Trump 2.0: déjà vu? Why investors should consider hedging inflation risk

Back in 2016, there were massive fears of global recession as oil prices dropped and China was believed to be slowing down. Then by year end, with Trump’s election, market sentiment shifted, and rates sold off by almost 100 basis points (bp) in less than two months. This might sound familiar, but there is a key difference today.

What’s different this time?

The themes that drove market sentiment for Trump 1.0 are virtually the same for his second mandate:

1. Trade wars: Trump’s proposed 10% flat tariff on imported goods (and 60% of those coming from China) would mechanically increase imported goods prices that have been one of the major sources of disinflation this year. The experience of the first mandate shows that tariffs were passed on to consumer prices by almost the exact amount, and if that holds true again, we could expect a rise in U.S. inflation of 0.5%-1%. These tariffs may be considered a consumption tax, dampening demand as they are implemented.
2. Job market: Based on campaign promises, deportation of undocumented migrants in the U.S. could be as high as eight million, providing a real supply shock to the economy. Some economist studies argue that such scale of labor market contraction could add 3.5% of inflation with a sharp GDP contraction until 2028.¹  We doubt Trump will be able to deliver fully on this promise, but the estimation gives a clear view of the likely consequences of this measure.
3. Fiscal spending: With no surprises, if the Trump administration were to implement the TCJA extension and further exonerations to public pension funds, it would increase the public deficit by 1%-2% from 6% currently. This is expected to support growth and could boost inflation in the U.S. through the “demand channel.”

However, one thing is different from 2016: the Federal Reserve’s (Fed) starting point on the cutting cycle. 

As opposed to the first mandate, the starting point of the Fed Funds rates is different. FOMC members agree on the fact that rates are in restrictive territory, and we agree. Trump’s proposed policies are inflationary, but at the same time show indications that they may harm growth as there are no stark productivity gains that would lift the neutral rate of the US economy. 

The graph below illustrates how real rates compare to the output gap of the US economy, suggesting that Fed Funds rate is still well above neutral.

While inflationary pressures resulting from Trump’s policies could push the Fed to be more cautious in its cutting cycle in 2025, we are not expecting rate hikes. Conversely, we see potential risk of a marked slowdown in growth that could make the Fed resume more aggressive cuts. 

One final consideration is the impact in other economies, like the Euro Area. The weighted average of U.S. tariffs on EU exports is currently around 3%. If we assume an increase to 10%, we estimate it would reduce total Eurozone goods exports by €30bn (0.2% of GDP) and the possibility of higher inflation in the region if retaliation measures are taken. 

How to position? 

For now, and barring any material spike in productivity, Trump policy intentions appear to be inflationary in the short term and negative for growth (locally and globally) in the medium term. We expect this type of “stagflation” environment to be supportive for inflation-linked bonds. 

The 2016 experience confirmed that the inflation-linked bond market does not efficiently forecast inflation but would follow it instead. While inflation break-evens have corrected from the lows seen last summer, we believe they are still mispricing risks to the potential upside on future inflation. 

Indeed, they are trading at levels consistent with the 2% objective so there is little inflation premium priced into current valuations. Many investors are tactically long U.S. break-evens as they expect them to move higher, and as the inflation premium builds in valuations. Inflation-linked bonds have continued to outperform their nominal counterparts and we expect them to continue to do so given the current environment. 

The graph below shows 2 years inflation swaps slightly above the 2% target for the Federal Reserve and well below for the Euro Area.

Making short-dated linkers great again 

On a more structural basis, Many investors prefer the shortest maturities on the inflation-linked bond curve that are more likely to track realized inflation. They are not only less volatile historically, but they could benefit from higher levels of indexation if inflation reaccelerates, while possibly carrying less duration risk. 

Also, the current level of real yields is not consistent with potential growth, and this is particularly acute in the Euro Area and the UK where we are anticipating central banks may be more aggressive in their rate cutting cycle. 

Inflation is certainly expected to be more uncertain and volatile than in the previous decade. The recent Trump election victory may be another wake-up call for investors to consider hedging the inflation risk of their portfolios, and to consider linkers in their core asset allocation.