In the event, there was no explosion. Instead, there was a clean-up effort that lasted years and the undamaged reactor did not reopen until 1985. However, the public’s confidence in the safety of nuclear power had eroded and Three Mile Island was eventually closed in 2019.

Grow your own

Despite the energy source remaining shrouded in speculation, in September 2024, Constellation Energy announced that Three Mile Island would be reopening, with Microsoft as the sole purchaser of its energy on a 20-year contract. The motivation? Powering Microsoft’s data centres for the growing presence of AI.

Microsoft is far from the only company to anticipate the burgeoning need for energy in coming years and to take matters into its own hands. However, as investments in AI have shot up in recent years, investments in energy, and specifically renewable energy, have tanked.

See also: Aegon: Data centres are the new dividend drivers

By 2030, the US Electric Power Institute estimates the energy demands of data centres could account for more than 9% of all US energy consumption. Currently, this sits at 4%. Jim Wright, fund manager of the Premier Miton Global Listed Infrastructure fund, says the phenomenon could lead to “a land grab” for energy supply and generation, exemplified by the Microsoft deal.

“The requirement for additional electricity will stretch the system capacity, particularly at seasonal and daily demand peaks. The inevitable solution is more investment in generation capacity, which will include renewables, batteries, gas-fired generation and nuclear power,” Wright explains.

“The costs, lead times and technological and regulatory challenges make new nuclear, either in the form of Small Modular Reactors or large power plants, a longer-term solution. There is considerable momentum, as shown by Meta’s recent request for developers to provide between one and four gigawatts of new nuclear capacity in the US to power its AI data centres.

“The growth in electricity generation capacity will require significant capital expenditure and changes the long-held perception of electricity utilities, which may now be classed as ‘growth stocks’ for the next decade.”

Read the rest of this article in the January edition of Portfolio Adviser Magazine

While the UK’s monthly services output grew by 0.1%, compared to a 0.1% fall during the previous month, the figure remained static over three months to November 2024.

Elsewhere, construction output improved by 70 basis points, from a 0.3% fall in October to a 0.4% increase in November. It also grew by 0.2% over three months to November.

In contrast, production output fell by 0.4%, following on from a 0.6% fall in October. Over three months to November, a drop in UK manufacturing levels led to a 0.7% reduction in growth.

See also: ‘Not out of the woods yet’: UK inflation falls by 10 basis points in December

Lindsay James, investment strategist at Quilter Investors, said that while the risk of recession in the UK “remains modest for now”, we are “not out of the woods yet” with three-month GDP growth flatlining.

“This weak growth can in part be attributed to the fallout of the government’s budget, which saw consumers hit pause on spending. As we move further into this year we could see an even bigger impact,” she warned. “Businesses will soon feel the effects of increased national insurance contributions, the costs of which are likely to be passed on to employees. Wage growth is expected to take a hit, and spending could be dampened further as a result.”

James added: “It appears the Chancellor has a large task ahead, given she is banking on growth to drive the economy.”

‘The economy needs stimulus from somewhere’

Neil Birrell, chief investment officer at Premier Miton Investors and lead manager of the Premier Miton Diversified fund range, agreed that while the UK economy grew in November,  it “only just” managed to do so.

“Manufacturing and industrial output was poor, reflecting the collapse in business confidence we have seen since the Budget,” he explained. “Perhaps a combination of improving inflation and a weaker economy will spur the Bank of England on to look at cutting interest rates at their next meeting. However, inflation hasn’t gone away, but the economy needs stimulus from somewhere.”

James added that markets have generally been sceptical about the Bank of England cutting rates during the first part of this year, with less than two 25 basis-point cuts priced into markets for the full year.

See also: UK unemployment rates remains unchanged at 4.3%

“The Bank of England stood alone in its decision to hold rates in December while the ECB and Federal Reserve forged ahead with cuts. However, should the economy fail to pick up at least some momentum and the UK falls into a recession, it may be forced to change tack.”

While Scott Gardner, investment strategist at Nutmeg, concurred the UK economy grew “only by a whisker” in the latest figures, the outlook for the UK economy remains “bright”.

He said: “Falling business confidence in response to the Budget and weaker manufacturing orders dampened economic growth. This clear mood shift, represented by recent instability across financial markets, could provide a headwind to the UK’s growth ambitions and is an important area to watch in the months ahead.

“Despite this change in sentiment, the outlook for the UK is bright with the economy predicted to grow quicker in 2025 than European peers including France and Germany.

“A potential uplift in housing market activity in the lead-up to the April stamp duty changes could provide a tailwind for the economy. While we remain in ‘wait and see’ mode ahead of potential US trade tariff announcements, if they come to pass, they are expected to have a larger impact on the UK’s European neighbours.”

