Some thoughts on market expectations from Trump

My previous post on what stock markets expected from Trump’s economic policies relied on a paper from Eric Zitzewitz and Justin Wolfers, claiming that markets expected S&P 500 stocks to be worth about 12% more under Clinton than under Trump. From there, I argued that a lot of the expected effect could probably be attributed to expected effects on GDP.

The thing is, the market’s opinion of Trump seemed to quickly reverse itself after the election. Justin Wolfers himself attempted to explain why this happened, noting that previously, markets had reacted negatively to increases in Trump’s likelihood of winning (and vice versa). In fact, the S&P 500 is up about 13% since November 8 (with about a 1.5% gain in the week after the election). There are a few questions to be asked here.

Have U.S. stocks risen because of the expectation of a corporate tax cut?

The IGM Economic Experts Panel said yes on January 17th (see Question A). But since then, various things have happened that would seem to reduce the probability of this happening. Previously, more heavily-taxed firms were doing better than the S&P average (probably because of the expectation of a tax cut), but since December 2016, this has reversed. Tax reform bills have been delayed, and the administration has admitted that it will probably not be able to pass corporate tax reforms by its August 2017 deadline. Also, while PredictIt markets are often illiquid and inefficient, PredictIt’s market for whether a corporate tax rate cut will happen in 2017 has fallen from an estimate of 80% on March 1, 2017 to 32% today.

The latter two details could be explained away if the market thinks a corporate tax cut will happen in 2018 or later. But heavily-taxed firms should still have had a higher gain since the election than the whole market, and they haven’t.

Scott Sumner points out that the market had little reaction to the failure of the first version of the American Healthcare Act, which could have been an indication of the difficulty of getting House Republicans to pass Trump’s desired reforms. He also observed in that post that markets in other countries, including China and Japan, rallied after the election. This is still the case with Japanese markets (the Nikkei 225 is about 14.6% higher than it was on November 8th), although not with Chinese markets (the SSE Composite Index is down about 1.2% since November 8th).

So the situation here is quite murky, and if anything, it seems like the chances of a corporate tax reform are lower than they used to be. It is worth noting that the S&P has changed very little from its level on March 1, 2017 (it’s about 0.8% higher today), so most of the rally was before then. So perhaps one could argue that the rally happened due to expectations of lower corporate rates and then has cooled off, but if so, why hasn’t the S&P fallen from its peak?

Have U.S. stocks risen because of the expectation of higher GDP growth?

The IGM Economic Experts Panel said no on January 17th (see Question B). This seems reasonable, both from looking at market expectations and from considering relevant supply and demand factors.

For inflation, we have 10-year Treasury Inflation-Protected Securities markets, which indicate an expected rate of about 1.8%. (This is for CPI-U, although we would expect that CPI-U and the GDP deflator would at least be in the same ballpark.) There is a Hypermind market for what nominal GDP growth will be in 2017, with participants indicating an answer of 4.1%. (Scott Sumner posted about the introduction of this market, noting that its level of prize money will be at least $5000 and probably more.) Of these two markets, the Hypermind market is probably less reliable, but it still tells us something, and for reasons I’ll address below, a 4.1% nominal GDP growth rate is probably a reasonable estimate. These estimates lead us to a real GDP growth estimate of roughly 2.26% for 2017. 96% of participants in the Good Judgment Project attempting to predict real GDP growth for the second quarter of 2017 say it will be between 1% and 3%. The CBO estimates that real GDP growth for 2017 will be about 2.1%.

Is 2.1-2.3% (or something close to it) a reasonable estimate? It probably is. It’s close to what real GDP growth rates have been in the past few years. Would anything change under the Trump administration that would significantly increase it? Probably not. Demand-side stimulus (such as tax cuts or infrastructure) is not guaranteed to even happen, and if it does, it could be offset by the Federal Reserve tightening monetary policy (and by crowding out, even without direct tightening). As for supply-side reforms that could increase GDP, it’s not clear what if anything will happen here, and it seems unlikely that anything that’s been talked about so far would raise real GDP growth rates to the 3-4% range that Trump administration officials have talked about. (A significant immigration increase could accomplish that in future years, and a nationwide push to encourage cities to scrap land use restrictions could potentially do that, but neither of those things have advocated prominently by Trump administration officials.)

So why have stocks gone up since the election?

It’s unclear. The expectation of a corporate tax cut late in 2017 or in 2018 (or perhaps later) could be the reason, but there should probably be more uncertainty about that happening now than there was earlier this year. Meanwhile, the S&P 500 price-to-earnings ratio is now about 25.55, which is high by historical standards. I don’t claim to be able to time the market or say with a large degree of certainty which way it will go, but a valuation this high is puzzling.

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