Growth vs. Inflation: The Incoming Administration’s Delicate Task

By TMC Research Staff | The Milwaukee Company | tmcresearch@themilwaukeecompany.com

The return of Donald Trump to the presidency brings renewed attention to his economic policies. On the campaign trail, President-elect Trump promised a mix of tax reform, deregulation, and even fiscal expansion. These pro-growth initiatives have fueled optimism in financial markets, but they are not without risks. The broader economic context—including historically high asset valuations, geopolitical uncertainties, and the potential for inflationary pressures—warrants significant caution. The administration will soon be facing a complex challenge: delivering on growth-oriented promises while managing the risks of overheating the economy, which has only recently begun to rein in inflation, and avoiding destabilization of financial markets.

Trump 2.0 Growth Agenda: Bold Proposals with Far-Reaching Implications

Central to the Trump administration’s economic vision is what many consider a set of aggressive pro-growth policies. These include extending the 2017 Tax Cuts and Jobs Act, reducing the corporate tax rate from 21% to 15%, repealing Social Security taxes, and potentially introducing additional tax reforms aimed at boosting domestic investment. Collectively, if successfully passed through Congress, these measures are anticipated by analysts to inject approximately $8 trillion into the U.S. economy over the next decade.

Financial markets have generally responded enthusiastically to these proposals. In the first three days following the election results, the S&P 500 gained over 5%, though it pared back some of these gains in the subsequent week. Nevertheless, the S&P 500 remains up over 24% year-to-date, driven by expectations of robust corporate profitability, increased investment, and the recent shift by the Federal Reserve to what’s expected to be an accommodative monetary policy.

Key sectors, such as technology, financials and energy, have experienced significant gains as investors position themselves to potentially benefit from anticipated regulatory rollbacks. The Trump administration is expected to adopt a more lenient stance on antitrust enforcement (read our article on the antitrust outlook under a second Trump term here), which could benefit large oligopolies, particularly in the technology and financial sectors.

Goldman Sachs projects a further 10% gain in the S&P 500 in 2025, contingent on the successful implementation of these policies and continued corporate earnings growth. However, this cautious optimism is tempered by longer-term concerns. The bank expects annualized returns for the S&P 500 to average just 3% over the next decade, largely due to elevated valuations and potential headwinds from inflation and rising interest rates. It is important to note, however, that Goldman’s forecast was issued long before the election results, and long-term forecasts generally need to be taken with a considerable degree of skepticism.

The Cost of Growth: Ballooning Deficits

The fiscal implications of the administration’s agenda are significant. The federal deficit, already nearing $2 trillion annually, is projected to expand further. The Penn Wharton Budget Model (maintained by the University of Pennsylvania) estimates that the proposed tax cuts and spending increases could add $800 billion annually to the trade deficit over the next decade.

History also offers a cautionary precedent: during Trump’s first term, despite implementing aggressive tariff policies, the trade deficit widened by 17%, driven in large part by increased import demand and a stronger U.S. dollar.

This sometimes-antagonistic interplay between fiscal and trade deficits underscores the complexity of the administration’s policy objectives. While tax cuts and deregulation aim to spur domestic growth, they may also exacerbate external imbalances, particularly in the absence of offsetting revenue measures.

Inflationary Pressures: A Persistent Challenge

Inflation continues to remain a critical concern for both policymakers and markets. The incoming administration’s agenda, particularly its focus on tariffs and immigration restrictions, could contribute to upward price pressures. Tariffs on imported goods, a cornerstone of Trump’s trade policy, have the dual effect of raising costs for businesses and consumers while inviting retaliatory measures from trading partners.

JPMorgan Chase projects that steep tariffs on Chinese imports could reduce China’s GDP growth by 0.8 percentage points and weaken the yuan by up to 15%. This, in turn, could disrupt global supply chains and halt trade flows, with potential spillover effects on U.S. exporters. Domestically, tariffs are expected to increase input costs for manufacturers, particularly in industries reliant on imported materials, further contributing to inflation.