Elsewhere, core inflation – which excludes food and energy –  fell from 3.5% to 3.2%, which was also below forecasts of 3.4% for the month. Despite falling by more than was broadly expected, inflation remains 50 basis points above the Bank of England’s 2% target.

Paul Noble, CEO of Chetwood Bank, said: “Some good news to start the year for Britons. Many will have approached today’s result with some apprehension, but 2025 can begin on a positive note despite the uncertainty.

“The economic environment is still nowhere near stable, with inflation yo-yoing back and forth from the 2% target. The uncertainty surrounding the budget has not dissipated, but these figures will help to calm nerves nationwide, at least in the short term.

“However, the spectre of public sector wage increases will keep experts guessing as the year goes on, and the Bank of England will be watching CPI closely as they consider the timing of their next rate change.”

See also: Tulip Siddiq resigns from Treasury following criminal case filing

Jonny Black, chief commercial and strategy officer at abrdn adviser, said: “This will be welcome news, but it doesn’t mean inflation won’t be something to watch in 2025.   

“A volatile economic landscape is making it hard to say for sure where inflation is going to go next, but the Bank of England’s own forecast suggests that it could stay stubbornly above the 2% target for 2025-26.” 

Scott Gardner, investment strategist at digital wealth manager, Nutmeg, added that policymakers will be “breathing a small sigh of relief” following the latest data.

“While it might be odd to be welcoming above-target inflation, these results have grown in significance after an unstable start to the year for the pound and government borrowing.

“In the lead up to this release, it was clear that markets could not afford any surprises after a troubling period which saw UK assets hit by fears of low economic growth and persistent inflation. This data will hopefully allay some of those concerns.”

He added the fall in core inflation was particularly positive, and this could fall further still throughout the year due to a cooling jobs market, as well as businesses paring back hiring ambitions following proposed changes to National Insurance business contributions.

See also: UK unemployment rates remains unchanged at 4.3%

“This data will increase the chances that the Bank of England cuts interest rates in February, though the path remains murky for multiple interest rate cuts this year.”

However, Zara Noakes, global market analyst at JP Morgan Asset Management, warned that “we are not out of the woods yet”, and that “inflation dynamics could prove challenging this year”.

“Inflation was already anticipated to accelerate in 2025 due to unfavourable base effects, but the policies announced in the October Budget have added fuel to the fire,” she said.

“Businesses have signalled that they intend to respond to the hike on employer’s National Insurance contributions by increasing prices to maintain profit margins, while simultaneously reducing hiring. Therefore, while across the Atlantic they are experiencing sticky inflation with strong growth, and on the continent, weaker inflation alongside stagnant growth, here in the UK, we are likely to experience challenges across both fronts.”

Salaries excluding bonuses increased by 5.2% between August and October this year, while pay adjusted for inflation using the CPIH index rose by 2.2%.

The UK’s employment rate for those aged between 16 and 64 amounted to 74.9% over the same time period, which marked a small increase compared to last quarter but remains unchanged relative to the same time frame last year.

UK unemployment rate among those aged 16 years and over came in at approximately 4.3%, which is above estimates compared to a year ago and is an increase over the last quarter.

See also: UK economy contracts 0.1% in October

Lindsay James, investment strategist at Quilter Investors, said the data “reinforces the picture of a UK labour market holding steady”, with “little change in the unemployment rate and wage growth figures compared to last month”.

“The unemployment rate of 4.3%, alongside a reasonable uptick in annual growth in regular pay to 5.2%, reflects a labour market that is not yet budging under the strain of the economic headwinds it’s facing,” she explained.

“Recent data from recruitment firms, such as Reed, still points to weakening demand for labour, with job vacancies continuing their downward trend. Vacancies have dropped by 13% between October and November and are 26% lower than a year ago.

“While this is a concerning sign of softening economic activity, it has yet to translate into significant increases in unemployment, suggesting that the labour market’s adjustment is happening gradually rather than in a sharp downturn.”

Michael Brown, senior research strategist at Pepperstone, said the rise in both regular pay and overall salaries “are clearly incompatible with a sustainable return towards the 2% inflation target over the medium term”.

“The acceleration in earnings growth in October [was] caused principally by an unfavourable base effect from 2023, coupled with this summer’s above-inflation public sector pay deals feeding into the data, with this latter factor also likely to skew the November print to the upside,” he warned. “Policymakers will clearly be seeking a significant cooling in earnings pressures before being convinced that the risk of persistent price pressures is receding, and that sticky services inflation may begin to ease.”

Overall, however, he does not believe the report will be a “game-changer” for the Bank of England’s Monetary Policy Committee, who are due to make a decision on interest rates this coming Thursday (19 December 2024).

