Mounting trade tensions, dwindling energy tailwinds and tighter monetary conditions are raising serious questions about the sustainability of US economic strength. In the following analysis, Tom Roderick (pictured), portfolio manager of the Trium Epynt Macro Fund, explores why advisers should be alert to growing risks in US markets—and what it could mean for portfolios in the months ahead.
With trade, tech dominance and cheap energy under threat, and the Fed tightening liquidity amid soaring deficits, Tom explains in the following analysis why he believes wealth managers must prepare for a shift from exceptionalism to instability in the world’s largest economy.
There are three key drivers of US economic outperformance that can no longer be relied upon. The first is open trade; the US has benefitted more than anyone from an open trading environment, even if the current administration do not seem to appreciate it.
The second is tech dominance. The ’Web 2.0’ era saw Microsoft, Google et al establish formidable ‘walled gardens’ around their integrated ecosystems to protect outsized monopoly profits. In the AI era, highly valued US companies will face increasingly stiff competition from Chinese/other tech players.
The final is cheap energy – the US has been a beneficiary of the huge growth in supply from shale oil fracking, but the mega boom is over, with production growth having fallen from a peak of 14% to less than 2% per annum. It was the first of these three factors that came to the fore in April.
Tarnished reputation
It is hard to see Trump’s ‘liberation day’ show as anything other than a spectacular own goal. To start with, it doesn’t make sense to upend the table when the ‘game’ is already going very much in your favour. Second, it would have been far more effective for the US to use its immense negotiating leverage to agree deals with trading partners one at a time rather than attempting to take them all on at once.
But we expect most market participants have long given up on making investment decisions on the basis of what seems rational. Although there will inevitably be further backtracking and moves towards deal making, Trump has ‘opened the box’. The damage has already been done to both the reputation of the US as a dependable trading partner and its economy.
The huge uncertainty around trade policy makes it impossible for CEOs to plan ahead, and business leaders will require much more in the way of carrots and less of the stick if the goal of onshoring is to be achieved. If the US pushes forward with its plan to eliminate its trade deficit, the other side will be an equivalent reduction in capital inflows into US Dollar assets.
US asset exodus
This is a problem if you need to fund high fiscal deficits. To make matters worse, overseas investors have been departing US assets en masse, and will have been extremely alarmed by increasing speculation that the US might look to convert foreign Treasury holdings into zero-coupon 100-year bonds as a means of forcing allies to contribute more towards security.
With tax hikes all but ruled out, Elon Musk’s DOGE had been attempting to shrink the fiscal deficit through spending cuts. With Musk now returning to focus on his day job, only a small fraction of the initial $2trn target has been achieved, with efforts directed toward politically popular but insignificant areas of expenditure such as the Federal government administration, foreign aid… and support for “transgender mice”.
More sizeable spending commitments (such as entitlements) will need to be tackled if real savings are to be delivered. But this would essentially represent a shift towards austerity, leading to a shrink in demand and lower growth/inflation. From a Keynesian perspective, even a completely useless government worker who loses his job will subtract from demand. The likelihood is, however, that entrenched interests gum up the system and make it very difficult to get anything meaningful done.
Trump’s unnecessarily disruptive trade stance will make an already precarious situation worse than it needed to be. The result of the US upending the table will be a smaller, weaker economy. If we do see a self-induced recession in the US, through the impact from tariffs/spending cuts, we think it unlikely that the administration manages to balance its fiscal deficit and will end up paying more in longer-term borrowing costs. This is a problem for long-end bonds.
While our concerns about the US economy lead us to believe there will be interest rate cuts ahead, we see little value in duration and have found better ways of hedging against further risk-off episodes.
The forgotten danger zone
In the face of this major shift in the US monetary backdrop, we pivoted from positioning for higher yields during much of the post COVID era to wagering on lower short-term rates today.
It is important to remember that the Fed conducts monetary policy through both the price (i.e. interest rate) and the quantity of money. Despite various predictions of doom and gloom over the last few years, nothing has ‘broken’ despite a prolonged period of high real rates.
This was due to the huge expansion of the Fed balance sheet during COVID, with the central bank expanding the money supply to hoover up Treasuries and MBS, releasing liquidity back into markets. But it is one thing for an economy to tolerate high real rates when the balance sheet is very accommodative and underlevered.
Once that benefit has been ebbed away, monetary policy bites much harder. Although still large in nominal terms, the Fed’s balance sheet has declined substantially relative to nominal US GDP, forgotten about in the background while contracting in “autopilot”. 2025 looks to be the year when restrictive interest rates meet a restrictive balance sheet.
Return of market mayhem?
Higher growth and higher inflation paradoxically mean that the effect of quantitative tightening has happened quicker than anticipated. Despite the Fed still having a balance sheet of a touch under $7trn (as compared with $4trn back in 2018), we are rapidly approaching the ‘danger zone’; the level at which balance sheet contraction caused market mayhem in 2018 as Powell sought to unwind the Fed’s GFC era stimulus.
This period of market history is often overlooked, due to the magnitude of what came next with COVID. But let’s recall that the Fed’s last attempt at balance sheet contraction saw US short-end rates explode higher like an emerging market, and periodic spikes in volatility culminating in a – 20% sell-off in the S&P.
Despite there having been no more than a minor hiccup in growth, the Fed was forced into a dramatic U-turn, cutting rates 3 times in 2019 (having earlier projected 4 rate hikes) and increasing the size of its balance sheet once again. We believe it could be worse today given the huge economic uncertainty.
Furthermore, the huge growth in US financial asset values since COVID has significantly outpaced GDP growth. Ultimately the balance sheet is needed as liquidity to facilitate the transfer of these assets. If we were to express the balance sheet as a proportion of financial assets rather than GDP, the situation would look even more stark; meaning we might already be in the ‘danger zone’.