Additionally, the incoming administration’s immigration policies are likely to tighten labor market conditions by restricting the supply of foreign workers in key sectors such as construction, hospitality, and agriculture—all industries heavily reliant on immigrant labor, including undocumented workers. Proposals to increase building permits and spur new housing developments may be undermined by labor shortages, as construction, in particular, faces escalating costs from a dwindling workforce. The administration's promise to deport millions of undocumented immigrants and revoke Temporary Protected Status (TPS) for migrants from Cuba, Venezuela, Nicaragua, and Honduras could further strain labor availability. While higher wages resulting from these policies might benefit workers in the short term, they also drive up business costs and risk exacerbating inflationary pressures. Market indicators, such as inflation-indexed bonds, suggest inflation expectations for 2025 have already risen by 0.25 percentage points—a figure that could escalate if these policies are enforced aggressively.

The Federal Reserve’s Tightrope Walk

The U.S. Federal Reserve, which has a dual mandate of controlling inflation while promoting macroeconomic especially labor market stability, faces significant challenges in the current environment. While it has already implemented rate cuts to support the economy, further easing is far from guaranteed. Fed officials have expressed concerns about the risk of economic overheating, especially given elevated asset valuations and the potential for pro-growth measures to accelerate inflation. Market expectations for additional rate cuts in 2025 add another layer of complexity, as any deviation from these expectations could result in heightened market volatility.

Further complicating the Fed’s efforts are concerns over the incoming Trump administration’s potentially more assertive approach to the central bank's operations. During his previous term, President Trump had what many described as a contentious relationship with the Federal Reserve, frequently and publicly disagreeing with its policy decisions. Additionally, some members of the incoming administration have expressed ideological opposition to the principle of the Fed’s independence, raising the possibility of attempts to influence its decision-making process. While it remains uncertain to what extent the Trump administration might directly intervene in the Fed’s policymaking, any such involvement would represent a departure from the norm observed under most presidential administrations.

Valuations: A Fragile Foundation

Perhaps the most pressing concern for investors is the elevated state of U.S. equity markets. By traditional metrics, such as the cyclically adjusted price-to-earnings (CAPE) ratio, the S&P 500 is in the 97th percentile of historical valuations​. This leaves very little margin for error. Even modest shocks—whether from inflation surprises, geopolitical tensions, or policy missteps—have the potential totrigger significant corrections.

The 2024 market rally thus far has been fueled largely by expectations of AI-related growth and continued monetary policy support. However, the reliance on future policy-driven gains underscores the fragility of the current environment. As José Torres, senior economist at Interactive Brokers, notes, “Extended valuations on equities mean we’re vulnerable to shocks, turbulence, and volatility”.

A Path Forward: Navigating Growth and Inflation

The Trump administration’s economic agenda seems to offer significant opportunities for growth but also appears to carry considerable risks. Successfully managing the delicate interplay between pro-growth policies and inflationary pressures will be crucial to avoiding unintended consequences. For policymakers, this means striking a balance between fiscal expansion and addressing deficits and external imbalances. Similarly, the Federal Reserve faces the challenge of navigating the trade-off between fostering economic growth and controlling inflation.

For investors, the current landscape demands caution. Elevated valuations and heightened uncertainty underscore the importance of diversification strategies. Inflation-protected assets, such as Treasury Inflation-Protected Securities (TIPS), commodities, and real estate, can serve as potential hedges against inflationary risks. Meanwhile, a sharp deterioration in market conditions could shift investor preferences toward quality equities with strong fundamentals, which may offer greater stability than the growth-oriented stocks that have driven recent rallies.

Balancing growth and inflation is both an economic and political challenge. The incoming Trump administration’s ability to deliver on its economic promises while mitigating the risks of overheating will be important not only for maintaining investor confidence but also for addressing public concerns. The election results have been widely viewed as a referendum on the cost of living, with President-elect Trump’s messaging perceived by the majority of the electorate as more aligned with price stabilization. This dynamic may push the incoming administration to avoid excessive inflationary policies, particularly if public sentiment begins to shift against them. While optimism surrounding pro-growth policies is understandable, it must be tempered with a realistic assessment of the challenges ahead.

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