See also: ECB cuts interest rates to 3%

Quilter Investors’ James said: “With inflation currently at 2.3%, and still above the Bank’s 2% target, policymakers face the same dilemma: balancing the need to maintain price stability with the risk of leaving monetary policy too tight.

“Rates remain at 4.75%, with persistent wage inflation remaining above historical norms, which is likely to keep the Bank on alert.”

Brown agrees rates will likely remain at 4.75% later this week, adding: “Continued uncertainty over the precise impact of the measures announced in October’s Budget, coupled with stubbornly high inflation, and accelerating earnings growth, help to reinforce the MPC’s ‘gradual’ approach to removing policy restriction.

“As such, a 25bp cut in February, with quarterly cuts thereafter, remains my base case.”

According to the latest fund flow data from the Investment Association, published last week, the IA Corporate Bond sector saw the biggest sector inflows during the month of September at £904m, far outpacing the second best-selling sector’s net retail sales of £244m.

This is no surprise given where interest rates stand relative to history, with developed market central banks now heading towards a rate-cutting trajectory. As such, however, there has been some concern over recent weeks that credit spreads are tight relative to history.

But could prospects for bonds have become even more appealing since?

While in the UK, the Bank of England’s Monetary Policy Committee voted 8-1 to cut interest rates by 25 basis points last week, it warned that policies implemented during last month’s Autumn Budget could increase inflation by up to 50 basis points at its peak. Figures from the Office for Budget Responsibility also confirmed the policies will increase inflation and impact the previous trajectory for interest rate cuts.

Meanwhile, in the US, the likelihood of inflationary policies from incoming president Donald Trump could also mean interest rates remain higher for longer. This is despite a rate cut from the US Federal Reserve last week.

See also: AJ Bell’s Hughes: Why money will keep flowing into fixed income funds

Samer Hasn, senior market analyst at XS.com, said: “We are witnessing a gradual decline in the probability of the Fed cutting rates next January, reaching 20% ​​today [13 November] after exceeding 60% a month ago. Also, if the Fed cut rates in January, the probability of further a cut in March is only 11%, after exceeding 60% a month ago, according to CME FedWatch Tool figures.

“The diminishing likelihood of a rate cut next year has driven yields on two-year treasuries—highly sensitive to shifts in short-term interest rates and expectations—up at a faster pace than 10-year treasuries. This surge has propelled two-year yields to their highest level since July, reaching 4.33% today.”

As a result, he said bond yields may “ultimately become more attractive” as investors capitalise on yields that could remain higher for longer than previously anticipated.

“Additionally, rising risk appetite in the markets, exemplified by record highs in stocks and cryptocurrencies… could lead Wall Street portfolios to shift toward a blend of high-upside stocks and high-yield bonds.”

That being said, a report from Bank of America Global research, published on the 11 November by credit strategists Ionnis Angelakis and Barnaby Martin, wanted that credit spreads have become “another leg tighter” since the US election result.

Despite this, they believe strong inflows into fixed income – namely credit – are likely to persist into 2025.

“The need for quality yield is here to stay. In a world of diminishing yields in “risk-free” proxies, like government debt and money-market funds, we think that credit will remain the asset in demand,” the wrote. “A growth shock could cause the inflow trend to wobble at times in 2025, but as long as the rates market doesn’t make a U-turn, we see strong inflows as a regular theme next year.”

Using rate volatility and the prevailing level of yields, the strategists predict that flows into investment-grade credit will be “strong” at between 5-7% of AUM in 2025, if yields continue to decline.

See also: What does the gilt yield spike mean for UK bond prospects?

“We believe high yield will also benefit, but to a lesser extent, with flows of around 2.5-5% of AUM.

“Last but not least, there will be a clear decoupling between credit and government debt funds; the latter is likely to see more muted inflows of around 1.5-3.5% of AUM.”

Elsewhere, the research team at Square Mile said “cautious optimism” remains the dominant view among most fixed income managers that they speak with.

“In a climate of economic and political unpredictability, investors are increasingly turning to fixed-income funds as a strategic play for a more stable return profile,” the team said.

“The consensus at present is one of a “soft landing”, where growth slows without triggering a significant recession, although some managers commented that a “hard landing” remains within the realm of possibility. This creates both risks and opportunities for fixed-income assets.

“Trump’s victory may have profound implications for fiscal policy given his rhetoric around aggressive tariffs and immigration restrictions. Such policies may complicate the Fed’s ability to meet anticipated rate cuts, potentially leading to higher yields. Investors should consider that, while monetary policy is used to stimulate the economy, in developed markets the rate hikes resulted in relatively benign impacts as shown by the resilience in the US. This raises the question of whether the reaction to rate cuts may also be more muted than expected.”

From a duration perspective, the team said overweight positions in US and European interest rates look to be a popular strategy.

