10/28/2024

For almost two years now, our investment positioning has been based on a soft landing scenario, the one we considered most likely to occur. This environment was characterized by three key elements: firstly, economic growth would remain robust despite the marked cycle of rising global interest rates. Secondly, inflation would gradually return to its long-term targets, and finally, central banks would gradually start to cut interest rates in response to lower inflationary pressures.

Of course, none of this was immediately apparent twelve months ago, but over the course of 2024, these projections came to fruition one by one. However, while certain uncertainties are dissipating, new ones are emerging. Indeed, with the rate-cutting cycle now underway, markets are focused on the speed and extent of rate cuts in each region. Meanwhile, a new element that has been largely overshadowed by monetary policy is also gaining momentum: fiscal policy.

A key message at the International Monetary Fund's annual summit in Washington was the need for a shift in fiscal policy. The institution claims that public deficits are high while the total volume of public debt stands at concerning levels. The IMF forecasted that it will exceed 100 trillion dollars in 2024 and will approach 100% of global GDP by the end of this decade, a level of indebtedness three times higher than experienced in 1970 and coming at a time of acute political polarization that severely limits the margin for fiscal austerity. Furthermore, the IMF warned that the actual debt situation could prove to be even worse than expected, as current projections do not take into account in full the growing spending pressures stemming from an aging population, the green transition, or increased defense investments.

While high levels of indebtedness seemed inconsequential when interest rates were extremely low, things have changed dramatically in a high-rate environment. The United States, for example, already spends 17% of its federal budget on interest payments on its public debt. This scenario poses a fundamental threat: fiscal dominance, which can affect the delicate balance between fiscal and monetary policy.

What is fiscal dominance? When a central bank is constrained by fiscal pressures, it is often forced to keep interest rates unnaturally low, which in turn can fuel inflationary pressures. This situation jeopardizes economic stability and undermines the central bank's credibility, particularly if financial markets perceive that the central bank has effectively become subservient to the government's fiscal needs, eroding confidence in its ability to control inflation.

Finally, in the most extreme cases, fiscal problems can lead to sovereign debt crises, which by no means are confined to emerging economies, as illustrated in 2022, when former UK Prime Minister Liz Truss announced an expansionary budget, sending sovereign debt prices plummeting to an unprecedented low.

Although each country will have to address its fiscal challenges separately, special focus should be placed on the UK's Autumn Budget in the coming days, which is due to be released on October 30. Meanwhile, in the United States, neither candidate has shown any particular interest in reining in the rapid expansion of public debt. Of course, fiscal consolidation is unpopular and unlikely to figure prominently in any political campaigns except in rare circumstances. Nevertheless, this does not mean that the outcome of the November 5 election is immaterial for public finances. The market anticipates that Trump's policies could worsen the country's fiscal situation significantly more than those of Harris.

Geopolitics is the other factor that will capture investors' attention in the coming days. Early Saturday morning, the Israeli Air Force struck Iranian military targets, concluding its response to Iran's launch of 181 ballistic missiles on October 1. While awaiting a possible response from Tehran, the Biden administration has described the Israeli response as "proportionate." In any case, it is plain to see that the current situation in the Middle East remains complicated, and the risks of escalation are far from gone.