As we head towards a very consequential US election next month, we are balancing our positioning between two opposing forces. The first is the strength of recent economic data. The second is the inevitable uncertainty that comes with a change in policies.
Recent economic developments have defied most expectations. US economic growth remains robust. At 3%, the economy is growing faster than most estimates of its potential long-term growth rate, despite tight monetary conditions. Job creation remains strong. The recent rise in the unemployment rate was clearly due to a faster-than-expected increase in labour supply. Inflation has fallen sufficiently for the Fed to have begun cutting rates.
It is premature to declare that the risks to growth and inflation have dissipated. The most recent core CPI figure, which annualises at 3.8%, echoes the strength of real economic activity. It suggests that the interest rate environment was not high enough to make a meaningful dent in the rate of economic growth. If inflation does not decline rapidly, it is likely that the bond market’s expectations of the rate cuts priced-in will be disappointed. The uncertainty around the level at which the Fed is likely to pause its rate-cutting cycle is high. The median expectation of FOMC members is around 3%. Some members expect the rate to be as low as 2.3%, others expect it to be as high as 3.7%.
Against this background, over the past month, we adjusted our portfolio positioning to align with the economic outlook. We increased our positioning in equities, while tilting away from the mega caps with very high valuations. We have also re-introduced a position in high yield fixed income in our portfolios, while noting that valuations are not compelling enough to justify a full allocation. Within fixed income we have shied away from increasing duration, as we see the risks to be asymmetric. We do not think that long-term rates are likely to decline, and taking duration risk introduces a level of volatility without adding to returns. This is in part because we believe that the current level of long-term rates to be about fair, and in part because we see the trajectory of interest rates to be dependent on the fiscal policy outlook after the November elections.
It is always risky to position portfolios around particular electoral outcomes, and current polling suggests that the outlook for November is too close to call. Nonetheless it is instructive to think about two possible scenarios, and their implications for fiscal policy.
The fiscal deficit is estimated to be around 6.7% this year, and is forecast to decline to about 6.5% next year. This is in part because the budget for 2025 has already been approved, and meaningful changes to taxation and expenditures are not likely to be enacted before the next budgetary cycle. A key element in the debate will be the expiration of the tax cuts that were part of the Tax Cuts and Jobs Act of 2017.
A Trump victory, coupled with a “red sweep” of Congress and the Senate, will imply that most of these tax cuts are extended. However, it is unlikely that all will be extended, as many in Congress will balk at the consequent rise in the fiscal deficit. The extension of tax cuts for those earning below $400k jointly will be a high priority, but the elimination of personal exemptions is likely to be one of the revenue-raising measures implemented. A cut in the corporate tax rate to 15% is likely under this scenario, and this can be partly financed by the elimination of energy provisions under Biden’s Inflation Reduction Act.
Perhaps the most controversial revenue-raising measure from a Trump administration would be the imposition of a 60% tariff on imports from China, and 10% from the rest of the world. The implications of such a policy will depend on a number of factors that are hard to estimate. The level of revenues raised is dependent on how the level of imports changes. Since the 2018/19 tariffs on China, imports of items impacted by the tariffs have declined between 25% and 45%. It is also not clear how America’s trading partners would respond to such tariffs. What is clear is that tariffs will immediately imply higher prices of imports, and an opportunity for domestic businesses to raise prices.
A Harris victory, coupled with a “blue sweep”, is unlikely to be a simple continuation of Biden’s policies. Like Trump, she is likely to extend the tax cuts on earnings below $400k, and to eliminate personal exemptions. But she is likely to introduce higher taxes on capital gains and raise the corporate tax rate to 25%. She will also introduce some manufacturing tax credits.
The market reaction to a second Trump administration is unlikely to be like the first, for several reasons. First, the starting point of the fiscal deficit and debt levels are much higher, and bond markets are likely to be more wary of tax cuts that are unfunded. Second, the economic cycle is more advanced, and there are limits to the extent to which growth can be spurred without reigniting inflationary pressures. Third, the level of the proposed increases in tariffs is sufficiently high to be a shock to the price level, at a time when inflationary pressures have not been convincingly subdued. Finally, his proposals on immigration will likely reduce the labour supply at a time when the market is tight, putting upward pressure on wages and prices.
A Harris victory is likely to put less pressure on prices. But other elements of the plan are not necessarily positive from an equity market perspective. Raising corporate taxes will not support earnings growth. Increasing taxes on capital gains and buybacks can also dampen market performance. Importantly, while Harris’ policy proposals will not imply a deterioration of the fiscal deficit in the medium term, they will also not have a very meaningful impact in reducing it either.
It is possible to think of scenarios in which each candidate will have a positive impact on some segment of the market. For example, Trump’s corporate tax cuts are likely to have a bigger positive impact on companies with lower free cash flows and small caps, but will have a negative impact on companies that are dependent on international supply chains. The reverse is true for a Harris victory.
What both candidates have in common, however, is a lack of serious concern about the level of the fiscal deficit, and the consequent rise in debt levels. As Minneapolis Fed president Neel Kashkari recently pointed out, the neutral rate of interest rises along with the debt levels. We believe we are at a point where, absent an unexpected boost to productivity, the fiscal outlook has placed a floor below which long-term interest rates are unlikely to fall. This, in turn, has long-term implications for investment growth and market valuations.