“Asset classes in favour are high yield, particularly in Europe due to cheaper valuations over the US, as well as emerging market debt and securitised assets. These asset classes are providing incremental and attractive levels of yield despite the tight credit spread environment.

“In the coming months, excess returns are more likely to come from carry rather than additional narrowing of credit spreads, i.e. capital appreciation. With spreads already compressed, focusing on yield seems to be the path most travelled in an attempt to offer a sustainable return profile.”

While this is a 10 basis-point dip compared to the 4.9% growth seen between June and August, total earnings including bonuses increased by 50 basis points from 3.8% to 4.3%. However, this was impacted by a one-off payment made to the civil service in July and August 2023.

The number of payrolled employees UK fell by 9,000 (0.0%) between August and September 2024, but rose by 136,000 – or 0.4% – over the course of the year, from September 2023 and September 2024.

See also: Interest rates stay at 5% as ‘dark clouds gather once again’ over the UK

The UK employment rate for people aged 16 to 64 years came in at 74.8% between July and September this year, which is an increase over the last quarter, but remains “largely unchanged” from a year ago.

Lindsay James, investment strategist at Quilter Investors, said: “Wage growth has been a real sticking point for the Bank of England, and though it remains well above the Bank’s 2% inflation target and this uptick will be unwelcome as far as the Bank is concerned, it is likely we will see a marked slowdown in the coming months.

“The changes announced at the recent Budget will see the government’s coffers receive a major boost from the increase in employer national insurance contributions from April 2025. While the government has not directly placed the tax burden on working people, the higher cost to business is very likely to need to be passed on to employees in one form or another, and we can expect to see a significant slowdown in employee pay increases as a result.”

She added that, while unemployment increased by more than expected to 4.3% in July to September, compared to 4% between June and August, the rate had previously remained “relatively stable” with today’s figures “buck[ing] the trend slightly”.

See also: Will the European Central Bank cut interest rates faster than expected?

“The Bank of England announced another 0.25% interest rate cut last week, leaving the base rate at 4.75%. However, the pace of future cuts is looking much less certain than it once was.

“Expectations for cuts have been scaled back considerably, and rates are now not expected to fall below 4% in 2025. Wage growth and unemployment will remain high on the Bank’s agenda, and we are likely to see a continuation of the slow and steady approach it is currently taking.”

Eight members of the MPC voted in favour of the cut, with only Catherine Mann diverging from the majority.

This is despite the fact the central bank predicts Chancellor Rachel Reeves’ Budget will nudge inflation up by up to 50 basis points over the next two years.

Headline inflation figures fell to from 2.2% to 1.7% during the month of September, 30 basis points below the central bank’s 2% target.

Lindsay James, investment strategist at Quilter Investors, said the cut had widely been priced into markets at a 95% probability, with both headline and core inflation easing.

See also: What does the gilt yield spike mean for UK bond prospects?

“Despite this benign inflationary backdrop, the UK economy has experienced weak growth over the summer, and pressures on employers have increased, even as unemployment remains low,” she pointed out.

“Interestingly, long-term bond yields have risen recently, and the market has adjusted to price in fewer rate cuts despite the economic conditions. This shift is driven by concerns over the Labour government’s additional borrowing and changes to fiscal rules, which, although sensible, are challenging to implement amid current pressures on public finances.

“Additionally, rising bond yields in the US, fuelled by fears that inflation will remain above target while the economy stays strong, have influenced this trend. Donald Trump’s aggressive spending plans, projected by the Congressional Budget Office to increase US debt to GDP to 143% by 2034, have further compounded these concerns.”

Colleen McHugh, chief investment officer at Wealthify, said the Bank opted for “sparklers over fireworks”, with policymakers choosing to look past last week’s Budget this month.

“But they likely won’t ignore the Office for Budget Responsibility’s latest projections, which anticipate both GDP and inflation climbing by 2025,” she warned. “For those counting on a third rate cut in December, brace yourselves: it’s likely to be a finely balanced decision. With a Trump presidency likely to be inflationary on a global level, and two more inflation reports due before the December meeting, now might be the time to temper expectations.”

Shamil Gohil, portfolio manager at Fidelity International, said challenges have now risen to the fore for the Bank of England over the medium term.

“The Monetary Policy Committee has a tough job balancing the future impact of the UK budget and government’s fiscal policy. Cost increases for companies from higher taxes, national insurance and national minimum wage will likely be at least partially passed on to consumers via price hikes next year,” he explained. “Fiscal stimulus should also have a positive impact on growth allaying any recessionary fears. Therefore, the sensible path continues to be for a gradual and cautious easing process as these affects are slowly realised over time.”

See also: Carne: 82% of UK asset managers considering LTAF launch

Zara Nokes, global market analyst at J.P. Morgan Asset Management, said the Bank of England must now resist the temptation to cut rates too quickly.

