Higher-for-longer inflation and interest rates have been our view for the longest time. We have written on this subject numerous times, warning that inflation will remain at levels that are higher than they were in the last decade. The era of increasing globalisation that drove the secular deflation in the prices of goods has ended. The reverse is now happening. Deglobalisation is being driven by the rise in populism and protectionism — for instance, the backlash against immigration we believe is irreversible — US-China tech war and decoupling, geopolitics, disruption to supply chains, reshoring and near-shoring — all of which will increase production costs and prices, at least in the short to medium term. Interest rate, meanwhile, is the price of money that is determined by market demand and supply. Higher inflation tends to translate to higher interest rates, as will the massive debts (that need to be serviced and refinanced) racked up by the government during the pandemic. We will not go into all the details here but we have selected three articles written in the past year alone that you can re-read in our archive (see Flashback).
Wall Street has finally caught on. Investors had been overly optimistic on the pace of disinflation and interest rate cuts, and are now having to adjust to the prospect of inflation and interest rates staying elevated. Hence, the sell-off in US and global stocks at the start of this new year. Higher interest rates negatively affect stock valuations and especially high-growth stocks whose earnings (cash flow) are further in the future. The market overshot and is now recalibrating.
In fact, borrowing costs have been moving broadly higher since mid-September 2024 — the benchmark 10-year Treasury yields have now risen above 4.8% (from around 3.6% back in September) and 30-year mortgage rates just topped the 7% threshold (at the point of writing). This is also the same period where the US Federal Reserve is lowering short-term interest rates, by a full percentage point in total.
This divergence, the steepening of the yield curve, underscores the strength of the US economy. Case in point: Despite some troubling signs of weakness a few months back, which prompted the Fed to make a big 50-basis-point interest rate cut in September, the labour market appears to have stabilised. The latest non-farm payroll report for December saw net job additions soar well past market consensus and accelerating from the previous month. Unemployment fell back to 4.1%. As a result, the Fed’s focus is now back on inflation, where progress on disinflation from the pandemic highs has stalled.
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The re-election of Donald Trump to the White House has exacerbated the uncertainties and risks. His campaign promises, the raft of policies in combination, are widely seen to be inflationary. At the same time, tariffs and retaliatory measures will cause disruptions to global trade and raise the downside risks to the US and the global economy. Nevertheless, we think his policies are, on balance, positive for the US economy and corporate earnings; at least, in the near to medium term.
We don't think the market is headed for a crash. In fact, we are generally bullish on US equity relative to the rest of the world. Still, we are likely to see more volatility, given that US stocks are priced to perfection and ripe for a reality check.
There is room for short-term earnings to disappoint, which could lead to multiples contraction. Currently, analysts are forecasting earnings growth for the S&P 500 companies at 14.6% and 13.6% in 2025-2026 respectively (according to FactSet), which is almost double the compound annual growth rate (CAGR) of 7.4% between 2010 and 2023. Meanwhile, the forward 12-month price-to-earnings ratio is 21.5 times, above the five-year average of 19.7 times and 10-year average of 18.2 times. Valuations are high not only for Big Tech, but also across the board.
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The mega-cap tech companies are continuing to invest heavily in artificial intelligence (AI) infrastructure. Like us, some investors are starting to question the sustainability of their ROI (return on investment). We analysed the historical and forecast capital expenditure (capex) and earnings for the “Magnificent Seven” companies. More than half are expected to report lower ROI in the next three years (2024-27), compared with the past 13 years (2010-23), due mainly to their massive capital spending and depreciation expenses. Yet, the stocks are trading at much higher multiples, relative to near- to medium-term growth (see Chart and Tables 1 and 2).
In other words, there are lofty expectations for increased profitability in the long run, built on the promise (hype) of AI. Still, since the high capex and lower ROI for the next three years are already known factors (in forecasts), there should be limited downside in the immediate term. But we think some of these expectations could be in for a reckoning beyond the next two to three years.
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We believe the AI revolution is real and is evolving rapidly. But productivity gains — and margins improvement — will take time to materialise, for new applications to be created and for adoption-usage to grow. The ultimate beneficiaries of AI will broaden out, beyond the current handful of mega-cap tech darlings to the users of AI-driven technologies.
Businesses applying AI tools will see significant improvements in efficiency and productivity over time, which will enhance their competitive advantage, drive global market share gains and earnings growth. US companies are well ahead of the rest of the world, including Europe, in terms of innovation and adoption of AI. This is why we are optimistic on the longer-term prospects for US stocks. And we will be hugely optimistic of Chinese stocks again, once the current property bust has run its course and the financial system restored.
