UK Q1 stagflation
Without any surprises, UK GDP flirted with recession in the first quarter of the year, scraping up 0.1% growth on the final quarter of 2022. For the month of March, there was a contraction of 0.3%. Not so long ago, the Bank of England saw the UK suffering a deep recession, perhaps spanning five quarters; its tone is much less pessimistic now. But the essential truth remains that we are going nowhere fast and we are almost unique among leading economies still to have economic output at below pre-pandemic levels. The quarter point base rate rise this week to 4.5% continued the Bank’s game of Grandmother’s Footsteps with the inflation rate. Even if the next print is hopefully expected to see inflation slow to single digits again, it must still be a point of acute discomfort in Threadneedle Street to be experiencing CPI at a multiple of five times the Bank’s mandated target of 2% while economic growth is flat as a pancake, and others have made better progress faced with many of the same issues.
US data points to a continued slowdown
A couple of months ago in his submission to the Senate finance committee, Federal Reserve (Fed) Chairman Jerome Powell remained worried that, despite the most aggressive monetary tightening in a century, the US economy was still too strong and inflation too high.

The most recent slew of US economic data points to his being able to take some comfort that the medicine is working: inflation in April fell below 5% to 4.9%, the tenth consecutive month in which it slowed since its peak last May. Corroborating the previously reported weakening in labour markets when the number of new job vacancies retreated markedly, on the flip-side of the same coin the weekly number of Americans making an initial claim for unemployment benefit rose for the third successive week to 264,000 in the first week in May, the highest since October 2021 (having said which, the jobless rate overall still remains below 4%: what economists regard as a “tight labour market”).

This all points to the Fed being more likely than not to pause its programme of interest rate rises at the next policy meeting on 13/14 June. Bond yields softened in sympathy, investors leading the witness gently by the nose that markets expect the next change in interest rates (whenever it might be—it depends on the future rate of decline in inflation towards the Fed’s target of 2%) to be down.
The Donald: Russian Roulette with five chambers loaded.
But away from the tumbleweed of bond yields blowing about in the breeze of economic data, it was aspiring Presidential candidate Donald Trump lobbing his own unique brand of economic mayhem into the mix which raised eyebrows. Last week we described the systemic risk posed by the ticking timebomb of the unresolved debt ceiling. Trump’s answer is to trip the switch and explode it.

The context is this: despite having no majority in the House, Biden is urging Congress to raise the $31 trillion dollar debt ceiling unconditionally. Republicans see such a strategy as perpetuating fiscal incontinence, economic illiteracy: without any restraint on public spending, and annual government deficits stretching out to the horizon, the inevitable consequence is simply to pile more debt on to the government’s balance sheet. In a political stand-off (posturing ahead of the primaries in Q1 2024 and the Presidential election in November 2024), Trump is demanding “massive spending cuts”, in the absence of which he urges Republicans in the Senate and the House to go nuclear: guillotine the debt ceiling and default on coupon payments to holders of US Treasury bonds.

While sympathising with his insistence on reining in public spending, actively causing the US government to default on its debt is insanity, tantamount to national economic suicide. And the knock-on effects would leave the rest of the world feeling distinctly under the weather too.

Creditworthiness is based on financial robustness and trust. Bond investors expect to see their money returned safely when their loans are due for redemption. The lower the expectation that might happen, the greater the rate of return they demand to compensate for the risk of default.

Of the $31 trillion of US government debt, $7.6 trillion (24.5%) is held by foreign governments, either as direct investments or as collateralised swaps as trade insurance. According to the US Treasury, currently the biggest international holder is Japan ($1.1tn), followed by China ($860bn) and the UK ($668bn). Were the US government willingly to default, technically those bonds would be worthless regardless of who owns them (the remaining three-quarters is held domestically in the US, mainly by strata of the government itself plus pension funds and insurance companies). The systemic risk is obvious. Not only would the world’s biggest economy be paralysed, that same paralysis would quickly become all pervading. The dollar, the world’s principal reserve currency would collapse.

The consequences are almost unimaginable. If there is nervousness over the risks posed by mere second and third tier regional banks failing, the world’s biggest economy accounting for 25% of global GDP is certainly too big to fail (or more pertinently to be allowed to fail, or worse, in Trump’s fantasy land, encouraged to fail).
“America First!”? Or bust and blitzed. China and the autocracies the winners
But were it to happen, and eventually stability were restored from the ensuing chaos, even when it eventually emerged from the rubble the US would always be suspect: ‘if they’ve done it once, they could do it again’. Trust would evaporate and its access to international capital markets would go the same way. Geopolitically, it would gift global financial leadership to China. With the centre of gravity no longer exerted by the US economy, the Treasury and the Federal Reserve, the renminbi would most likely become the world’s principal reserve currency and Beijing would assume unrivalled economic dominance (the same could not be said for the EU or even the eurozone for one simple fact: in its half-baked structure, the absence of fiscal union to compliment monetary union, neither is a fully-fledged, homogenous economic system; it remains innately unstable).

But such an outcome would also tip the scales in other ways too. With America on the rocks, Ukraine’s ability to resist Russia would realistically collapse. The whole tilt of the global balance of power would shift, not least because NATO would cease to function (in Macron’s terminology, it really would be “brain dead”). Nobody would be able to stop an invasion of Taiwan, or any other opportunistic land grab. America’s abrogation of its responsibilities would create a considerable vacuum with all the consequential instability while others jockey to fill it.
Bang heads together
Democrats are naïve to believe that they do not need to compromise on government spending, however politically difficult it will be for Biden to argue the case with the left wing of his party. After all, that there is a debt ceiling crisis in the first place is entirely a creation of his and his Treasury Secretary Janet Yellen’s own making (“remember their political strapline on government spending? “We’re gonna go big! Go BIG!”; in the event, way too big). Equally, it would be surprising were Republicans so obtuse to think that self- inflicted total immolation is the right answer to a domestic debt problem. Trump’s nuclear option should not happen in a rational world and one would hope there are enough clear-thinking, rational Republicans who would see sense: Trump’s case for spending cuts is entirely reasonable, it lights a fuse under the argument and challenges the existing fiscal orthodoxy; that is healthy in a mature system. But nobody in their right mind would want the fuse to burn to the detonator resulting in a large flash and an even bigger bang.

This political Mexican stand-off may well go right to the wire and possibly beyond (in which case more likely is the temporary suspension of government services, as if that is not economically and politically damaging enough for both parties in the resulting mud- slinging and finger-pointing) but some form of compromise will be reached. Otherwise, as the saying goes, the defaulting-on-the-debt option would make the Charge of the Light Brigade look like a quiet Sunday afternoon ride across the common. The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

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