Playing chess versus checkers

One of my most often used expressions for our investment teams, after Humility at the Highs, references the two popular and ancient board games noted above: “We’re playing chess, not checkers! And let’s assume everyone else is, too.” In other words, when predicting the impact of A on B, it’s helpful to work through how everyone else in the economy, government and financial market might also react to A, and so play for move C further down the board, or potentially even move D or E. Chess, not checkers.

What is striking to me about all the commentary and predictions coming out of traditional economists and progressive think tanks is that most of them seem to think checkers is good enough and, in a kind of “two mistakes for the price of one” tirade, are also arrogant enough to assume the other players in the game, particularly the incoming President of the United States, are not smart enough to play chess anyway. This memo will outline a number of areas where we think Trump and his allies may be playing chess, and how that could be positive for the market, particularly the value/small cap side of it where we’ve tilted our balanced portfolios. Warning: if you’re not a chess fan, file this memo away in your waste bin and move on to the next “post-election outlook” piece cluttering your desk or smart phone.

Here are a few of the ways President Trump is likely engaged in a chess match, and how he might win that match during the upcoming term of office he’s about to serve:

1. The second order effects of tax cuts are likely to boost growth, not the deficit. Most of the accountants in the Congressional Budget Office (CBO), along with traditionally trained economists from the finest schools in the nation, calculate the impact of tax cuts assuming little to no impact of taxes on economic activity going forward. So for instance, in 2017, the CBO calculated the impact of the tax cuts enacted that year as revenue decretive for the federal government, by multiplying the amount of the tax cut times the tax base. Yes, they did reluctantly tack on a modest second order impact via some growth (“dynamic scoring”), but in truth they largely ignored this. Of course, that is not how the chess game of a complex economy actually works. As any CFO will tell you, a lower tax rate means higher after-tax returns on any given investment project, and a higher tax rate, the opposite. So lower tax rates, all other things being equal, result in more capital projects getting approved and higher levels of investment. Those higher investments then lead to stronger growth of GDP, which in turn leads to a larger tax base. And since the tax revenues of the government are a function of the tax rate and the tax base, a lower rate can theoretically result in a larger tax revenue if the tax base expands enough. This, by the way, is what happened in the years following the 2017 tax cuts. Despite the dire warnings from the CBO and others at that time, 2023 revenues, six years later—even with all the Covid dislocations—actually came in $275 billion higher than the CBO had projected. Trump was playing chess, considering the next moves/responses by individuals and corporates to the lower tax rates; the CBO was playing checkers, assuming little to no reaction. From our perspective, therefore, we are less concerned about the present dire warnings about government deficits going forward due to the coming Trump tax cuts. In the short term, that might be true; but over the long haul, a well-crafted tax cut plan would likely spur growth and expand the economic pie, at least in the out years. One final point on this. While Harris and the Democrats broadly like to reference the across-the-board Trump tax cuts as a “boon to the rich” (because those cuts to ordinary rates were across all brackets, including the highest ones), the dirty little secret is that the US economy depends on 90 million small businesses, most of whom file their returns as individual tax payers. So allowing those tax cuts to expire would be very negative for investments and growth among the many smaller companies that fuel the US economy.
2. The follow-on impact of threatening to hike tariffs might boost growth, not inflation. Trump’s threats to hike tariffs are another example of playing chess; the inflation doomsayers’ concerns, on the other hand, an example of checkers. The traditional “Adam Smith” argument against tariffs, taught in Economics 101 at all Ivy league schools, is that tariffs raise price levels because the price of imported goods go up by the amount of the tariff. But this simplistic assumption belies the chess game that real economic players are engaged in on a practical level. For one thing, the company exporting the product to the US on which a tariff is imposed, might choose to keep their selling price the same, and absorb the tariff hike out of their own profits; this is more likely the case when those profits are cushioned by government subsidies or other anti-competitive practices within their home market. Other companies might choose to set up production facilities in the US, again boosting US growth and a key second-order impact that Trump is hoping for. Another player in the chess game is also the government of the country whose goods are subject to the tariff threat; threatened with the loss of a key export market such as the US, they might cut a deal to avoid the tariff in exchange for increased imports of products produced in the US. The foreign government might also stimulate their domestic economy to absorb more of the excess production that is currently being dumped on the US market; that too would increase US exports. Both these actions would be stimulative to US economic growth. A third way the tariff might not lead to higher inflation is the enactment of other Trump policies, also part of the chess game, that could offset the tariff impacts. For example, policies designed to boost oil and