Safe-havens can be casualties of politics too

Safe-havens can be casualties of politics too

The outcome of the US presidential election has removed at least one aspect of the uncertainty that has dogged markets over the past few months. Now that Donald Trump is confirmed to be heading for a second term in office, the market is reassessing the impact of election outcomes on various asset classes. While the initial knee-jerk exuberant ‘Trump trades’ have been receiving attention, we believe that investors should be focusing more on the potential longer-term impacts.

The US seems set to continue its spending spree
Plans to bring the enormous US debt burden under control were notably absent from both candidates’ campaign plans. The non-partisan Committee for a Responsible Federal Budget calculated the fiscal impact of both candidates’ campaign plans in late October 2024, and found both Harris and Trump’s policies likely to grow the US debt materially by 2035. Of the two, however, a Trump victory was seen as having the most detrimental impact on the budget deficit and US debt levels. With significant planned tax reductions not being offset by increased tariffs and reduced spending, it is unclear how Trump will seek to ‘balance the books’, other than relying on the proposed Department of Government Efficiency (DOGE) to help trim substantial costs from the national budget. US national debt is now approaching US$36 trillion (with nearly US$29 trillion held by the public), the federal budget deficit for 2024 is estimated at
US$2 trillion, and total interest on the debt is expected to exceed US$1.1 trillion this year.

Rate cuts are still on the cards – for now
The US Federal Reserve (Fed) cut rates by a further 25 basis points on Thursday 7 November 2024, despite the US economy remaining strong. While the Fed’s preferred inflation measure (the personal consumption expenditure (PCE) index) fell to 2.1% in September, core CPI is expected to remain sticky above the Fed’s target for some time (currently at 3.2%).

While we wait to see if Trump’s stated policies will be fully implemented, most of his high-profile policies are inflationary. Tariffs, tax cuts, a clamp-down on immigration, and a weaker dollar should all put upward pressure on US prices. Trump’s planned reduction in energy-related regulations is seen by some as increasing the supply of US oil and gas (and hence potentially reducing prices) but, in practice, US exploration and production (E&P) companies’ production has been constrained by their own capex and shareholder return objectives. Reduced regulations are unlikely to drive a material increase in production in the short-term. As Trump’s prospects improved, we saw the 10-year US breakeven inflation rate rise from 2.0% in September 2024 to 2.3% now, reflecting the markets concerns about higher inflation under Trump.

In addition, the International Monetary Fund (IMF) recently warned that global inflation is vulnerable to supply side shocks from various sources, including geopolitical tensions, health issues and climate change. With ever-widening geopolitical instability in the Middle East, the possibility of supply disruptions cannot be completely ruled out. Despite this clear potential risk, the price of oil has remained largely anchored to date. While market concerns around weak demand from China may continue to keep oil prices contained, any conflict that impacts refining capacity or traffic through the Strait of Hormuz could impact both the price of oil as well and the price of liquid natural gas (LNG). We should also not forget the potential impact of any supply chain disruptions in an increasingly geopolitically fragmented world.

In short – it seems increasingly unlikely that inflation will remain contained for long. There is a distinct possibility that the Fed may have to reverse its rate cutting cycle sooner than anticipated, if inflation resurfaces. Since September 2024, the market implied 1-year Fed funds rate has increased from 3.75% to 4.25%, implying only 2 more rate cuts.

While short-term market optimism has bolstered the US dollar as well as select shares seen as being beneficiaries of a Trump administration, a high and volatile inflation environment is generally not supportive of longer-term returns from either equities or bonds.

The US may have to pay more for its exorbitant privilege
US Treasuries remain the world’s safe-haven asset class of choice, and while the spectre of rising inflation may not deter all foreign buyers, our research shows that 31% of marketable interest-bearing public debt or US$9 trillion matures within one year. If we add to this the expected budget deficits, we get a funding requirement of some US$11 trillion. Many of the largest holders of US debt, including China, and Japan, are less likely to be active buyers of US Treasuries going forward for various disparate reasons.

The US will be seeking to place a lot of debt in the market, and it may have to do so at rising bond yields. Bond markets were quick to respond as the likelihood of a Trump win became clearer, given the more detrimental impact his second term in office is expected to have on both inflation and the budget deficit.

While it would have been outside the realm of possibilities just a few short years ago, some market participants are starting to ask whether we may be poised for the re-entry of so-called bond vigilantes. By forcing down the prices of bonds, causing their yields to rise, investors can seek to influence policy choices – as the UK most recently saw when Liz Truss announced her mini budget in 2022. Given what many now believe to be an unsustainable debt burden, even the mighty US may not be immune to the perils of rising borrowing costs. We believe US policy makers may find inflating away the problem, or resorting to fiscal repression, to be the most palatable choice.

Portfolio construction will be key
While US equities may benefit in the short term, longer-term outcomes are less clear. US equities are already trading at stretched valuations, with the S&P500 price-earnings ratio about 26X. In addition, nearly one-third of the index comprises Magnificent 7 shares which are trading at 39X earnings. We believe investors need to ensure that their portfolios are positioned for the possibility of a higher inflation environment. Gold and real assets can play a crucial role as inflation hedges in a high inflation environment, and these assets are still relatively cheap compared to the rich valuations on some of the more popular mega-cap technology stocks.

Our 3M investment process leads us to look for overlooked gems in less popular areas of the market. As a result, our portfolios are particularly well positioned for a change in the status quo environment and, in addition, our holdings are generally trading at a substantial discount to our assessment of fair value, providing some protection in the event of market turbulence.

John Gilchrist is the Chief Investment Officer at PSG Asset Management.