"It's still the economy, stupid"

Last week, UK politics returned to a (much welcomed) predictability, whereas French politics entered unknown waters and US politics thrown into turbulence, with Joe Biden becoming the first incumbent pressured to quit ahead of the election since Lyndon B. Johnson. **

The political landscape ostensibly looks like something out of Jackson Pollock's paintings: impossible to understand at first glance, and allowing each viewer to draw their own individual conclusions. 

Yet a closer look at the numbers, suggests a string of themes that are all-too-familiar, and relate directly to the economy. 

1. Voters remain resentful

In the UK, the only two parties that gained a significant number of votes (a combined gain of nearly 5 million, for 21% of the total vote), compared to 2019 were Reform and Green. This means that five million voters directly challenged the narrative behind the return of “boring” to government.

In France, things are clearer. Mr Macron’s technocratic centre was haemorrhaging voters to his left and right, both of which are also significantly more militant, so he made a pact with the Left to thwart Ms LePen’s advance. He scored a pyrrhic victory, again thanks to the idiosyncrasies of the electoral system and disciplined behaviour by his and the NFP’s candidates before the second round, which essentially turned a proportional system into a run-off. Now the French President also has a tricky job at governing (lest he faces even angrier voters by the next presidential election) in coalition with the Nouveau Front Populaire. The latter is a coalition itself of La France Insoumise (Melenchon), the Communist Party, Ecologists, The Socialist Party, and other centre-left and left-wing parties united under a singular goal (stopping LePen) that has now been achieved.

Their common programme, assuming commonality is still there, includes undoing many of Mr Macron’s own reforms, like the 2023 French Pension reform, increasing public sector salaries and welfare benefits, raising the minimum wage by 14% and freezing prices at the supermarket, all of which should be paid by the same wealth tax Mr Macron lowered to foster the return of France’s wealthy after Mr Hollande’s presidency.

While Germany has not declared an election yet, the AFD and the CDU (which under Mr Mertz has taken a turn to the right compared to Mr Merkel), are significantly ahead in the polls.

As for the US? Resentfulness defines politics even more so than Europe. Four de-industrialised states, formerly known as the ‘Steel Belt’ but are now collectively called the ‘Rust Belt’, have become swing states and defined presidential elections in the past two decades. Pennsylvania, Ohio, Wisconsin and Michigan with a total of 51 electors out of 538 have been giving their vote to the highest bidder, compelling all candidates not only to try and deliver American re-industrialisation, but to demonstrate that they share the frustration of their constituents. 

2. delivering on promises is very difficult

In the UK, Labour has to deliver on growth, without significantly raising taxes (as promised), and against a backdrop of significantly reduced fiscal space and vigilant bond markets. 

Mr Macron’s situation is similar to Mr Starmer’s. Raising tax receipts in a meaningful way is a difficult proposition, and fiscal space also remains tight, with France featuring a similar debt profile to the UK. 

And if the two European leaders will find it hard to deliver, re-industrialising the American north, after years where globalisation moved blue-collar jobs to the east seems like a Herculean task.

In an economy that suffers from poor demographics (especially in Europe), where inflation remains sticky and where the fourth industrial revolution has yet to yield any tangible productivity gains (if anything, productivity is waning in the West), where, oh where, is the growth necessary to assuage voter frustration going to come from?

Either taxes or borrowing.

3. Running on Debt

Avoiding a significant raise in taxes has been the cornerstone of the winner’s platforms across the board. Where the politics of anger have not yet prevailed, breaking that promise and taking even more money out of people’s pockets than inflation has, is a certain way for economies to reach a boiling point. 

Certainly, some taxes can be levied on the ultra-high net worth, capital gains and possibly inheritance.  But that won’t be enough to deliver growth back to the West, as income re-distribution can only go so far in improving efficiencies beyond a short-lived consumption boost.

In an era of stagnant demographics and lower productivity, the best way to increase marginal wealth is to create it through debt, and not only for the West. Since Covid-19, debt in the US has increased by 2.7% per annum, in the UK 3.2%,  in Japan 3.3% per annum (one way to get the economy out of its own “Japanisation” has been even more debt), and in China a whopping 8.1%. This later number, even if it’s halved, will bring the world’s second-largest economy’s debt to GDP at 106% by 2028, almost where the US was in the turn of the decade.

Governments, long used to relying on central banks to create wealth enough to buy their own debt, are now facing an existential problem: inflation.  Unlike the first rounds of QE, debt accumulation in the last few years has passed right through the economy, increasing the supply of money and creating inflation.

