Equity market volatility stepped up in August, reflecting a still highly uncertain economic and geopolitical backdrop. The outcome of the US presidential election – now less than two months away – is a particular focus in this regard. On the macroeconomic front, every data release is closely scrutinised by financial markets in the hope of gaining some clarity on two key questions: whether the US will be able to avoid a recession and by how much the Federal Reserve will cut rates. One trend, however, seems unstoppable, that of rising government deficits and debt. Which, combined with slowing activity, makes for an “unstable financial/economic equilibrium”.
The huge public spending programs put in place during and after the Covid crisis, when interest rates were close to zero, sadly did not serve to strengthen economic fundamentals. Rather than replacing badly outdated infrastructure or addressing the intended energy transition, government outlays were mostly focused on household purchasing power. As such, consumer spending has been the main driver of post-pandemic economic growth across the Western world.
Unfortunately, this spending spree now seems close to ending. The US personal savings ratio has plunged to less than half its 2019 level. Consumer loan default rates are rising, and credit card balances are piling up. The fact that the US labour market has begun to cool down, with slowing wage growth, a shorter workweek and an uptick in the unemployment rate, is also starting to weigh on consumption.
Which makes for a grim picture: Western economic growth is headed for a further slowdown (perhaps even a recession), at a time when public finances are already very stretched. Government debt ratios stand at historical highs, and interest expenses are increasingly weighing on budgets, partly also because existing debt has to be refinanced at higher interest rates. With sovereign debt moving in only one direction (up), pressure is mounting on central banks to cut rates again. Monetary easing is already underway in Europe and Chairman Jerome Powell made it clear at the August Jackson Hole Symposium that the US Federal Reserve will follow suit, starting this month. This is now possible as inflation appears to have cooled sufficiently.
From an investment standpoint, the forthcoming rate cuts should sustain equity markets, provided corporate profits remain more or less intact. This, however, is not evident should the economy experience a significant slowdown. Companies operating in sectors that will benefit from additional government spending (to the extent it can be financed) logically stand as prime potential beneficiaries.
On the fixed income side of portfolios, it also seems obvious that longer-duration (government) bonds will react positively to a more accommodative monetary policy. In practice, though, the case is not that clear-cut. Not all governments and companies are equally creditworthy in this respect and finding buyers for new debt issues could become progressively more difficult, even for the US Treasury.
A Wharton Business School (Philadelphia) study has shown that the US budget deficit (and hence national debt) will continue to increase sharply over the next decade, regardless of who moves into the White House. The cumulative additional deficit for the next 10 years is estimated at USD 1.2-1.7 trillion under Democratic rule (Harris) and USD 4.5-5.8 trillion under Republican rule (Trump). The difference between these two projections stems mainly from each party’s proposed tax regime, with Trump pushing for lower taxes and Democrats just wanting to raise them.
To finance such large deficits, Wharton suspects that the central bank will have to come to the rescue again by buying US government bonds (quantitative easing), which would push inflation back up towards 4-5% within a few years.
In Europe, there seems to be a desire to make the same thing happen via, on the one hand, a limitation in the growth of national debt, but also greater issuance of “European” bonds. According to the recent Draghi report, as presented to the European Commission, Europe needs an additional EUR750-800 billion per annum to close the technological gap with China and the US, build up its own defence industry and realise the energy transition. This can be done through levying new taxes or taking on additional debt (or a combination of both).
Either way, financial markets will clearly be heavily solicited during the coming years and another round of “quantitative easing” – with accompanying inflation – lurks around the corner.
For the time being, we are making no changes to our current asset allocation, keeping average fixed income duration on the longer side (to benefit from a pending drop in interest rates) and sticking to a rather “tactical” approach in equity markets: not too much exposure, ample diversification, and some ammunition kept to respond to temporary corrections, given the higher volatility regime.
Overall, we do try to remain cautious, aware that the current unstable financial/economic equilibrium leaves little room for exogenous shocks.