“The UK economy is now contending with a number of cross-currents which make the growth and inflation outlook highly uncertain,” she said.

“Last week’s UK Budget revealed plans for front-loaded fiscal stimulus which – at a time when the supply side of the economy is constrained – risks stoking inflation next year. The return of President Trump to the White House adds another layer of complexity. While there is still a high degree of uncertainty as to what the next Republican administration will enact when in office, tough protectionist measures could be a headwind for global growth and the UK may be vulnerable given the openness of its economy.

“For these reasons the Bank should be very wary of giving concrete forward guidance on the pace of further cuts. In our view, with the underlying dynamics of the domestic economy pointing to inflation lingering for some time, the Bank should resist cutting too quickly.”

In a speech by Chancellor of the Exchequer Rachel Reeves (pictured), it was revealed the OBR predicts inflation to average at 2.6% for 2025, 2.3% in 2026, 2.1% in 2027, 2.1% in 2028 and 2% in 2029.

In terms of economic growth, Chancellor Reeves said the OBR has not only published five-year growth forecasts, but “detailed assessments of growth policies over the next decade”, which, she said, will “become a permanent feature” of Labour’s framework.

Real GDP is estimated to come in at 1.1% for this year, 2% in 2025, 1.8% in 2026, 1.5% in 2027, 1.5% in 2028 and 1.6% in 2029. While this is faster than was previously forecast for 2024 and 2025, growth projections have reduced for 2026, 2027 and 2028.

See also: Autumn Budget 2024: Capital gains tax hiked to 24%

Following a review by the OBR conducted earlier this year, however, the body found the previous Conservative government “did not provide the OBR with all the information to them”. Had they known, according to Reeves, the Spring Budget forecast would have been “materially different” – therefore making it difficult to compare figures.

In terms of government debt, the OBR predicts the country will be in deficit by £26.2bn in 2025, but will reach a surplus of £10.9bn during the 2027/28 fiscal year. This will fall slightly to £9.4bn in 2028/29, then tick upwards to £9.9bn by 2029/30, which, Reeves said, will meet Labour’s ‘stability rule’ two years early.

“Economic growth will be our mission for the duration of this parliament,” Reeves said. “Our stability rule means we will bring the current budget into balance so we do not need to borrow to fund day-to-day funding. We will meet this in 2029/30.”

The immediate trigger for the sell-off was news that the US had added just 114,000 jobs in July. Consensus forecasts had pointed to 175,000 jobs created. This sparked a panic that the Federal Reserve had been too slow in cutting interest rates, and a slowdown in the economy was now a possibility.

Preston Caldwell, chief US economist at Morningstar, says: “Make no mistake, it is bearish news.” He says that the increase in the unemployment rate to 4.3% in July is the biggest concern. “This triggers the “Sahm Rule”: the observation that the US economy had always entered a recession if the unemployment rate (using a three-month moving average) experiences a trough-to-peak increase of 0.5 percentage points within a 12 month period. Unemployment has averaged 4.1% in the past three months, up 0.5 percentage points from August 2023.”

Rates on hold

The Federal Reserve had only just announced its decision on interest rates for August. It maintained rates at 5.25%-5.50%, but Fed Chair Jerome Powell said the central bank may reduce interest rate cuts in September, if the economic conditions were right, with inflation still falling. He said: “We’ve made no decisions about future meetings and that includes the September meeting. We’re getting closer to the point at which we’ll reduce our policy rate, but we’re not quite at that point yet.”

The narrative built up by markets was that the Federal Reserve had dropped the ball. It had not been quick enough to cut rates and now recessionary pressures were building. The US market was hit hardest, particularly the Nasdaq, which was already struggling to digest some lacklustre earnings data from the large technology companies. The Nasdaq is now in ‘correction’ territory, having dropped more than 10% from its high on 11 July. Elsewhere, the impact has been more muted. The FTSE 100 is down just 1.3% this week, while the S&P 500 is down 2.1% (source: MarketWatch, to 2 August 2024).

The immediate reaction from financial markets looks overblown. Employment data is volatile, and significant gaps between expectations and reported data are not unusual. However, there is a wider concern that investors may have gone too far in assuming a soft landing for the US economy is inevitable. Salman Ahmed, global head of macro and strategic asset allocation at Fidelity, outlines the problem for many asset allocators: “We are still comfortable with our assumptions to the end of 2024. But if you ask me whether these probabilities will hold into 2025, my answer would be no. At that point, we will need to start thinking about a cyclical recession a bit more seriously. I’m not saying it will be the dominant scenario, but what happens in 2025 will depend on what happens on the political outcome in the US.”

The high levels of US debt remain a key source of fragility. In June, 76% of income tax revenues were spent on debt repayment. Neither side of the political divide appears inclined to tackle the yawning gap between revenues and spending.

