Monday Digest
Posted 11 November 2024
Known winner, unknown outcomes
We expect some risks but potentially higher rewards for US assets under a second Trump term. Markets are clearly excited, but some of the equity rally was about pent-up demand – as investors had de-risked ahead of an uncertain election. The policy details are still murky, and economists worry that tariffs (which would reach record highs if they matched Trump’s campaign promises) and deportations could stoke inflation. The timeline for policy implementation therefore matters as much as the policies themselves, so we expect stimulatory supply side measures like tax cuts before the restrictive measures like tariffs.
We might see protectionist policies in Germany too, following the government’s collapse and upcoming election (in which the centrist parties will try to appeal to the growing populist vote). The German economy has been stuck between a rock and a hard place: energy prices hit by Ukraine, industrial profits squeezed by Chinese overproduction. Both could improve, if Ukraine cedes territory (likelier under Trump) and China succeeds in stimulating its domestic demand. We just hope Germany has a functioning government to guide toward that light at the end of the tunnel.
Almost lost in the news this week was the US Federal Reserve and the Bank of England both cutting interest rates. UK and US bond yields fell in response, and the two bond markets remain closely tied. That won’t change soon, but we could see some divergence in the long-term if UK bonds come closer in line with Europe, and US bonds are weighed down by debt deterioration.
Trump’s second term could be very different to his first. Markets liked his previous tax cuts, but there was a sense that turbulence and drama were barriers to achieving more. His “promises made, promises delivered” victory speech suggests he is aware of this, and might try to keep a stable cabinet for the next four years. We will need to keep an eye on who is appointed ahead of inauguration. Markets seem to be betting that policy will be more coordinated and less disruptive this time around. For investors’ sake, we hope so.
What does Beijing do now?
Chinese assets sold off after Donald Trump’s election win. His 7.5%-25% tariffs on Chinese imports in his first term already hurt Chinese producers, and he supposedly wants to hike them to 60%. That would compound China’s disinflation problem – which recently spurred the government into announcing economic stimulus. There have been mixed messages from Beijing about how much actual support they are willing to give, as some policymakers (and possibly Xi Jinping himself) seem reluctant to wholeheartedly boost consumer demand – as previous stimulus created the credit bubble that led to the current downturn.
60% tariffs would force Beijing to confront its demand problem. Last week, policymakers announced a 10 trillion yuan ($1.4tn) debt plan, but this mostly amounted to relocating debt from local to central government. There were suggestions that Beijing was waiting for the US election before committing to a plan – a reasonable tactic. We expect a plan to boost consumption, possibly after December’s economic conference for the communist party. Chinese stocks will rise if markets like the proposals, but we would caution that long-term profit improvement is needed before China can be seen as a good long-term investment.
Business sentiment is improving faster than expected among manufacturers and service providers – but some of this is due to exporters rushing out orders ahead of tariffs coming in. Xi has talked up the need to draw in foreign capital, but that requires removing some structural barriers and building domestic citizens’ confidence in their own asset markets first. Oddly enough, the US-China decoupling could actually help build that domestic focus.
We should note that China’s market impact goes beyond just its domestic risk assets. China is heavily invested in US treasury bonds, and it remains to be seen what happens to those holdings in Trump’s second term. It’s possible that Chinese growth could suffer even if global growth benefits – due to Beijing’s demand stimulus.
US debt risk
Donald Trump’s tax cuts threaten US bond markets in a way that’s hard to quantify. Government bonds are called ‘risk free’ – but only because governments can theoretically print money to pay back debts. Prices can still be volatile (as we know all too well from the ‘Liz Truss moment’) and one way people try to measure this risk is through the so-called ‘term premium’, the difference between long and short-term yields. However, this measure is blurred by the fact yields at different maturities also reflect economic expectations.
Another good way to measure bond risk is by comparing yields to swap rates between banks, where one bank swaps a long-term interest-paying instrument for a secured overnight lending rate. After the global financial crisis of 2008, the Federal Reserve effectively guarantees this lending, making the swap rates even more ‘risk free’ than government bonds.
Last week, the difference between 10-year treasury yields and equivalent maturity swap rates climbed to an all-time high of 0.53 percentage points. This suggests markets are worried about higher US debt. US fiscal deterioration is a long-term trend, but Trump’s tax cuts could materially shrink the tax base and stretch debt to the limit.
You might look at the higher yield-swap spread as an indication that treasury bonds are cheap and due a rebound – but that bounce-back demand has not been forthcoming lately. The biggest risk is a Liz Truss moment in US bond markets, which would be substantially worse for the global financial system than the UK bond panic two years ago. US bonds don’t have to get that bad to weigh on markets either. If international investors decide to hold fewer US treasuries, domestic savers will have to make up the shortfall, taking money out of stocks. Much depends on whether the growth benefits from Trump’s tax cuts outweigh the increase in underlying risks.