Very interesting times

The US election results

This week has certainly lived up to the billing. The most significant event, of course, is the US election result with a clean Republican sweep of the Senate and the House of Representatives, and of course, Donald Trump back in the White House with a significant popular mandate. Financial markets have already reacted broadly as we might have expected: US equities up, government bonds down, the dollar a bit stronger, and Bitcoin at an all-time high.

Some sectors have fallen within the US equity market, especially those seen as the most significant beneficiaries of Biden’s green agenda and its signature Inflation Reduction Act. These initial reactions are to be expected, but clarity on Trump’s actual policy agenda will have to wait until early next year. Rather than speculate now, I will wait until we have that clarity before commenting on the specifics. However, I think it is reasonably clear that Trump’s tax-cutting agenda will likely lead to higher growth than we would otherwise have seen, but I’m not quite so sure about the consensus view on higher inflation. I can see why the consensus thinks this is an inevitability, but, as ever, energy prices will be pivotal to the inflation outcome, and Trump’s agenda is to “drill, drill, drill”. The US is already the world’s largest oil producer by some margin (over Saudi Arabia), and the energy market is already far from tight. My guess is that Trump’s energy policy could put further downward pressure on oil and gas prices (see below), which could more than offset the potential inflationary consequences of higher growth.

Trade policy

Donald Trump’s trade policy is also something to keep a very close eye on. Of course, most commentators are focused on its implications for China, but as far as we know, Trump's promised tariffs would also apply to exports from other countries that have large surpluses with the US. One of those is the UK, which exports £190 billion in goods and services to the US and enjoys a surplus (in 2023) of just over £72 billion. This is by far the UK’s largest trade surplus, being nearly 3x bigger than the second largest, with Ireland. At first sight, this looks potentially worrying for the UK economy, but the mitigation here is that £68 billion of the £72 billion surplus is in services, on which it is much harder to levy tariffs, with only £4 billion being the surplus in goods.  

Interest rates

There is not much to say here other than that the FED and the Bank of England’s cuts in official rates of 0.25% were broadly expected.

In the future, I expect that the Bank of England will continue to reduce rates over the next 12 months, cutting in February, May, August, and November next year to 3.75%. It is also worth saying that the MPC’s inflation expectations for next year already look significantly too high, as do the OBR’s. Both organisations forecast a peak in UK inflation next year at about 2.8% in Q3. Both see higher inflation as a consequence of the National Insurance increases in the Budget, base effects and the higher energy price cap. Their forecasts are significantly too high, in my opinion, principally because I do not see UK companies mitigating for the higher cost of NI by putting up prices. I expect them to adjust wage costs and employ fewer people due to these changes. In other words, the cost of higher employer’s NI will be borne by employees in their wages and by higher unemployment than we would otherwise have seen. According to the latest data, downward pressure on UK inflation will also come from lower input prices, which are now falling in absolute terms.

By way of context, as regular readers of this blog will know, the OBR and the Bank of England have form on this issue. For example, a year ago, the MPC was forecasting UK inflation would now be 3%. In September it was 1.7%.

As for the FED, today, the narrative accompanying the rate decision was, in my opinion, very sensible. The vote to cut was unanimous, and the Committee said that it had “greater confidence” that inflation in the US is moving sustainably towards the 2% goal. There, too, I would expect that we will see further rate cuts, albeit that, as ever, the FED’s policy decisions will be data-driven.

The UK gilt market – why is it falling?

I mentioned this in passing in my previous blog. Some consensus commentary is attributing the recent weakness in the market (higher yields) to effectively a “buyers’ strike” in anticipation of greater gilt issuance following Rachael Reeves’ recent budget, which announced a significant increase in government borrowing. Those of you who have read my previous two blogs will know that this is fallacious. There is no relationship between the size of the government deficit and 10-year yields.

This was borne out in a gilt auction earlier in the week that was 3x oversubscribed—no evidence here of a buyers’ strike.

10-year yields have risen here in the UK because yields have also risen in the US and because the market is pricing in the expected inflationary consequences of the recent budget. I think this is a mistake. I believe, as I have outlined already in this blog, that the inflationary consequences of the budget have been exaggerated. Consequently, I expect this kerfuffle in the gilt market to subside and for yields to return close to the level from which they recently came (around 4%).

China’s stimulus package

Today, China unveiled what appears to be Phase 1 of its fiscal policy stimulus programme. As expected, the announcement today contained details of a 10 trillion yuan (US$1.4 trillion) refinancing plan for local government debt, much of which has been “hidden”, alongside the first increase in the local government debt ceiling since 2015. This initiative is designed to alleviate the debt problems that have crippled local governments’ ability to fund local growth-friendly initiatives as they have struggled to repay their debt following the collapse in receipts from land sales.

This important announcement addresses one of the major challenges confronting the economy and has been welcomed by commentators. However, the additional fiscal policy initiatives designed to stimulate consumer demand which the market had been anticipating, have been delayed until the new year. China’s finance minister, Lan Fo’an, has promised “more forceful” fiscal policy measures then, but the plan now appears to be to wait for Trump’s inauguration in January and for more clarity on the tariff measures that he will propose.

Although there was some market disappointment that more fiscal stimulus was not announced today, this decision to wait for more clarity looks sensible not least because the extent of the trade barriers that Trump erects will naturally partly inform the decision on the scale of the domestic stimulus.

I remain confident that the eventual package will be of a scale that will have a meaningful impact on domestic demand, but we will just have to wait a few more weeks before we can make that assessment.