There is method in Trump’s perceived ‘madness’
We think the issue for Donald Trump is that his personality and character do injustice to his economic policies and ideas. We know we are going to shock our readers, but his “madness” in terms of tariffs, lower taxes, deregulation and mass deportation is exactly what we believe is needed for this moment. They are not empathetic, liberal, progressive, inclusive, universal or fair (all the words that sound nice) — but they are necessary policies to benefit Americans and the US economy. Yes, these same policies will be negative for almost everyone else, and especially for smaller and developing countries. But that is what one should expect from the leader of a country — to make his own country great, to seize every opportunity, every instrument to further the interest of his own country.
On balance, we see Trump’s proposed policies — primarily universal baseline tariffs on all imports with higher levies for Chinese imports, broader individual and corporate tax cuts, deregulation, boosting US oil and gas production and mass deportation of illegal immigrants — to be inflationary but net positive for the US economy and corporate profits.
There is little argument that tax cuts (fiscal stimulus) and deregulation will boost US economic activities. A lower corporate tax rate, from the current 21% to 15% (at par with the minimum global tax), coupled with less government regulation and intervention will attract investments, from both domestic and foreign investors. Capital inflows will lower cost of capital, spur investments, entrepreneurship, dealmaking, mergers and acquisitions and, generally, ignite the animal spirit — driving an acceleration in innovation and productivity gains. This can create a self-perpetuating virtuous cycle. As productivity and profitability improve, companies will have more to spend on reinvestments as well as share buybacks and dividend payouts to boost shareholder returns. This will make US stocks more attractive to global investors, leading to even higher capital inflows, market liquidity and valuations, and cement Wall Street as the destination for initial public offerings, or IPOs.
Rising asset values, in turn, will create a wealth effect for consumers. Extending individual tax cuts and exempting more sources of income, such as tips and overtime from taxes, will put money into consumer pockets. Stronger domestic investments and corporate earnings growth will trickle down to jobs creation and higher wages for workers. At the same time, capital inflows — foreign direct investments and capital markets — and stronger economic growth (relative to the rest of the world) will strengthen the US dollar, which also means greater purchasing power. All of the above is supportive of consumer spending growth, which is the key driver for the US economy.
The biggest problem is that tax cuts must be funded, or it will further inflate the budget deficit and public indebtedness and potentially create a backlash effect on yields and the greenback. The Department of Government Efficiency or DOGE, headed by Elon Musk and Vivek Ramaswamy, aims to cut as much as US$2 trillion in wasteful government spending. But many (now including Musk himself) see this target — from a budget of about US$6.8 trillion — as unrealistic, considering that the bulk of spending is for entitlements-benefits, defence and debt servicing. The entire discretionary outlays stood at US$1.7 trillion in 2023. As such, the actual quantum of spending cuts is likely to fall far short of this claim. It is far easier to cut taxes than spending in countries where governments are democratically elected based on popularity. And while countries can grow out of debt, it is rare in the real world, especially in developed countries where economic growth has slowed.
Tariffs are undoubtedly the most controversial of Trump’s policies. Sceptics insist that government revenue from import tariffs cannot possibly pay for the proposed tax cuts, as Trump claims, not without trig- gering significantly higher consumer prices and inflation. Indeed, the majority of economists and academics believe that Trump’s tariffs will trigger retaliatory measures and be counter-productive in terms of stimulating domestic production and jobs, making American goods less competitive globally and will ultimately lead to slower economic growth — and, in the worst case, stagflation. Investors, on the other hand, mostly think that maximum tariffs are simply a negotiation tactic. And perhaps they are. But is it so outrageous?
Yes, tariffs in the quantum that Trump is talking about — sufficient to offset his range of tax cuts — must surely raise the cost and prices of imported consumer goods. It will also increase the cost of intermediate goods that go into domestic production, thereby also raising selling prices. But remember, corporate tax cuts will at the same time reduce taxes (a major expense item) and, therefore, costs. Deregulation and lower energy prices (if domestic production of oil and gas expands as Trump expects) could also be deflationary. That said, we suspect companies will pass on tariff-driven cost increases to protect — even expand margins in a strong economy — by raising selling prices, to the extent that a competitive market will bear. After all, the primary objective of private companies is to maximise profits and shareholder returns.
