Monday digest
Posted 22 January 2024
Overview: ‘Lower, slower’ replaces ‘Higher for longer’
Positive sentiment, driven by expectations of an imminent and significant onset of rate cuts, began to wane last week, and global capital markets resumed their volatile path of last year. The combination of a distinct slowing in the downward trajectory of inflation, paired with increasing confirmation that economic conditions are more on the up than down (at least in the US), have made it even less probable that rates will be cut soon and fast. As a result, some investors are facing up to the very distinct possibility that rates may only begin to be cut later and then more slowly. In other words ‘lower, slower’ seems to be replacing last October’s ‘higher for longer’ narrative.
Consequentially, bond yields rose again last week, led by more rises in the US Treasury market. In the US, mega-caps were notable performers and the Nasdaq Composite regained the 15,000 level. However, equities overall generally drifted downwards with smaller caps under pressure. Non-US markets also declined.
Global companies are reporting lacklustre results for the last quarter of 2023 and giving similarly tepid forward guidance. It’s still the early stages of the reporting cycle, with just 6% of S&P 500, companies having reported, mostly banks, consumer and industrials. Bank results have been mixed, while consumer names are seeing less US spending power as households’ cash savings decrease. Revenue ‘beats’ may be not as positive as hoped, but broadly speaking, expectations for US companies’ earnings growth are still strong, driven mostly by US domestic demand.
Last week’s return of seemingly indecisive markets suggests a creeping realisation that the inherent impatience of markets has once again led to unrealistic expectations over the potential rates ‘reward’ on falling inflation. Does that mean market sentiment has reversed and investors are no longer optimistic? No, not at all from what we can see. A dose of realism into how long it may actually take for economic and market fortunes to be sustainably positive again may well offer up some short term investment opportunities, particularly while markets have re-entered range-bound terrain.
Just how sustainable are European and US deficits?
At the moment, fiscal deficits are high by historical standards and rising over the long-term. This is not the short-term funding gap we saw in the pandemic, but a sustained push toward looser fiscal policy, and it is happening across virtually all major economies. With bonds currently in limbo, understanding countries’ fiscal positions – and whether they might lead to instability – is key. Even though rising deficits can be seen across the world, the outlook varies by region – most consequentially between the US and Europe.
In the US, deficit spending has continued and grown under President Biden. Some of this is a hangover from pandemic-era policies, but even after those have faded there has been a substantial increase in the gap between federal tax receipts and spending. The US government is running a cumulative deficit of $509 billion for the 2024 fiscal year so far, $94 billion more than in the same period in the prior fiscal year. Tax receipts are growing, thanks to the enduring strength of the underlying economy, but outlays are growing faster. Sustained fiscal expansion is one of the main reasons why US growth remained surprisingly strong last year. It is almost inevitable that this impetus will reverse but a sharp change in outlays could make things extremely difficult. Some analysts have argued on this basis that the US economy will struggle in 2024. The flipside of this, though, is that the Federal Reserve (Fed) has made clear its intention to cut rates, bringing down short-term yields and lowering immediate borrowing costs. That would constitute a substantial relief in terms of interest expense for the Treasury, since it has done a lot of its borrowing through short-term markets.
Heading into election season, the fiscal deficit will likely be an avenue of attack against Biden. This will probably happen regardless of which Republican candidate ends up on the ballot, even though Trump’s own fiscal record is clearly questionable. Fiscally conservative rhetoric will be heard – even perhaps from the more centrist Democrats – but that does not guarantee fiscally conservative policy.
Despite some major crises over the years, European countries are generally more fiscally conservative than the US. This is by design: the Eurozone’s fiscal sustainability rules prohibit debt or deficits above certain levels. These rules were reformed at the end of last year, with measures introduced to evaluate national debt sustainability on a more individual basis – rather than the old ‘one-size-fits-all’ approach that all found unsatisfactory.
After a long process and significant negotiating, the end result of the fiscal reforms is a thoroughly European compromise: kick the can down the road and let future politicians deal with the inevitable crisis negotiations. The political impact of fiscal deficits seems a bigger issue for Europe than fiscal sustainability itself. The average required annual fiscal adjustment for European countries under the new rules amounts to removing 0.5% of GDP each year. That is significant, but arguably less than the fiscal adjustment required in the US to ensure fiscal stability. The adjustment required for certain core nations, though, could be very onerous. France, Spain, Italy and Belgium have to make significant changes from next year and beyond. In the last decade, populism has grown dramatically in each of these countries. France already has perennial social unrest. With economies so weak after Covid, the Ukraine war and cost of living crises, European-enforced cuts could well lead to exit rhetoric in the EU’s core nations. Here in the post-Brexit UK, we have seen close-up how damaging this can be for economic prospects and domestic asset values.