Ahmed says leading indicators suggest that the cycle is losing steam, adding: “There is still positive growth, but the momentum is negative.” The main drag has been global trade and commodities. Even though business surveys have been positive, there is a deceleration in the strength of growth. He believes the readings on services inflation in the latter part of 2024 will be very important, particularly the strength of the US consumer.

Financial market fragility

Andy Warwick, co-portfolio manager of the BNY Mellon Real Return fund, says a cloudier economic picture could destabilise financial markets. He adds: “As market participants continue to debate the likelihood of a more significant economic slowdown, they will be evaluating the legacy of the build-up in government debt and stubborn inflation levels, as well as the potential impact of political change. We think this trio of influences will continue to cause volatility in markets in the second half of 2024 and beyond.

He believes a ‘soft landing’ is within reach, but only if central banks are quick to take the top off their high cash rates. Caldwell agrees: “It’s time for the Fed to cut the federal-funds rate. The data quality issues make our picture of the economy somewhat murky. But there’s enough risk to call for substantially cutting rates now. Rate cuts in each of the final three meetings this year, beginning in September, is the base case if the unemployment rate does not fall back.”

Warwick says the balance of risks are now in favour of a cut: “The odds of a downturn becoming more severe and developing into a proper hard landing are higher than the possibility of world economic growth reaccelerating and pushing inflation (and then interest rates) to new highs. On balance, the soft-landing scenario still appears most likely, but it has previously proved a difficult act for central bankers to pull off.”

The current sell-off appears a little petulant, but there is a serious point behind it. It is tough to get the timing right on rate cuts, and the Federal Reserve is looking increasingly slow to the party. This should make a decisive case for a rate cut in September.

The French elections shone a spotlight on its government debt crisis. The country’s political sclerosis has troubled financial markets, because it makes tackling the vast and burgeoning debt even more difficult. Greece, Italy, France, Spain, Belgium and Portugal all have debt levels of over 100% of GDP.

A recent survey of central bankers by UBS found that the level of global government debt was their fastest-growing concern. Some 37% of central bank managers said global sovereign debt levels were among their main worries for the global economy in the year ahead. This was an increase from just 14% who were troubled about the same issue last year.

See also: What will the French election result mean for financial markets?

The Institute of International Finance says that global government debt is now over $90trn though more than a third of this ($34trn) is attributable to the US. In aggregate, global debt as a percentage of GDP is likely to tip back over 100% this year. Governments have struggled to normalise spending after the pandemic.

Central bankers are not the first to raise the alarm. In June, the IMF urged the US to address its mounting government deficit, criticising both presidential candidates’ fiscal plans and warning that the country faced higher financing costs.   

It said: “The fiscal deficit is too large, creating a sustained upward trajectory for the public debt-GDP ratio. The ongoing expansion of trade restrictions and insufficient progress in addressing the vulnerabilities highlighted by the 2023 bank failures both pose important downside risks.

“Under current policies, the general government debt is expected to rise steadily and exceed 140% of GDP by 2032. Similarly, the general government deficit is expected to remain around 2½% of GDP above the levels forecast at the time of the 2019 Article IV consultation. Such high deficits and debt create a growing risk to the US and global economy, potentially feeding into higher fiscal financing costs and a growing risk to the smooth rollover of maturing obligations.”

Manageable?

That said, there are those who believe deficits are, for the most part, still manageable. It is also worth noting that government debt is not central bankers’ greatest concern: they are more worried about geopolitical conflicts, persistent inflation and an uncontrolled rise in long-term yields.

Oxford Economics says: “Key risks to fiscal sustainability include rising debt servicing costs, aging populations with related social spending, geopolitical risks and associated defence spending, and climate-related greening investment. All of these risks are currently manageable.

“Higher debt servicing costs are not critically threatening even if higher inflation leads to higher-for-longer policy rates as it would also mean higher fiscal revenues. Although defence spending is likely to rise from here, it is still a relatively low budget item (around 1% of GDP in most European economies) and therefore is unlikely to cause disruptions. Climate spending too is relatively low, though it already exceeds previously established targets in most advanced economies.”

See also: Barings: Glimmers of optimism in EM debt, but risks remain

It believes European countries could reduce debt without major fiscal changes. However, it believes the US may have problems ahead. It is currently running with debt at 122% of GDP and will need significant policy adjustments to stabilise its growing debt levels. Oxford Economics believes political changes might shift the short-term debt trajectory, but will not change the overall sustainability as it stands.

There are also more encouraging signs ahead. Growth is improving across much of Europe, including previous laggards such as the UK. This may incrementally start to improve the debt problem. Falling interest rates may also improve the sustainability of debt levels.