In other words, high and universal import tariffs will quite likely push up prices and end up as a “tax on consumers”. But the impact on consumption and economic growth is not necessarily negative. Case in point: The sharp rise in inflation during the pandemic did not trigger the highly anticipated recession, thanks to government largesse that boosted incomes and savings. Instead, consumption continued to grow and the US economy and job market consistently outperformed market forecasts. The government has socialised a large portion of private sector debts during the pandemic. Corporate and household balance sheets improved and remain generally healthy. For instance, most homeowners have locked in cheap fixed-rate mortgages and, therefore, are insensitive to interest rate hikes. Individual tax cuts and a strong economy will further raise disposable incomes and wages, providing a partial if not full offset against higher consumer prices.
In fact, Trump’s plan to replace income taxes with import tariffs that will likely be passed on to consumers as a pseudo-consumption tax is not as outrageous as it appears at first blush. Other forms of consumption-based tax like value-added tax (VAT) or goods and services tax (GST) are widely accepted as sound economic policy worldwide. VAT is a major source of government revenue in more than 170 countries. The US does not have sales tax or VAT at the federal level, but nearly all states do.
Is there any downside to our rosy narrative? Yes, of course. We think the economy will do well, but at the cost of higher inflation and higher-for-longer interest rates. High interest rates will benefit those with savings and penalise borrowers. Corporate and individual tax cuts as well as rising asset values (stocks, land and property) will inevitably favour the rich while consumption tax is regressive. Higher consumer prices disproportionately hurt lower income households. All these mean that inequality will widen further.
Trump’s proposed policies in combination epitomise pure capitalism, at its best — or worst, depending on where one stands. The fundamental principle of capitalism is a market economy driven by a profit-maximising private sector with limited government intervention. Is any of these a surprise, given that Trump himself is a capitalist (businessman)?
Conclusion
There is a good chance that Trump will be able to implement most, if not all, of his promised policies, given his strong influence in the Republican party, which is now in control of both the Senate and House of Representatives. Furthermore, since he is a second-term US president, there will be no re-election risk. The proposed policies will, we believe, translate to a stronger US economy and corporate profits, at least in the short to medium term, but at the cost of higher inflation. Tariffs and retaliatory measures will cause disruptions to global trade and, in the worst-case scenario, hurt the US economy in the longer term and, even more so, the global economy.
We think the Fed will continue monetary easing to manage government debt servicing, albeit at a slightly slower pace. Interest rates will stay higher for longer, which is supportive of US dollar strength, but real interest rates will fall.
The equity market rally overshot in anticipation of larger and faster interest rate cuts. Investors are now in the process of recalibrating expectations. Valuations for the broader market, and notably the Magnificent Seven stocks, are elevated and vulnerable to negative developments. But the outlook for US equity remains positive relative to the rest of the world.
China’s economy, we think, is still some way from full recovery in the aftermath of its property bubble burst and falling consumer confidence and domestic consumption. The Chinese government, thus far, appears more inclined to provide incremental support to maintain its 5% growth target than roll out aggressive fiscal stimulus. A better policy for China would be to let the property market correct sharply lower and developers go bust, acquire and consolidate the weak and small regional banks and recapitalise the banking system — that is, flush out the weak, take the pain.
Weakness in the world’s second-largest economy raises the risks for Asean countries, which are also hurting from the strong US dollar and likelihood of a global trade war. Meanwhile, Europe is heading into a more fractious political landscape and may see weak leadership from its largest member countries. Economic growth has been sluggish and is expected to be much slower than that of the US economy.
In summary, we believe the US economy and capital market will continue to attract more than their fair share of global funds. And the US dollar strength is sustainable for all the above reasons. Hence, while caution is warranted on prevailing high stock valuations as well as higher-for-longer inflation and interest rates, growth will be positive, and the US dollar will remain strong. Therefore, relative to the rest of the world, US equities will almost certainly outperform. US bonds could become more attractive once the current selldown tapers off and prices stabilise. Prevailing yields are already higher compared with other developed countries in Europe and Japan. In short, US equities now, bonds later.
The Malaysian Portfolio traded flattish for the week ended Jan 21. Gains from Insas Bhd – Warrants C (+16%), Harbour-Link Group (+1.4%) and KSL Holdings (+1.2%) were offset by losses from Kumpulan Kitacon (-2%), Gamuda (-1.6%) and United Plantations (-1.3%). Total portfolio returns now stand at 197% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 13.6% over the same period, by a long, long way.
The Absolute Returns Portfolio, however, was up 2.7%, lifting total returns since inception to 19.6%, mirroring the improved sentiment on Wall Street. All stocks in the portfolio traded higher except for MAP Aktif Adiperkasa, whose shares were down 7%. Talen Energy (+7.6%), Palantir Technologies (+7.2%) and Swire Properties (+5.5%) led the gainers list.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
