The effects of monetary tightening have yet to surface in the US. Economic activity has been far more robust and resilient than economists have anticipated. We see 3 reasons for this:
- strength in the labour market has buoyed consumption
- an increase in immigration has bolstered the supply of labour
- government fiscal programmes have incentivised corporate investment activity, effectively bringing it forward from future years
In the short term, this makes the US an enviable beacon of strength. Looking further ahead however, it raises serious questions about financial sustainability and stability. This level of gratuitous fiscal ill-discipline seldom ends well.
Who cares?
Economics 101 advocates saving in the good times to support debt funded programmes and policies during downturns. Yet despite unemployment at near record lows and economic growth holding up, the US government has rolled out successive stimulatory fiscal policies over recent years, resulting in a fiscal deficit of $1.7trn in 2023- more than 6% of GDP. For financial year 2024, it’s on target to expand even further. The Congressional Budget Office forecasts the government will spend one third of its income on debt interest alone by 2030.
This is clearly unsustainable and untenable, yet the markets don’t seem to care – for now.
Source: Bureau of the Fiscal Service, Bureau of Economic Analysis
If there’s a slowdown and unemployment rises, this fiscal deficit, already high, will rise meaningfully. The US risks exceeding deficit levels that, as a percentage of GDP, are typically associated with wartime.
As we head towards the US election, neither the Republicans nor Democrats are calling this out as an issue, and we could be sleepwalking into a known and growing problem.
Intriguingly, the markets appear unperturbed, presumably because growth is still ticking along. Should it stall, risk premia would likely rise. Given the elevated valuations of US equities where consensus expectations of a soft/no landing prevail, this raises a note caution.
It's all relative
Post Covid government debt levels are high across the world, so the US debt situation is not unique. However, higher interest rates mean that the cost of servicing that debt is projected to expand from about 3% of GDP pre Covid to over 4.5% in 2024, based on OECD forecasts.
At a time when the UK government interest rate payments as a percentage of GDP are projected to fall and the EU’s are gently nudging up from 1.75% towards 2%, US exceptionalism is evident - and not for a good reason.
Source: LSEG Datastream, OECD, J.P. Morgan Asset Management
Our view
While there has been plenty of commentary on this in the financial press, specifically on this side of the Atlantic, in the US it appears to be a non-issue. If anything, Trump and Biden are pitching for more fiscal looseness. This makes the Federal Reserve’s (Fed’s) job, which was already hard, even harder. Negotiating the tricky path to a soft landing is extremely difficult using the blunt instrument of interest rates to guide the way, but when you’re also navigating the impact of uncapped fiscal programmes, it’s almost impossible.
We assume the Fed will keep rates high for longer, acting as a drag on growth and leading to rising delinquencies, defaults and possibly even pockets of financial distress. On a relative basis, this makes other markets comparatively attractive, something we are increasingly leaning into within our Tactical positioning.
That said, if signs of strain do emerge in the US, the Fed is likely to step in swiftly and kick the proverbial can down the road. So, we’re certainly not writing them off. After all, where the US goes the rest of the world tends to follow - US exceptionalism in all its glory!
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Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.