Political instability

Even if European debt is – largely – sustainable at current levels, it makes fragile politics a greater risk. A wayward populist government could destabilise countries’ fragile fiscal balance. Oxford Economics adds: “Even in countries where current debt paths don’t call for significant cost cuts, the question remains whether current spending plans might in unfavourable scenarios jeopardise debt sustainability.”

This circles back to the problem in France. Frédérique Carrier, head of investment strategy for RBC Wealth Management in the British Isles and Asia, says: “Markets worry that the National Rally’s expansive fiscal policy at a time when the country’s fiscal deficit exceeds 5% could destabilise the region, much like Greece did in 2012. This would be problematic as France is the second-largest economy in the eurozone. Ultimately, we believe that if the RN becomes part of the government, it would likely align itself with Brussels’ fiscal policies. It would not be in the RN’s best interest to upset the apple cart ahead of the French presidential elections in 2027, in our view.”

See also: Biden vs Trump: What to expect from the next biggest election

Jim Cielinski, global head of fixed income at Janus Henderson Investors, says the US election could bring the US debt problem to the fore. “This could shine a spotlight on government debt levels and fiscal profligacy…It could also reawaken concerns around protectionism and tariffs on trade, given that easing of supply chain bottlenecks has been instrumental in helping to bring down inflation from its post-Covid highs.”

While global debt levels appear sustainable for the time being, they remain vulnerable to poor political management and – in particular – populist governments with little inclination to fiscal responsibility. The situation in France may be a trial run for an even bigger problem in the US later this year.

The second round of parliamentary elections produced no clear majority in the National Assembly – with a near-even split between the left, centre and the far right. The prevailing view is that France is now ungovernable, with no mandate on either side. Prime minister Gabriel Attal of President Macron’s Renaissance party will stay on in a caretaker role to see the country through the Olympics, but will step down after the summer. Macron will almost certainly appoint a prime minister from the left alliance NFP, which won the most seats.

See also: How will UK markets be influenced by Rachel Reeves and the Labour Party?

This horse-trading and uncertainty wouldn’t necessarily be a problem were France not teetering on the brink of a financial crisis. Its debt now sits at over 110% of GDP (source: Trading Economics), while the annual fiscal deficit is over 5.5%. The EU has warned France to cut its deficit by €15bn or face sanctions. Under the Eurozone’s Excessive Deficit Procedure, EU member states must keep their deficit below 3% of GDP. Against this backdrop, there is a real need to take difficult decisions to address the deficit, but that has become increasingly unlikely amid political stalemate.

Azad Zangana, senior European economist and strategist at Schroders, says: “The government’s Stability Programme’s stated plans are for the deficit to fall to 4.1% in 2025 and to 3% of GDP by 2027, but these targets seem unlikely to be met given the current political landscape, and the backlash against austerity.”

He adds that investors are concerned that a left-wing anti-capitalist government could impede some of the larger French companies. Moody’s has warned that the outcome is negative for the country’s credit rating.

Financial markets

The elections have sent European equity and bond markets on a rollercoaster ride. The CAC 40 dropped 9% from its peak in May to its trough in mid-June. It has since stabilised, but has not recovered its previous levels.

Some sectors have been particularly hard-hit. Johann Scholtz, equity analyst at Morningstar, says traders heavily shorted French banks amid the turmoil on the French election, viewing them as a proxy for the general French economy.

He adds: “The main risk to French banks from political uncertainty is increased funding costs based on wider French credit spreads. French banks rely more on wholesale funding than many of their European peers, making their position even more acute. There is also a risk of populist intervention by a new government in savings and mortgage interest rates. However, French rates are already regulated, which will blunt the impact of further intervention in rate setting.”

The European Banking Authority showed that France’s five largest banks — BNP Paribas, Crédit Mutuel, Groupe BPCE, Crédit Agricole and Société Générale — had a combined exposure to sovereign debt of €366bn in June 2023. However, credit ratings group Moody’s says the impact on their regulatory capital should be ‘muted’.

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The election result does not resolve the situation in the bond market. The French 10-year bond yield has been steadily rising over the past three months, increasing from 2.9% to its current level of 3.2%. It has been moving higher since the election announcement in spite of a rate cut from the ECB. This is in notable contrast to the German 10-year bond yield, which has remained steady over the same period.

Mark Dowding, chief investment officer at RBC Bluebay, has had a long-term underweight on French government bonds: “In France, we’ve been saying we see no value in government bonds for some time and have been actively short where we can be. That has worked well. The direction of fiscal policy is not healthy, and there are the underlying political problems as well.”

However, for most French companies the risks appear minimal. Christopher Rossbach, manager of the J. Stern & Co. World Stars Global Equity fund, says: “The headlines are often more extreme than the policies for these parties. Nevertheless, sentiment can be a problem. The calling of the election gave rise to significant volatility, but we see it more as an opportunity to take advantage. We are looking at long-term fundamentals and volatility around short-term events can allow us to pick up great companies at great prices.”

