The Trump trade is off to a strong start, but will it last?

The inauguration of President Donald Trump came as advertised: Bold promises, symbolic gestures, and a fresh all-time high for U.S. stocks.

In Trump’s first full week back at the White House, the S&P 500 Index rallied 1.8%, reaching a record closing high of 6,118.71 on Jan. 23.

Although the rally was partly driven by stronger-than-expected corporate earnings, Trump’s demanding lower interest rates certainly helped.

“With oil prices going down, I’ll demand that interest rates drop immediately,” Trump told the World Economic Forum while boasting that America has entered its “golden age.”

Trump stopped short of telling the Fed what to do, but his intentions about reshaping the central bank have been well documented.

The Fed’s interest rate policy has been a major sticking point for investors, who were spooked by Chairman Jerome Powell’s December comments that policymakers must slow the pace of rate cuts due to lingering inflation.

Trump has vowed to reverse Biden-era cost pressures by unleashing America’s energy sector. However, economists worry that his America First policies of tariffs, low interest rates, and mass deportations could make inflation worse in the long run.

These are just some of the landmines investors are navigating through with Trump at the helm. The urge to see the market with a rational eye must be put on hold for now amid Trump’s policy overhaul.

“Right now, earnings are almost the undercurrent of the stock market, and policy is taking center stage,” said Callie Cox, the chief markets strategist at Ritholtz Wealth Management.

“Short term, markets will have to contend with building fiscal, trade, and monetary policy uncertainty, even if [corporate earnings] are solid,” said Cit US equity strategist Scott Chronert.

Despite the policy fog hovering over Wall Street, the situation appears to be improving on Main Street, as Trump’s arrival coincides with a rebounding business cycle.

Stocks and the business cycle

To better understand the direction of the U.S. economy and its impact on stock prices, it’s important to look at the Purchasing Managers Index (PMI)—a monthly sentiment indicator that tracks the performance of the manufacturing and services sectors.

PMI indicators measure business conditions on a scale of 1 to 100, where 50 separates expansion and contraction. Readings above 50 represent growth or expansion within manufacturing or services, whereas readings below that level signal a downturn.

According to the Institute for Supply Management (ISM), the U.S. manufacturing PMI is inching closer to the breakeven mark, rising from 48.4 in November to 49.3 in December.

While still below 50, the PMI reading was the highest since March and marked the third consecutive monthly increase. Economists interpret this as a sign that the business cycle is ramping up.

Meanwhile, the ISM services PMI has been in expansion mode for six consecutive months, rising from 52.1 in November to 54.1 in December.

“ISM leads the economy by about a month,” said Real Vision founder and macro strategist Raoul Pal. “But it’s not just the economy—it’s every asset.”

Pal was referring to the strong correlation between PMI and the economy, which has a direct impact on stock market returns.

This relationship was verified back in 2011 by professors Kevin J. Watson and Mark A. Johnson, who submitted research to The Journal of Investing.

“Utilizing time-series regression analyses, we find a positive relationship between changes in PMI and stock returns,” the authors said.

“This suggests that optimism (pessimism) as indicated by changes in the PMI translate into higher (lower) subsequent stock returns,” they said.

PMI readings have the biggest impact on small-cap stocks and industries such as technology, automobiles, textiles, and precious metals, the paper concluded.

Research from S&P Global went a step further, concluding that PMI data also predicts corporate earning trends.

“Our PMI-based US earnings indicator exhibits a 74% correlation with changes in reported earnings per share for S&P 500 companies,” wrote Chris Williamson, the chief business economist of S&P Global Market Intelligence.

Williamson said the PMIs anticipated “every turning point in earnings over the past 14 years.”

Now, PMI readings suggest that Donald Trump’s return to the White House will be good for business and the economy.

“Many firms are generally anticipating that business will pick up in the New Year, with respondents pinning hopes on expectations that the new administration will loosen regulations, reduce tax burdens, and boost demand for U.S.-made goods via tariffs,” Williamson said in response to the December PMI data.

Uncertainties remain

As Investors Observer reported, financial analysts are generally optimistic about stock returns under Trump, but that doesn’t mean the escalator up won’t be bumpy.

For starters, Trump’s tariff threat was benign during his first week. As JPMorgan noted, the “lack of concrete tariffs” in Trump’s first wave of executive orders is the biggest surprise so far.

Analysts at the investment bank expected Trump to take a carrot-and-stick approach to trade policy. Although the President threatened America’s allies during his World Economic Forum address, he stopped short of announcing concrete tariffs.

However, when new tariff measures are finally announced, stocks are likely to sell off quickly. In Trump’s first presidential term, U.S. stocks plunged by a cumulative 11.5% on days when his administration announced new tariffs.

Sources close to Trump’s administration told Politico that “tariffs are coming in the next couple of months” once the president’s inner circle agrees on the best approach. This means Trump’s benign approach won’t last much longer.

“The president is serious about the universal tariff,” one anonymous source told the publication.

The other major area of uncertainty is what economists call the “macro backdrop,” which refers to the overall economic environment of the country.

Even before Trump took the helm, there was plenty of uncertainty around the economy, inflation, and interest rates. Throw Trump into the mix and the picture becomes even more complicated.

“Anyone not plugged directly into the new administration will have difficulty assessing the macro outlook, because policy shocks are likely to be dominant here,” said Gerard MacDonell, an economist at 22V Research.

While stocks were broadly higher in Trump’s first term, Evercore ISI strategist Julian Emanuel said trading conditions were far from smooth.

“The intraday swings in oil (lower) and stocks (higher) underscore market volatility accompanying Trump v2.0,” he wrote.

One area in which Trump appears crystal clear is his support for tech innovation. He has vowed to make America the global leader in AI.

Trump’s AI commitment was bolstered by the announcement of the Stargate initiative—a $500 billion private sector investment led by OpenAI, SoftBank, and Oracle. As Forbes reported, Stargate is the largest AI infrastructure project in American history.

Some analysts believe that a strong AI sector alone could power the S&P 500 Index to 7,000 this year, especially as more businesses adopt the novel technology.

This S&P 500 price target implies a further 15% upside from current levels.

Although there aren’t many AI companies in the S&P 500, several Big Tech giants are spending billions on AI development. Some of the most notable include Google, Amazon, Meta, and Microsoft.

According to Goldman Sachs, these companies are planning to spend a combined $1 trillion on AI over the next five years.