US Election, Inflation, and the UK Budget

Apologies for the later-than-usual delivery of your (somewhat longer) monthly commentary.  However, you probably noticed a budget at home and an election in our former colony, and it behoves me to feature these and their likely effects on market behaviour in greater detail.

Through October, markets marked time until the US election outcome became clear (with the notable exception of the UK and our budget, which will be discussed later). These events have played out against a background festooned with inflation concerns and interest rate expectations in the US and the UK. October saw abundant US economic data published; alas, Federal Reserve (Fed) Chair Jerome Powell’s stated dependency on data depends on undependable data. The latest job figures included significant downward revisions in the previous two months’ numbers and a dramatic drop in the number of new jobs added.  This supported the Fed’s decision to cut interest rates by a further 0.25% at its scheduled meeting two days after the US election. 

And so, to that event.  Survey results in 2024 have recorded that over three-quarters of US voters claimed inflation had caused them hardship this year. Despite the rate falling dramatically, food prices are, on average, 22% higher than at the start of the Biden presidency.  Pandemic-related inflation has been a global phenomenon, and every governing party standing for re-election in the developed world in 2024 has lost. According to the Financial Times, 120 years of past voting data show this has never happened before.  One might argue that COVID's economic and psychological effects continue to have an insidious influence on the course of history.

Trump's Return: A new agenda for policy, trade, and economic impact

Donald Trump has more than enough Electoral College votes to reoccupy the presidency on January 20^th.  His dominance of the popular vote and his party’s likely (as I write) clean sweep of the two houses of Congress means he should feel free to turn his campaign rhetoric into policy.  However, his 2.4% lead over Ms Harris was certainly no landslide compared to the likes of Nixon in 1972 or Roosevelt in 1936, who led their respective opponents by more than 20% - today, almost half of the population may feel disenfranchised.  In comparison, more than two in every three voters did not vote for Labour in the last UK election.

A second Trump administration will be better prepared and staffed than in 2017. With a compliant Congress and an assumption that he delivers on his economic promises, expect a series of tax cuts announced early next year and 10% tariffs on all imports, with up to 60% on those from China.  The US is the world’s biggest importer, at $3.2trn, with China and the EU forming more than a third of that figure.  Tariffs are effectively taxes borne by US buyers of imported goods. Many of those goods are parts and other components to be used in manufacturing, so as these move along the supply chain, they would contribute to rising prices on finished goods even if those products were built in the USA.

Rising Inflation and its subtle impact on consumer goods and bond markets

Ironically, perhaps, inflation might be expected to rise to varying degrees across a whole range of consumer items, but less obviously.  Some companies’ margins might be squeezed, while tariffs are less likely to apply to frequently bought (and hence US-sourced) items, like fuel and food. Higher inflation would slow the pace of interest rate cuts and raise bond yields (i.e. lower bond prices).  Bond markets have already started to discount this.

US regulation is likely to be eased, especially for energy companies and Banks, while digital currency may become more mainstream (hence the dramatic rise in Bitcoin’s price post-election night).  Green companies are unlikely to curry favour with the administration, given Trump’s apparent aversion to windmills.  It has been suggested he might challenge the independence of the Fed. However, this has been exaggerated: while Trump may look to replace Jerome Powell as Chair when his tenure ends in 2026, removing the Fed’s independence would be catastrophic for markets. He may want more influence, but the Bank will remain de facto independent. The election has positively impacted the equity market, with new all-time highs being achieved in the days following the election. Trump’s relatively recent conversion to cryptocurrency supporter has boosted Bitcoin’s price to a record $81,000, some 20% higher than on the eve of election day.

Labour’s tax hikes and new borrowing framework

Here at home, meanwhile, Halloween week’s maiden (pun intended) Labour Budget produced a somewhat predictable Daily Telegraph headline (“A Nightmare on Downing Street”), following an apparent “one-off” record-breaking (£40bn) tax raid on businesses via a National Insurance hike and a slashed payment threshold.  An already whopping £300bn in gilt issuance this year was topped up by another £20bn or so, the budget haul being supplemented by £40bn in planned tax increases and an additional £142bn borrowing over the life of this government, versus what was planned in the (Conservative’s) Spring budget in March.

It's worth clarifying that the ability to raise this extra borrowing is not a ‘fiddle’, as has been described in some quarters (including my golf buddies).  Most countries have fiscal rules to demonstrate a commitment to prudent management of government finances. We have only had these rules in the UK for 30 years, after decades of running budget deficits (and the government setting interest rates).  The International Monetary Fund (IMF) advocates fiscal rules that allow leeway to borrow for investment (rather than to cover current liabilities not paid for by taxes) and a borrowing capacity ‘formula’ that accounts for government assets as well as liabilities, and the anticipated benefits of those investments.  Hence, Labour’s new measure - Public Sector Net Financial Liabilities (rather than Net Debt) allows for greater borrowing.

Rising gilt yields

From an investment viewpoint, the market’s immediate reaction and more considered attitude the following day crystallised around the obvious nominal debt burden rather than any longer-term benefits arising from how that money will be invested.  As Ms Reeves was 15 minutes into her speech, the yield on the 10-year Gilt stood at less than 4.2%; by 4.00 pm, it was 4.4% and almost 4.7% by early afternoon Thursday.  This upward pressure has, however, eased back 4.4% since the Bank of England’s (BoE) decision to reduce rates further.

This is important.  The government’s ongoing borrowing commitments are satisfied via the issue of new Gilts.  The Debt Management Office has said it will issue £297bn in new gilts for the year to April 2025. This is the second only to the COVID year, 2020, as the highest on record. The redemption yield on these new bonds must compete with existing bonds with similar maturities.  This could be a brake on further interest rate cuts; the market has already reduced its near-term expectations on that score by 0.25%. Expect a shallower trend of rate cuts but not hikes. 

A plethora of infrastructure and technology innovation initiatives were announced, but it remains to be seen what ripple effects those might have on employment and GDP growth. The independent Office of Budget Responsibility (OBR) published its report immediately after the Budget speech, forecasting sluggish growth. Still, their press conference answers contained so many caveats that they were all but useless (to me, at least) as robust guides to productivity expectations.

The anticipated removal of the Inheritance Tax mitigation benefits of investing in companies listed on the Alternative Investment Market (AIM) proved premature.  Given the government’s commitment to growth, a severe attack on the viability of this market would have been irrational.  As it is, the effective IHT rate is 20%, still an advantage and incentive to investors to focus on smaller companies.  That market rose 3.5% during the speech.

Rate cuts continue despite inflation warnings

Subsequently, the Bank of England cut rates again by 25bps and warned of geopolitical risks, but it more pointedly suggested Labour’s budget was inflationary due to increased employment costs. However, Governor Andrew Bailey added that the effect was unlikely to compromise planned rate cuts. That helped calm the recently beleaguered Gilts market; as mentioned above, the 10-year yield has risen by almost a whole percentage point since September and accelerated since Budget Day’s borrowing bonanza.

In conclusion, this last 6-week period may have hogged the headlines and the attention of market traders, but our long-term strategy will remain the same.  Investors (as opposed to speculators) should refocus on the long-term investment story. Inflation and interest rates, especially in food and energy, remain on a downward trend despite speculation about the effects of possible US tariffs. People will pay over-inflated prices for only so long before they become more discerning.  Companies may have to drop prices or cut costs to compete and/or find new markets.

As history demonstrates, despite politics and fashion, capitalist economies continue to grow as companies profit from providing services and making things that people want to buy. That remains the case today.

Graham Bentley

Chief Investment Officer

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