Canning Cook
Hopes for more US interest rate cuts have also supported risk assets. That said, we’re not comfortable with some of the longer-term implications of looser monetary policy, especially if it comes from White House pressure and leads to higher inflation. Unable to unseat Chair Jerome Powell, President Trump has turned his attention to another governor, Lisa Cook, whom a government acolyte has accused of making a fraudulent mortgage application. Trump has fired her ‘for cause’, but she is taking the fight to the courts.
A president’s intervention in monetary policy matters is not exactly unprecedented, at least when it comes to getting people sympathetic to his views onto the board of governors and into the regional chairs. But the increasingly autocratic nature of Trump’s actions is unsettling.
The red line of market tolerance
Where is the red line of market tolerance, beyond which US government bond yields and other asset prices move sharply in response? We’ll only know after we’ve passed it – but the market consequences could be unpleasant. For the moment investors, overall, view the glass as half full; they’ve bid up shares positively exposed to the promise of lower interest rates. The Russell 2000 small cap index, for example, jumped 7% in August.
AI anticipation
The main driver of equity returns this year, as for the previous two years, is the anticipation of the profits to come from the implementation of AI. The financial benefits have largely accrued so far to companies involved in the investment phase. That means chip manufacturers, such as Nvidia. It also means data centre builders: both the owners, such as the leading tech companies, and those involved in the construction and the provision of the huge amount of power the centres need.
However, investors are still beset by moments of doubt about the returns from AI-related investment. This happened in January, when China’s DeepSeek Large Language Model entered the wider consciousness. The latest bout of nerves was triggered by a report from the university initiative MIT NANDA. To quote from the release:
“Despite $30–40 billion in enterprise investment into GenAI, this report uncovers a surprising result in that 95% of organizations are getting zero return. The outcomes are so starkly divided across both buyers (enterprises, mid-market, SMBs) and builders (startups, vendors, consultancies) that we call it the GenAI Divide. Just 5% of integrated AI pilots are extracting millions in value, while the vast majority remain stuck with no measurable P&L impact.”
But a deeper reading of the MIT report suggests it’s more a problem with implementation than with the technology itself. This is especially so where a company has attempted to build its own AI capability or bought an off-the-shelf tool that can’t understand its business. That could well mean that AI-based applications will deliver better returns once people learn to use them better.
However, with US technology valuations elevated (although not in a bubble, in our opinion), share price performance will increasingly depend upon positive returns on the new capital expenditure being generated. For now, investment analysts forecast that existing high returns on capital can be maintained. If that’s the case, we could also expect to see productivity benefits flowing through the economy as non-tech companies successfully use the technology.
Large and persistent deficits
Another persistent theme today is the size and persistence of many countries’ fiscal deficits. Markets attention shifts from one country to another, but the net effect is that long-term borrowing costs keep rising as investors sniff out future policy risk. Two countries currently in the spotlight are France and the UK.
In France, Prime Minister François Bayrou’s attempts to reduce the budget deficit ran into the brick wall of a parliamentary minority. In response, he called a confidence vote for 8 September. He’s unlikely to survive, although a new premier will probably be appointed to continue along the same lines. A snap parliamentary election is also possible, but there’s only an outside chance of an early presidential election. The upshot has been a widening of French government bond yield spreads over German Bunds, with the 10-year spread at 78 basis points (0.78%). This is approaching the most recent high of 88bps last December. But it’s still far short of the close to 200bps seen during the Eurozone crisis in 2011. A warning shot, but no crisis – for now.
In the UK, the 30-year gilt yield is at 5.6%, up from 5.13% at the beginning of the year and its highest since 1998. At that time, our debt-to-GDP ratio was a puny 32% vs around 100% today. We’re fast approaching another pivotal Autumn Budget, where Chancellor Rachel Reeves must find a palatable combination of lower spending and increased taxation to stabilise finances. The UK seems to be running a real-time experiment on the shape of the Laffer Curve to determine exactly how much tax can be imposed without destroying incentives to work. This curve shows how much tax revenue is actually raised in the real world for any given rate of taxation.
Even so, we don’t entertain alarmist stories that the government will need a bailout from the International Monetary Fund as it did in 1976. Much is different today. For example, inflation peaked at over 25% in the mid-1970s, thanks to oil shocks and policy mistakes in an era when the Chancellor controlled interest rates, not the Bank of England. Inflationary pressures could push yields higher, depressing bond prices. But gilt yields are already quite high, offering a decent cushion. Moreover, sterling is doing fine, suggesting no panic move out of sterling-based assets.
The key point, though, is that French and British fiscal problems look intractable.
France hasn’t generated a budget surplus since the 1970s and government spending comes to more than half its GDP. That was sustainable when debt-to-GDP ratios were lower, yields on French and German bonds were similar and the European Central Bank’s (ECB’s) benchmark rate was close to zero. Despite the attempt by President Emmanuel Macron’s government to confront reality, opposition parties see more political capital not merely in maintaining the status quo of fiscal incontinence, but in giving away even more.
In the UK, Labour’s attempts to curtail welfare spending were shot down by its own MPs. And the populist Reform Party, could, judging by some polls, win more votes than Labour and the Conservatives combined. Reform’s fiscal plan looks unsustainable.
Two grisly phrases
One of our main tasks as custodians of clients’ hard-earned wealth is to separate signal from noise. It’s easy to be scared into liquidating assets after falls in markets, which are, sadly, inevitable. With so much going in the world at the moment, we’re taking care to navigate around the obstacles and concentrate on long-term outcomes.
It’s possible that we’re entering a period of ‘fiscal dominance’, a grisly phrase we should all become familiar with. This is when monetary policy falls subservient to fiscal policy, with interest rates forced to inappropriately low levels to reduce debt service costs – something Trump has explicitly called for. The US president is leading the way in trying to make this happen, but most other countries could also eventually be forced down the same route.
If higher inflation is the result, as we believe is probable, safer, cash-like investments will lose value in real terms. This is the concept of ‘financial repression’, another unpleasant phrase that we should also recognise.
It will be important to have the right mix of assets in portfolios to deal with this. Corporate revenues and earnings can grow with higher consumer prices, so equities are well placed to maintain and increase real wealth in the long run, for all their short-term volatility. Carefully selected commodities and actively managed strategies, such as hedge funds and trend-following funds, can provide diversification.
