US trade policies could be particularly high for European and Asian economies. Some central banks may need to lower their key interest rates even more than previously expected. In the eurozone, inflation is on a more encouraging trajectory than it was a few months ago, which should reassure European Central Bank officials. The downtrend in UK inflation also accelerated, but the Bank of England is sticking with a more cautious approach, as it has thus far avoided signalling that it would cut rates in quick succession. The outlook for European corporate earnings recently deteriorated, while the yen’s volatility does not bode well for returns on the Japanese market (graph 8). This could mean that global markets may not advance as much as expected.

The US election’s outcome was particularly good for risk assets, especially in the US. In contrast, bond markets bore the brunt of revised expectations for interest rates. Global and Canadian equities won’t get as much of a lift from this political change, which will put America first. Investors are likely to remain optimistic as the new administration makes various announcements, given the support they expect from the president-elect. But after many years of robust returns on market indexes and a slew of policies focused on short-term gains (graph 9), profits will have to stay sky-high to justify already elevated valuations, especially for the US equity market.