For investors, this also answers another existential question: is 4.5% yield for the world’s risk-free “an opportunity” or “appropriate”? Given the global debt profile and the promises that now need to be kept, we should lean towards the latter. In a world that could be more inflationary and a lot more debt-laden, it makes sense for investors to require higher returns for lending to governments and corporateions. If higher yields for longer are indeed the case, it makes refinancing government debt even more difficult, as it will significantly increase the profile on interest payments, leading to a vicious debt cycle, where debt is accumulated to pay more debt. 

So governments not only need to consider the effects of extra debt but also the devastating effects of inflation, which renders the further creation of debt useless.

In other words, modern monetary theory (or the magic money tree as it often called) may not be able to produce much more growth going forward, any more than the re-distribution of taxes will.

Thus, the trend is likely to continue. Governments will continue to be faced with increasingly harder choices, increasing voter resentment as promises won’t be delivered, at least not without division and sacrifice along the lines of income.

*The catchphrase was widely used in Bill Clinton’s the 1992 election campaign. Incumbent President George Bush, was defeated to upstart Bill Clinton, who emphasised the economy. To this day it signifies the importance of economic realities as a factor in making political choices.

** I have often said that electoral gambits seldom play out. In the case of both Mr Sunak and Mr Macron, they seem to have done so. Mr Macron sacrificed stability to thwart Ms LePen, and this seems to have worked, even at great cost. In the UK’s first-past-the-post system, Reform overtaking Conservatives could have led to a Tory electoral wipe-out, for the first time since the rule of William Pitt the Younger (1780s), as every seat could be in danger even for a few votes. Mr Sunak ended his stint as Prime Minister a few months earlier than anticipated, simply to avoid that outcome and give his party a few years -instead of months- to fight off Reform. I wonder whether their “success”, pyrrhic to be sure, will encourage other leaders to take similar gambits, leading to more political and financial volatility, if for no other reason than to save moderate politics from the angry fringes.

George Lagarias – Chief Economist

Market update

There was plenty of action in both equity and bond markets last week. US Treasuries were rising at the start of the week as markets began to price in a greater likelihood of a Donald Trump victory in November, with Trump committed to further tax cuts. However dovish comments from Fed Chair Powell on Tuesday contributed to US 10Y yields finishing the week 11 basis points lower at 4.28%.

Equities had a smoother upward ride, initially boosted by Powell’s aforementioned dovishness, and further buoyed by weaker than expected US services data. US markets were closed on Thursday for Independence Day, before rallying again on Friday. Although non-farm payrolls for June came in slightly stronger than consensus estimates, the revision down of previous months’ estimates was a further data point in support of rate cuts arriving sooner. In local terms US equities rose +2.0%, however with the US Dollar falling on the various dovish new points, returns were +0.7% in Sterling terms.

The UK election results had little effect on markets, with the result largely expected and already priced in. UK equities returned +0.5% over the week, with 10Y Gilt yields down 5 basis points – returns not dissimilar to other markets. Indeed, in Sterling terms both European and emerging market equities returned +0.7%. The main outlier were Japanese equities which gained +1.9%.

Gold rose by +2.8% over the week, while oil was up +1.9%.

Macro news

Headline inflation in the Eurozone fell to 2.5% year-on-year, down from 2.6% in the previous month. The figure was in line with economist expectations and reflected a slowing in energy and fresh food costs. Services inflation remained high at 4.1% however, which may encourage caution among rate-setters at the European Central Bank with regards to interest rate policy.

The US services PMI fell five percentage points from 53.8 to 48.8 (figures under 50 indicate a contraction), the sharpest drop in this index since the early stages of the Covid-19 pandemic. Before April, the services PMI had registered growth for 15 consecutive months. Reasons quoted for the contraction included lower business activity, a slowing of new orders and a continued contraction in employment. The manufacturing PMI contracted for the third consecutive month in June, registering at 48.5.

US non-farm payrolls rose by 206,000 in June, above economist expectations of a 190,000 rise. However the beat in headline expectations was overshadowed by the fact that payroll growth in the previous two months was revised downward by a total of 111,000 jobs. The unemployment rate also rose to 4.1%. Markets interpreted the data as showing a trend of slowdown in the job market, as yields fell and interest rate futures priced in two rate cuts by the Fed in 2024.

The week ahead

All eyes will be on the US this week, as inflation data comes out on Thursday, while Federal Reserve Chair Jerome Powell will give a number of speeches. Consumer sentiment and producer price inflation data will also be released on Friday. In the UK, GDP figures, released on Thursday, will be in focus as consensus estimates predict a 0.2% growth rate in May.