Prices, jobs, and personalities. Here comes the US election

Rate of change 

For investors, the expected inflation rate is key to making investment decisions. Inflation over the course of an investment time horizon will partly determine the level of real return. As such, having a stable inflation rate is desired. This is not just important for investors but for the broader economy in general. Individuals and businesses can take more efficient decisions on consumption and investment spending when there is more certainty about how the general price level will evolve. Inflation shocks, like the one the world experienced in 2022, are not good for real returns or making optimal business investment or consumer spending decisions. Hence the importance of inflation targeting. Central bankers know the importance of trying to maintain stable inflationary expectations. Expectations are formed by the institutional policy framework, the cyclical position of the economy, and the recent experience that consumers and businesses have faced. If inflation has been high, then it is normal that expectations become more volatile and elevated. A key role of central banks is to work on those expectations by persuading economic agents that inflation will return to “normal” and thus long-term decisions on spending, wage demands, and pricing should not be permanently impacted. In this cycle, central banks have done a pretty good job.

Real returns solid 

So the rate of inflation is important in markets. If nominal fixed rate bond yields are 5% and inflation is expected to be 2%, then the expected real return from bonds is 3% over the lifetime of the investment. If investors believe that we are close to inflation stability again, then bond markets do currently offer decent prospective real returns. The back-up in bond yields since the Federal Reserve (Fed) cut interest rates by 50 basis points (bp) on 18 September has returned some value to that equation. Personally, I don’t think the cut was a mistake nor do I blame the back-up in yields on the Fed’s decision (the counter factual of what would have happened with a 25bp cut is impossible to know, but the outcome might not have been that different). Instead, the rise in yields across the curve is more a combination of policy uncertainty the closer we get to the US election, and some risk premium that the very “goldilocks like” return to a neutral interest rate level in 2025 might not be as straightforward as the perfect pricing of early September would have suggested. Today, the market based expected inflation rate in the US for the next 10-years is 2.3%. The nominal 10-year Treasury bond yield is 4.2%, so real prospective returns are just under 2% annualised. That seems fine for a risk-free rate.

The level of prices 

For voters, however, the inflation story needs to be looked at differently.  When assessing whether to vote for an incumbent government or something new, voters will have a view on what has happened to their standard of living. Key to this is what has happened to prices, and the lower down the income scale it is the price of essentials – food, energy, transportation, healthcare and so on – that is important. Voters look at the price of things today and how much of their income they need for the weekly grocery shop compared to how they remember that being in the past. According to the official CPI data, food prices are 26% higher today than they were four years ago.

I looked at what happened to the broad consumer price index in the US during Presidential terms of office ending in the September prior to election day (September normally being the latest monthly available data assuming elections take place in early November). Under the current Administration, the consumer price index rose by 20% between November 2020 and September 2024. This is the highest accumulated increase in prices during a discrete Presidential term since Ronald Reagan’s first term in office between 1981 and 1985. It is noticeable that both Presidential candidates have discussed ways of controlling inflation instead of discussing the arguably more important issue of long-term fiscal deterioration. They know that higher prices for food and gasoline have left a bad taster in voters’ mouths. They must be seen to be promising to do something about it (cue picture of bolted horse looking back to see the stable door being shut). 

Cost of living may cost the White House 

When living standards have been compromised, other issues can swing voters. Hence the ridiculous amount of focus on personality and where candidates stand on what are often marginal social issues. The polls are close, so any potential attack on the other seems game. Donald Trump can say the incumbent Administration has been bad for living standards because of inflation. This time, disposable income growth during the current Administration has been stronger than at any time since the early 1990s. In theory, real incomes have marginally seen growth, but voters don’t typically reflect that and income distribution means that many will at least feel they are worse off. To me, if Trump wins, it won’t be because voters are overlooking the issues surrounding his personality and behaviour, it will be because they are angry at stagnant living standards and the enticement that things could be better going forward.

Bond volatility higher 

Of course, the election outcome is not going to be determined by what happened to the CPI over the last four years. It is important but there are other factors – unemployment is low, the stock market is at a record high, housing is recovering. These should work in Kamala Harris’s favour. Against that are the populist totems of immigration and issues that are portrayed as a “leftist woke agenda”. It makes for an election outcome that is hard to call. We could be faced with another disputed election result on 6 November. Volatility in rates markets has picked up over the last month and it may be sometime before that subsides, which makes taking bets on the direction of long-term yields difficult. Bond returns might be volatile for some time. The case for higher quality, shorter-duration or a buy and hold exposure in credit markets again seems strong,

Beyond the polls, the US has strength 

Ultimately, what matters for investors is whether the US economy can keep performing. If higher rates have not been enough to cause a recession so far, then we need to question what will? Disruptions to spending because of actual or feared policy decisions might do it, especially if they are transmitted to the evolution of cash-flow. If uncertainty about growth emerges, the fiscal outlook might become a more present concern for investors. The risk in long-end risk premiums, arguably evident in the Treasury market today, could extend. Monetary policy may also become compromised by fiscal uncertainty, leading to a permanently higher level of interest rates. That, with less clarity on corporate revenues, would undermine the valuation case for US financial assets as it stands today. Not much of this will actually be evident for some time, so making long-term strategic asset allocation decisions regarding US financial assets – which have delivered strong returns – is not easy.

There will be a lot to assess for the US economy in the weeks ahead. Bad outcomes are possible which would be reflected in poorer returns from equities and bonds. However, as one bank pointed out in a note to its clients this week, GDP growth and equity returns have historically been remarkably stable no matter who sits in the Oval Office.

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 24 October 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.