Heading into his second presidential term, many investors assumed that President Donald Trump’s bark would be a lot worse than his bite on trade and other policies, primarily because the stock market was doing well and investors assumed that Trump wouldn’t want to see the market get hurt on his watch. Those assumptions have now been put to the test as Trump has gone forward with certain tariffs, and the market has sold off sharply.
Since Feb. 18, the Nasdaq Composite Index has entered correction territory, down more than 11%. Now, it’s still quite early in Trump’s second term and he seems to change his stance on tariffs by the day, but I think the president is overlooking the biggest risk to the stock market — and I’m not talking about a recession, although that’s a risk too.
Putting the Fed in a potential bind
During a recent television interview, Trump put investors on edge when he did not rule out a recession and said he expected the U.S. economy to see “a period of transition.” However, Trump may not be overly concerned about a recession, at least when it comes to the stock market.
Trump has already publicly expressed a desire for the Federal Reserve to lower interest rates. However, the Fed has been on pause in recent months as inflation has accelerated. February inflation data did come in below estimates, but a rate of 2.8% was still higher than the Fed’s preferred 2% target. That said, other data, including the monthly jobs report and gross domestic product estimates, have shown signs of weakness, leading to a decline in U.S. Treasury yields and traders increasing their bets on more interest rate cuts this year. Trump’s tariffs and the ensuing trade war have also made many market strategists grow concerned about economic growth, and some of the major Wall Street banks have begun to lower their forecasts for the S&P 500.
From a political standpoint, it might make sense for Trump and the Republicans to implement tariffs now and worry about the market later. After all, Trump would probably prefer to deal with a recession now and see the market struggle and then hope for a recovery closer to the midterm elections. However, in doing so, Trump might be discounting an even bigger risk to the stock market: Stagflation.
Stagflation occurs when consumer prices rise rapidly and unemployment increases, leading to slow economic growth. This scenario also puts the Fed in somewhat of a bind because cutting interest rates risks reigniting inflation while raising interest rates could lead to higher unemployment.
The U.S. economy and stock market dealt with stagflation in the 1970s due to a combination of several factors, including a rising fiscal deficit and the Arab oil embargo, which led to a spike in oil prices. It turned into a lost decade for the stock market, with the S&P 500 only rising 17% during the period, which is well below its long-term historical average and the rate of inflation at the time.
Markets are hard to control
I do think there’s a possibility that Trump will make agreements with key trading partners like China, Mexico, and Canada. However, he’s been erratic so far, and the market is clearly unsure of what’s next.
Many economists and investors, including the great Warren Buffett, believe tariffs have an inflationary effect over time. Many of Trump’s tariffs from his first term are still in effect, so the longer Trump leaves new tariffs in place, the more likely that consumer prices will remain high or potentially rise. This, coupled with a labor market starting to show cracks, could result in some level of stagflation, which I don’t think the market will respond well to.
I’m sure officials in the Trump administration are aware of this, but the matter seems to get little attention right now. Trying to predict how markets will react or what will happen to the economy is also a difficult task. The administration may view a recession as a worst-case scenario that can be mitigated quickly by Fed rate cuts, but the end result could ultimately be very different.
Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
