The market’s honeymoon with Trump may not end well if U.S. policies tilt into a protectionist stance.

As of mid-December 2016, we wonder how much further the global reflation trade can go in the absence of more details about the policy priorities of a Trump presidency. Interest rates moved sharply higher after the election and then consolidated, and U.S. equities have roughly followed a similar path. But while U.S. rates have pulled up nominal rates in most of the rest of the world, the equity move has been much less even globally, with U.S. equities generally outperforming. The story that global markets are telling us is that the U.S. outlook has changed, but will the market reprice once more details are known about Trump’s agenda? Are markets taking the story of the “growth friendly” Trump too seriously and willfully ignoring his lurking “protectionist” self?

Arguments for caution abound

We remain cautious about those aspects of the Trump campaign that we perceive to be unfriendly to growth, such as ad hoc interventionism, protectionism, and hostility to immigration. There certainly are those who believe that the threats to tear up NAFTA and label China a currency manipulator were just campaign rhetoric that will be abandoned as smoothly and easily as the promise to investigate, prosecute, and jail Hillary Clinton. Politicians say things to get elected, after all, and there’s a time-honored tradition of treating campaign promises cavalierly.

Are markets taking the story of the “growth friendly” Trump too seriously and willfully ignoring his lurking “protectionist” self?

But what of trade? It is important to understand that some of the President-elect’s economic advisors are non-academics who interpret national income accounting identities, the formulae economics uses for calculating things like GDP and GNP, as proving that imports are harmful to growth. Wilbur Ross, Trump’s nominee for Commerce Secretary, recently said: “It’s Econ 101 that GDP equals the sum of domestic economic activity plus “net exports,” i.e., exports minus imports. Therefore, when we run massive and chronic trade deficits, it weakens our economy.” Ross is undeniably a successful businessman, but, clearly, success in business does not require nor confer an understanding of economics.*

Some of Trump’s trade advisors have a history working as industry lobbyists, and some of these individuals and the industries they have represented have a big axe to grind with trade. We think investors should be highly cautious about this side of Trump’s policy agenda. Adding to this uncertainty is how little we know about the proposed Treasury Secretary Steven Mnuchin. He has said his priority will be tax reform and growth, but we do not know what he thinks about currencies and international trade.

Where Trump seems to stand on trade

Trump himself seems to have believed for a long time that other countries steal growth from the United States. In the mid-1980s, he paid for a full-page advertisement in The New York Times that attacked Japan for a currency policy that was, he said, undermining the U.S. economy. Fresher in everyone’s minds, of course, is the United Technologies/Carrier “deal.” In our view, this is exactly the wrong kind of industrial policy to adopt, as it encourages rent-seeking corporate behavior and challenges the concept of a level playing field for business.

We will have to wait and see how Trump’s unexpected telephone call to Taiwan and some recent tweets about China’s currency will affect U.S./China relations. These actions certainly point to a different U.S. approach to China. In addition, Trump’s tweets about 35% tariffs being imposed on relocating companies’ shipments into the United States strongly suggest that caution over the incoming administration’s approach to trade is warranted.

Inflationary effects to watch

On the other hand, any protectionist moves would tend to push inflation up and reduce the downward pressure on inflation from an appreciating dollar. While we think protectionism would also be harmful for growth, in the short term the inflationary aspect would probably matter more for interest rates than any impact on growth prospects.

But there is more to come. First, the presidential election result has likely broken the policy logjam in Washington. Second, growth dynamics were improving anyway and inflation risks are already rising, which means Trump comes into power just as the economy is looking relatively strong. Lastly, the global backdrop may come into play in 2017 as well, although this is more likely to be a force keeping interest rates lower, rather than adding to upward pressure. Again, it’s important to note that you don’t have to believe that the promise of this new world will be realized; you just have to believe that the political shift has changed the probability distribution of outcomes. And how the rest of the world will interact with these new U.S. dynamics will be something to watch closely.

* The Wall Street Journal, among others, offers a discussion of what’s wrong with Ross's statement.

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Significant assets may be poised to move in response to the new story of U.S. political change.