The Hidden Meaning of Dow 20000
Since Donald Trump won the U.S. presidential election, the Dow Jones Industrial Average has risen almost 9 percent, flirting with closing for the first time ever at the 20,000 mark. The year-end rally is the market’s way of saying it approves of the president-elect’s ideas.
As well it should. Trump’s tax-cutting, deregulating and deficit-spending policies are tailor-made to boost corporate profits.
Now would be a good moment to wave the yellow flag. This may not be such great news for the rest of the economy. What’s happening is exactly what some economists had predicted over the summer: In Trump’s first two years as president, business-friendly policies would lower corporate costs, and stock investors would get a bigger share of the economic pie.
But the Trump effect isn’t just sending stocks into record territory. It’s also leading inflation expectations higher, which could cause interest rates to rise even faster than the Fed now intends and the dollar to strengthen. All of that is pushing the economy in the opposite direction from what Trump wants.
Put it all together -- stronger dollar, higher deficits, wage and price inflation, tighter monetary policy -- and you have all the ingredients for an overheated economy quickly morphing into a weaker one. Trump’s anti-immigration policies and trade restrictions, if adopted, would make things worse -- and could even trigger a recession.
The bond market is perhaps more telling than the stock market. Trump’s tax cuts and large-scale government-spending plans are likely to add to the deficit and raise borrowing costs, scaring bond investors: Yields on 10-year Treasuries have risen 37 percent since the election.
Faster economic growth could result from the Trump stimulus. But with the economy at full employment, companies will have to pay higher wages to meet any new demand, and that will add to the inflationary spiral. Factor in increases in state minimum wages and Trump’s anti-immigration policies, which could result in worker shortages in some areas, and labor costs might spike. The Fed, which doesn’t like to get behind the curve, might have to tighten policy more aggressively than currently planned.
Trump could make inflation worse if, as promised, he imposes steep tariffs on the goods that U.S. manufacturers produce overseas and import back into the country. Wal-Mart Stores Inc. and Apple Inc. products, many of which are made in China, would almost certainly be more expensive for American consumers.
The Fed’s interest-rate increase of last week and the prospect of three more expected in 2017 already have investors shifting their capital to the U.S., where yields are better than in most countries. That, too, is adding inflationary pressure. Deregulation of the financial industry, which would make it easier for banks to lend, could make sectors like commercial real estate bubbly.
Mark Zandi, chief economist of Moody’s Analytics, thinks inflation will breach 3 percent on a sustained basis, “well above the Fed’s inflation target” of 2 percent.
The Fed will respond, Zandi predicts, by increasing interest rates to nearly 4 percent by early 2020. The bond vigilantes, in turn, will push 10-year Treasury yields as high as 4.5 percent. “These are the classic symptoms of an overheating economy,” Zandi writes, “which historically have ended in recession.”
While he’s not yet predicting a recession, Zandi sees the economy coming “unnervingly close by the end of Trump’s term.”
The more muscular dollar could mute the Trump effect somewhat. The stronger dollar makes U.S. exports more expensive relative to European and Asian domestic goods. It also makes foreign goods less expensive for U.S. consumers. A strong dollar, then, pushes down exports and pushes up imports, resulting in less inflation but higher trade deficits -- exactly the opposite of what Trump says he’ll accomplish.
Of course, President Trump might not get all the changes he called for as a candidate. He’s already pulled back from his pledge to deport 11 million undocumented people. The cost of his original tax proposal has been cut in half. Congress may not want to spend $500 billion on infrastructure. If so, the economy would be better off.
It may not be readily apparent from the stock-market euphoria, but the more successful Trump is in getting Congress to adopt his ideas, the worse off the economy will be in the long run. Beware the sugar high.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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