Emma Moriarty, Portfolio Manager, CG Asset Management, considers how the results of the US election and the UK Autumn Budget have affected the markets.
The result in favour of President Trump in last week’s US election has resolved one of the big uncertainties facing the US economy. The question now turns to which ‘flavour’ of Trump presidency will prevail: Up to this point, most of the narrative has been from the perspective of debt sustainability and has focused on the $7.75tn central case estimate of the additional 10-year impact of a Trump presidency on the US fiscal deficit.
The two major features of these projections were sweeping tax cuts, only partially offset by additional tariff revenues. However, the decisiveness of the victory has now prompted optimism as to whether the resultant administration has leeway to be more moderate. The more moderate version of the administration would see less aggressive tariffs, higher productivity from deregulation (e.g. in the banking sector), and narrower fiscal deficits.
From a pure interest rate perspective, either of these outcomes increases r*: In the central case, by pushing on aggregate demand through fiscal stimulus; and in the moderate case, by increasing productivity through deregulation.
From the perspective of an index-linked bond investor, the central case is obviously more inflationary. The impact of the moderate case is more nuanced: higher productivity is deflationary, but the extent to which this is capable of offsetting both the direct costs of and lost economic output from tariffs is difficult to answer but feels unlikely in the very short term.
More generally, the recent UK budget and the wider national debt debate around the US election has given renewed importance to Reinhart and Rogoff’s work on the impact of debt on growth.
The concept behind the work is that at some point countries reach a debt threshold – roughly 90% government debt to GDP for advanced economies – where the level of government debt becomes a significant constraint on the country’s growth rate – for example, as a greater share of the fiscal deficit is used for debt service rather than investment.
The work also introduces a second concept, the debt limit, which is the level of debt beyond which additional borrowing is infeasible. The debt limit will be a function of a number of factors, for example, institutional frameworks, inflationary environment, currency, and depth of capital markets. While US Treasury markets have been able to absorb the election news relatively unscathed, the extent of the gilt market response to the recent UK budget, which loosened the fiscal rules and increased the path of borrowing, has perhaps demonstrated that the UK is much closer to reaching its debt limit than the US is.
Accordingly, we maintain short duration in index-linked gilts (c. 5.2 years in our multi-asset funds) but allow longer duration in US TIPS (c. 8 years). We continue to maintain our cap on risk asset allocation (c. 35%) given stretched US equity valuations and the potential for a wider correction in these markets.
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