Writing in the aftermath of one of the most contested election in modern US history most of the attention has been spent trying to predict the effects of Donald Trump’s comprehensive victory. However, it also makes sense to focus on the glaring issue that would have remained in place no matter which way the voters turned last week’s poll. This is the country’s fiscal position, which combines full employment with a budget deficit of roughly -6%. This means that whoever enters the White House in January is going to be facing the most significant constraint on any potential shift in fiscal policy, whether this be attempts to increase spending or enact tax cuts to satisfy their party base.
What is notable about the chaotic campaign of the last few months is the degree to which this constraint on fiscal policy was largely ignored by both candidates, and there really have been few signs that the electorate have really focused on this issue. Instead, promises have been made without a serious consideration of their feasibility while the wide difference between social, immigration and foreign policies have dominated whatever discourse has moved above the primitive tribalism of most of the discussions leading up to the poll.
This is a far cry from the state of affairs 44 years ago, when Ronald Reagan’s proposed combination of tax and spending cuts with deregulation was derided as “voodoo economics” by George H. Bush, then his rival for the Republican nomination. An economist reviewing this statement today is far more likely to express outrage over the rights of voodooists to practice their arts without disparagement than to agree that there are limits to the actions of the state within the fiscal sphere. The 1992 election between George H. Bush and Bill Clinton was also dominated by fiscal policy, with the victorious Democrat needing to satisfy voters of his willingness to limit welfare payments to those truly deserving of them.
The current election saw nothing like this level of scrutiny over the candidates’ fiscal policies, or more accurately their ability to actually fund the stated aims of their Presidency. We cannot place this blame totally on the candidates themselves, for society itself has moved away from considering budget deficits as an area worthy of attention, absence the periods around a debt ceiling when there is some half-hearted handwringing before the pork barrel is wheeled out once more.
We have written several times over the years about the process of marginalizing budgetary debate, which started with the introduction of quantitative easing during the financial crisis and was then greatly accelerated during the pandemic. At least 15 years ago there was a serious debate over the choices being made, and the Eurocrisis briefly introduced the disciplining force of credit markets into the equation. However, many of the warnings proved to be premature, and in recent years the battles have been fought over who the beneficiaries of the state’s generosity should be, not the danger of its realistic limits being reached.
It is increasingly our belief that given the trajectory of the US budget deficit, capital markets are unlikely to remain patient throughout the lifetime of the next US administration, no matter which candidate prevails. A party achieving a sweep across the House, Senate and Presidency would probably accelerate the point at which unsatisfaction becomes translated into market volatility, but even a divided Washington will sooner or later face a reckoning that it can either target the amount of debt being raised from the capital market or the yield it must pay to keep the orders rolling in.
It remains true that the Federal Reserve can exert overwhelming control over the short-term funding costs of the US Treasury, but its control over the long end of the curve is somewhat less than total, and it is the latter which dominate the funding costs of the corporate sector via credit markets. The central bank also has very limited influence over the exchange rate, which represents a real time opinion poll of the attractiveness of US financial assets. We do not doubt that in the buildup to a crisis, tools such as QE would be employed to the fullest degree, but they may prove to be rather less effective than expected if confidence in the underlying fiscal position of the US is the issue at hand.
Looking ahead, the most dangerous combination that could be imagined would be another period of fiscal largesse being followed by a technology led slowdown in the US economy. This would result in a combination of a significantly larger fiscal deficit, driven by the collapse of income and capital gains tax revenues and increase in government transfer payments, with a reduction or even reversal of the very strong international flows into the US equity market. Under such a scenario, losses in the US equity market would be combined with losses in treasury and credit markets and then compounded by FX markets.
This is not a prediction for 2025 or 2026, merely a statement of an imaginable combination of events which deserves to be priced into any consideration of the risks and rewards present in the US treasury market. Instead, most fixed income investors continue to treat long duration treasuries as a hedge against their pro-cyclical positions, believing that they will once again provide a useful cushion should risk markets, particularly equities, decline in tandem with the economy. 2022 just showed us that this does not always prove to be the case, with long term treasuries declining by over -30%, almost exactly matching the dismal returns of the Nasdaq 100, without enjoying most of the subsequent rebound in the latter.
Our concerns over the fiscal position of the US are not new and are the reason why we have consistently argued for swapping out of long duration treasuries and their proxies into precious metals. This has generated excellent returns in recent months, with gold up 33% in 2024 through the end of October.
Precious metals were not closely associated with either candidate and have sold off from their recent highs in the face of the Trump victory. This probably reflects the wish for current holders to reposition into more obvious “Trump trades” such as cryptocurrencies or domestic US equities. However, we would expect this process to be short lived, and would expect to see new highs reached by the time President Trump is sworn in as President in late January 2025.
