War Economy

Neoliberal economics went wrong. The Western social contract has been broken a long time ago, and populism is the result of persistent inequality and a lack of opportunity for new generations. While it was easy for over eighty percent of young adults born in the post-war years to be richer than their parents, today’s young generations struggle. At the core is a lack of productivity and investment, and ultimately a lack of competition. These problems, of course, are neither solved by monetary stimulus, nor by markets regulating themselves.

The result of broken capitalism is populism. In economics and market terms, a populist is simply someone who portrays a quick fix, selling a political dream to the electorate and pursuing it with unsustainable policies.

A first wave of populist governments in the US, UK, Italy and Greece achieved mixed results and in most cases were not able to live up to their promises. The result was often a return to more orthodox policy. In some cases, like Greece, post-populist policy worked to boost growth and address structural imbalances. 

In others, like the US, it failed. While the Biden administration did boost growth with substantial fiscal spending, it failed to address inequality. At the same time, Fed front-end hikes combined with dovish forward guidance and limited QT failed to contain inflation and even hurt short-term borrowers and small businesses the most, leaving wealthier households untouched, as we discussed earlier. The result is a return to populism.

Will Trump 2.0 be better than the first?

Since mid last year, we anticipated a Trump victory and its potential consequences. Investors priced the election results with optimism. Today, we find the investor consensus a very optimistic one across financial markets. This consensus appears based on the following assumptions. 

First, that disinflation will continue and that the Fed will continue to adopt a dovish reaction function. Rates markets currently price fewer cuts, but the path remains downward. Second, that the Trump administration will be able to boost growth and reduce spending at the same time, optimising public spending even in its first years. Third, that US exceptionalism will continue to run, while at the same time China and Europe are flirting with sluggish growth.

We believe consensus is wrong and too optimistic on these three points. We expect US growth and inflation to stay up, and the Fed to lean against persistent inflation. We expect the US to keep running a substantial deficit, pushing long-term yields higher, as the supply of Treasuries resumes to average and long maturities. We see upside in Europe on concentrated pessimism and short positioning, with EU-level spending picking up and a ceasefire in Ukraine boosting growth. 

After a decade of monetary dominance and quantitative easing, are investors ready for fiscal dominance? A populist national fight means we are in a de facto war economy where recessions are not allowed, spending and inflation are persistent, the Fed put becomes softer, and dislocations and volatility become more frequent.