Well, nearly gone. Hopefully. Economists and investors tend to be focused on one big macro issue at a time. For a couple of years it was Covid. For the last 3 years it has been inflation and the consequent monetary tightening to deal with it. But that phase is nearly over. This year the focus has been on ‘the last mile’ - getting inflation down from 3-3.5% to 2% - and when rates will start falling.
If we are not going to worry about inflation anymore, what are we going to worry about? I suggest there are three looming issues. One is the ‘landing rate’ for interest rates. How far down will they go? That will certainly keep bond investors focused because a Funds rate with a floor of 4% doesn’t leave much room for longer yields to fall today, absent a recession. Whereas, if the policy rate continues down to 3%, 10-year yields could rally a lot further. But the policy rate isn’t crucial for the US equity market. Equities were strong in 2021 when rates were near zero and strong again over the last year with rates above 5%.
Another candidate for investor focus is broader government policies. The UK is going for a reset at the moment with the new government focused on reform in areas like planning, the labour market, prisons and maybe the NHS. This doesn’t seem to be fazing markets so far. If anything, it is encouraging a new interest in UK equities.
A Trump Presidency which could bring broad protectionist policies, a reduction in Federal Reserve independence and new pressure on Western allies might focus market attention in a negative way, however. It certainly makes for uncertainty over the next few months and, if Trump wins, we will have to wait through the winter to see how far he follows through. It will depend to some degree on who wins in Congress, which also seems wide open at present.
But even if Trump wins, his choice of policies may not be the main focus in the next few years. It could be a more basic issue, which would apply to a Harris presidency just as much. The budget deficit.
Debts rose during Covid while deficits are still high, despite unemployment being low. Meanwhile, interest costs are rising fast while demands for more spending remain clamorous, including on defence, green transition and industrial policies, not to mention ageing populations wanting more healthcare and pensions.
Running large deficits in a recession is normal and desirable. But once the economy has fully recovered (the ‘output gap’ has closed, in the jargon), the deficit won’t close any more on its own. It needs higher taxes or lower spending. Neither Harris nor Trump show any inclination to do that. There are question marks over France and Italy too and, while the British government is sounding a cautious note, it is not clear they will prioritise deficit reduction either.
Fiscal crises are nasty things for markets. They happen when investors say ‘Wait a minute - the government is going to have to do something drastic here’. Typically, the exchange rate weakens pushing inflation higher so interest rates rise. Meanwhile the political debate heats up because the government is under pressure to raise taxes or cut spending. Bonds sell off but equity markets are impacted too because reducing budget deficits usually has the Keynesian effect of slowing the economy. That can sometimes be offset by lower interest rates but only if there is confidence that it will work and inflation really will come down. It usually takes a while. And a recession is a real risk.
Is a fiscal crisis in the offing? A lot of people are beginning to wonder. It could be headed off if economic growth comes in strong for a while, perhaps because AI delivers. It could also be avoided if governments apply the brakes smoothly, bringing deficits down gradually while central banks nicely offset with lower rates. That could be a Goldilocks outcome. And it is probably still within reach. But what would make it harder is more societal polarization or a war or a new crisis of some other sort.
The third issue that could be the big focus in coming years is China. So far, China’s slide onto a low growth path has caused few ripples outside. True, its push to export surplus production has triggered protectionist moves in the US and EU, seeking to fend off cheap imports of EVs, batteries and solar panels. But China has so far managed to avoid a financial crisis, despite the biggest property slump anywhere, ever. And slowing Chinese growth has helped to dampen world inflation.
There are several ways China could become the key focus. One is if a Chinese financial crisis does erupt. There are good reasons for thinking the government can keep a lid on – essentially a lot of the debt is owed by government entities to government banks. But there is plenty of debt in the private sector too and panic could easily be triggered. Another way it could become the focus is if the government decides on a foreign policy adventure.
Perhaps it links to the issue of a new Trump presidency. A US-China economic confrontation could easily escalate into something more and that would surely be the key investor focus for a while.
Interesting times! What is your forecast for the next big issue? Let us know at Info@Tricio-Advisors.com
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