A Complex Year Ahead

The past year has been one of positive surprises. Inflationary pressures were brought under control in most countries. US economic growth remained strong, exceeding most forecasts.  Equities and credit performed well.   

The outlook for the global landscape is far more complex for the year ahead. There are three pressing challenges. First, the fiscal outlook on both sides of the Atlantic is far from comfortable. Second, the landslide re-election of President Trump promises significant changes to trade policy and global trade flows. Third, hampered by a lack of political will, the growth outlook for both Europe and China is very subdued.   

The fiscal outlook poses immediate challenges to policy makers. With economies having recovered, governments on both sides of the Atlantic have been able to reduce deficits from the exceptional levels during the Covid era. However, debt levels have not materially declined. In an environment of higher interest rates, this implies that interest spending is consuming a much larger share of total government expenditures. 

The problem is that the space for cutting government spending is severely constrained by voter preferences, while tax rises are deeply unpopular. France and the UK offer cautionary tales. The Trump administration promises a different direction. By reducing taxes and regulations, while attempting to find efficiencies in government spending, it is hoping that a boost to growth will address the debt problem over the medium term. This route, while theoretically appealing, entails risks. It remains to be seen how much savings can be achieved through efficiency enhancements, and the degree to which growth can be boosted. In the meantime, the deficit and debt levels will rise.  

The outlook for global trade has also worsened. It is unclear whether President Trump’s stated intentions to institute tariffs on imports from China (60%), Canada and Mexico (25%) and the rest of the world (10%) are the opening salvo of trade negotiations, or firm policy. But when it comes to trade, the devil is inevitably in the details, not the headline figures. Rules of origin are exceedingly complex. Taxes on intermediate goods (40% of US imports) can backfire by hurting domestic producers.  

Regardless of how the Trump administration will handle trade, it is clear that global trade flows have been fragmenting for a number of years. Geopolitical exigencies led to a shift towards trade within politically aligned groupings. Trade within certain regions has grown faster than between different regions. Protectionist pressures are unlikely to be a uniquely American phenomenon. In some sectors, in particular Autos, excess capacity in China represents a shock that will raise protectionist pressures around the world.  

With global trade unlikely to be an engine of growth, domestic growth drivers become more important. Here the European economies and China face difficult challenges. In both of these cases, the solutions are structural in nature. There are no short-term policy fixes that can accelerate growth in the medium term.  

 Against this background, we foresee a global outlook marked by significant downside risks in the period ahead. The US economy is growing at a healthy clip, but the threat of tariffs means that US imports will not be a catalyst for global growth.  

Where does all of this leave investors? Valuations of risk assets in the US are priced for blue skies. Equity valuations are high, and credit spreads are tight. Such valuations can be justified if growth remains robust, and interest rates decline in line with market expectations. This leaves the market very exposed to negative surprises.  

To address these risks, our US portfolios are positioned to overweight value stocks, and smaller capitalisation companies. These stand to benefit proportionately more from tax cuts, than the very large “magnificent seven” stocks that have highly optimised tax structures.  

In addition, we expect that structural changes to global trade flows and taxation will offer opportunities for active equity managers. Banks tend to perform well with deregulation and increases in M&A activity. Tariffs will benefit some manufacturers but hurt others. A shift away from heavy subsidies to renewable energy sources would hurt some regions while benefiting others. Such opportunities will be apparent at a company or sub-sector level, rather than at a macro level. 

Outside the US, it is tempting to see valuations in Europe and some emerging markets as attractive. However, we struggle to see the catalyst for performance. The European market is dominated by large companies that depend on global trade growth. Emerging market exporters are in a similar position.  

We continue to maintain an overweight in fixed income but prefer credit and short duration to taking long duration risk. In the US, the potential for a wider deficit and high financing needs does not support a decline in long term rates. At the same time, inflationary risks are not fully under control, leaving open questions whether the Fed can deliver all of the rate cuts that are currently priced into the market.