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It looks like Labour will raise taxes equivalent to about 1%-1.5% of GDP at the upcoming budget. This is a big fiscal tightening and I am already briefing my wife and children to downgrade their (already low) holiday expectations. One interesting thing to me is that we have a Labour government in the UK that are being pretty fiscally conservative. Meanwhile, in the US a Republican administration is running some of the largest non-recessionary deficits in history. The conservative left vs the profligate populist right.
To put this into numbers, the UK deficit is currently running at -5.4% of GDP but should be closer to -4% once the budget is done. The US, in contrast, has a bigger deficit of -5.8% but is going to cut taxes next year rather than raise them as part of the One Big Beautiful Bill. This means while the UK will be putting the brakes on, the US will be hitting the accelerator:
I would be tempted to add here: no wonder US equities are outperforming (which they are). But the reality is that much of the recent US outperformance has come from the US technology giants (the so-called Magnificent 7). 6 of the 7 have now reported Q3 earnings (only Nvidia is left) and, as a group, they have continued to outperform the broader market. One way to show this is to compare their performance to the S&P equal weight index (where the Mag 7 make up only 1.4% of the index compared to 35% for the S&P 500). The Mag 7 are up 37% over the last 12 months, compared to just 4% for the equal weighted index.
And that trend has continued this quarter: the Mag 7 are +4.8% QTD compared to -1.3% for the equal weight. The dominant theme in investing remains continued earnings growth for US technology companies and you are under-performing if you are ignoring it. And whatever you think of the current Labour government’s fiscal policies, for equity markets they remain a rounding error.
But while fiscal policy is not mattering much for equities, it is having an impact on government bond markets. And here I have a silver lining to offset some of the cloud of higher UK taxes. Even though the Bank of England did not cut rates this week they look likely to do so in December. And lower UK deficits are starting to translate into lower UK interest rates as the market adjusts to lower expected gilt issuance. Here is the UK 10-year government bond yield quarter to date for example (a period when US yields have been more or less unchanged):
Of course, lower interest rates (and mortgage rates, and corporate and government borrowing costs) should help cushion the impact of higher taxes. The big question is whether higher taxes push growth down by so much that the overall health of government finances does not improve much, if at all. For those that worry about this (as I do) then at least the picture is pretty much the opposite in the US.
Finally, one very understandable concern investors have today is that equity markets have come a long way very fast since the lows in April this year. This is, of course, undoubtably true. And equity markets will, of course, inevitably fall again at some point. But if this is enough to scare you out of the market then it is my professional duty to remind you that timing these things remains hard. As an example, say you had a (crazy sounding?) strategy which was only to invest when the market was at all-time highs. Bank of America have run the numbers on this and they think those dollars (or pounds) invested would do just as well (or even better) than if you waited for a sell-off before you invested (or rather if you invested only when the market wasn’t at an all-time high). Nothing in these updates is financial advice, but, on average, rising markets and all-time highs are not reason enough by themselves to sit on the sidelines and wait. And because UK equities, and especially UK mid-caps, seem to prefer lower interest rates even if they come with higher taxes.
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