especially natural gas production would cut oil prices, lowering a key component of the nominal CPI. Policies to cut regulatory costs (see below) and lower taxes might lower the relative costs of manufacturing in the US, leading more foreign exporters to set up plants here. I could cite more examples, but you get the point. It is not at all clear, in a real-world chess game, what the impact of tariffs on inflation and the economy might actually be, but our guess is that it will be far less deleterious to the US economy than projected by the economists. That was certainly the case in Trump’s first term, in which inflation remained very restrained despite round one of the “trade wars;” for example, US core PCE inflation in 2019, before the onset of Covid and in the third year of Trump’s first presidency, was only 1.7%, while real GDP growth in those first three pre-Covid years averaged 2.8%.
3. The threat of Trump’s aggressive stance towards Russia and Iran might lead to a “peace dividend.” At the moment, the US economy is spending a significant sum of money ($193 billion, according to the Council on Foreign Relations) fighting two proxy wars, one in the Mideast and one in Ukraine. Although these expenditures are good for US defense goods makers, the “multiplier effect” of this spending is not high; in the end, most of what is produced ends up destroyed on a far-off battlefield, not to mention the ongoing tragic loss of lives. However, if Trump’s perceived erratic and “dangerous” behavior brings Russia and Iran to the bargaining table (which we suspect it will), he might finally end the senseless killing that has been underway now for over two years in both areas of the world; the resulting peace dividend would also free up US resources for more effective and efficient uses. This would be good for growth and inflation-reducing.
4. Trump’s deregulation campaign might make the US economy more efficient and productive. Under the current administration, the size of the administrative state has exploded; American Action Forum estimates that there were 851 new regulations imposed on the economy by the Biden administration, imposing an estimated cost on the US economy of $1.37 trillion. While many of these regulations were implemented, I’m sure, with good intent, the reality is that most of them simply led to additional red tape and higher costs of producing the goods and services that American consumers purchase from the private sector. Cutting back this regulatory monolith, if executed thoughtfully by someone like, say Elon Musk, could add materially to GDP growth in the years ahead, while also lowering the cost of goods and services (i.e. inflation). The checkers players are not counting on this, but Trump most assuredly is.
5. A smaller Federal government might help solve the labor shortage in the private sector. Another Trump program that the Bears with their worry beads focus on is the coming cuts to the US government work force, a potential by-product of Musk’s efforts noted above. While these cutbacks might slow economic growth in the very near term by raising unemployment rolls, in the longer term, they will be releasing to the private sector large numbers of skilled workers to fill the many job openings that can’t be filled at the moment. This would be inflation-lowering and, assuming the private sector positions are more productive than similar ones in the government, growth enhancing. Another win for the chess player.
6. A controlled border combined with immigration reform could be a big long-term win for the US economy. The last area to think about is immigration. Trump has threatened to deport “millions,” leading many checkers players to fret about a new labor shortage and rising wages for the lower income consumers who compete with these immigrants for jobs. While an effect like this might be near-term negative on a humanitarian and on a macroeconomic level (but not by the way for the long-suffering US lower-income consumer), our guess, again, is that Trump is playing chess here. By threatening mass deportations, he might elicit a positive response from a variety of actors in this particular chess game. For one, given the now rising probability of deportation for illegal immigrants committing crimes (surely a high-priority target of Trump’s deportation threats), a decline in this kind of anti-social, anti-economic activity is likely to quickly ensue. And further waves of illegal immigration would also probably slow, giving Trump time to properly seal and control the border. Once sealed, what if Trump and his allies actually then developed a path to citizenship of those already here, while also allowing more immigrants into the country-- legally, documented, and paying taxes? For sure, any effort to fix immigration by first legalizing those already here, while sounding more humane, would simply spark another mass immigration before the borders could be controlled. Playing the game in reverse is likely to lead to a more sustainable outcome. Trump has hinted this is his end game, but he can hardly state that if he’s playing chess.

As we add all this up, our conclusion is that the coming Trump presidency is likely to be positive for economic growth and, eventually, for lower inflation and interest rates. All of this is stock market positive, particularly for those areas of the domestic US market we’ve been tilted towards (large-cap value, cyclicals, dividend payers, and small caps.) The only caveat is that in the short term, the checkers players over in the bond market, sometimes called the “bond vigilantes,” might be playing checkers, and if so, Wednesday’s spike in long-term rates might be a harbinger of more bad news to come for bonds. So for now, we are remaining underweight bonds as well underweight bonds’ equity counterparts, large-cap growth stocks, and are maintaining our overall overweight to stocks in our balanced portfolios.

Pawn to king’s knight 4. Your move.