Oxford Economics points out that a hung parliament will limit the scope for major changes to the domestic business environment. However, that doesn’t necessarily make French equities a compelling buy. It adds: “We maintain our underweight on the market as earnings per share momentum is lagging the recovery elsewhere in the eurozone. Domestic activity remains relatively lacklustre, and a weak China consumer recovery will continue to weigh on the consumer discretionary-heavy market.”

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There is a question on whether the problems could spread beyond France. France is the second largest country in the eurozone. Zangana says there is the potential for broader instability: “A less austere French government could undermine the EU’s Excessive Deficit Procedure, empowering other governments to also fall foul of the bloc’s fiscal rules. This raises the likelihood of higher volatility in markets, and taken to the extreme, a new sovereign debt crisis. The European Commission (EC) will have to stand strong together with the European Central Bank (ECB) to guard against such an outcome.”

The French election shows how politics can become more important when a country has high debt levels. It may be a lesson worth learning ahead of the US elections in November.

Even bottom-up stockpickers such as Nedgroup’s Mark Landecker have to take macro factors into account when making investment decisions to ensure they are not walking into any traps unwittingly. “We think of ourselves as macro aware,” he said. “It’s not so much that we specifically are making macro forecasts, but we don’t want to step on mine fields that we should have known existed.”

Despite still being focused on the fundamentals of companies, Landecker said ignoring macro can be a dangerous game. Many bottom-up fund managers will claim that watching such data points will distract investors from their long-term goals, but being aware of the macro world has steered his Nedgroup Contrarian Value Equity fund clear of hazards that crippled other asset managers.

“Many value investors were in housing stocks around 2007 and 2008,” Landecker said. “They looked really cheap and had mid-single digit earnings multiples, so what could go wrong? The manager at the time Steven Romek was aware that it seemed a little hot and frothy at the time so decided not to play there

“I’d say be aware of where the potential pockets of weakness in an economy are and steer clear of those. If we feel like there’s an industry that’s overheating – or that it’s running above trend and above average – we want to be mindful of that and incorporate those thoughts into our models.”

Yet global markets have become even more volatile and difficult to predict since the global financial crisis. Sensing the growing influence of geopolitics on markets after conflict began in Ukraine, Amundi, one of Europe’s largest asset managers, created a dedicated role to analyse it.

Anna Rosenberg was appointed head of geopolitics in 2022 to advise its fund managers – who run €2.1trn in assets – on how it could impact their portfolios. And given how tensions across the globe are only growing, Rosenberg expects geopolitics to play an increasingly important role in investment decision making over the next decade.

But some fund managers might be slow to pick up on this. Many have been taught over their whole career to analyse individual companies without being influenced by the sectors or regions they sit in – an approach that is slightly hypocritical when they use some forms of risk mitigation and ignore others, according to Rosenberg.

“You care about a company’s ESG ranking but you don’t care about a company’s geopolitical exposure? That’s madness,” she said. “You need to understand if a company is at risk because of geopolitics, so it’s as much bottom up as it is top down.

“I think we are seeing that everyone – economists, forecasters, portfolio managers – all have to better learn how to deal with geopolitics and understand what it means and how it affects them.”

Nevertheless, most fund managers now understand the growing importance of geopolitics in investing, following several years in which macro factors have dictated markets. Rosenberg even said the monotonous use of it in reports and earnings calls has turned geopolitics into “a buzzword” in the industry. “Sometimes for fun during calls I write down how often my colleagues say it,” she joked, “but it shows you how it is informing the backdrop against which decision makers are making decisions.”

Yet while many asset managers are factoring in geopolitics, most lack the knowledge to do so in a sophisticated way. “Geopolitics is so central these days to every portfolio manager, but you don’t have anyone who actually has the qualifications,” Rosenberg explained. “There’s a lot of opinion sharing, but not necessarily analysis, and I think there is a need to have a common level of understanding so that you have a discussion based on a factual basis.

“People have realised this is here to stay, but they don’t know how to deal with it. Some of them are trying to figure it out and create trading models and tools, but we’re talking about economists and people who have studied economics here – they think they will find the answers in the data, but the reality is that the data is very often not predictive, it’s usually retrospective. So the data can be supportive, but it doesn’t tell you what’s going to happen. That’s why you really need political analysis.”

But how are portfolio managers themselves implementing this? Francesco Sandrini, who manages Amundi’s multi-asset strategies and is advised by Rosenberg on macro matters, said he has made investment decisions that were influenced by geopolitics. He noted that it is often mentioned in the context of avoiding risk – just as it stops Landecker “stepping on mine fields” – but it is equally about finding new opportunities.

Like with any change, it brings opportunities. Nearshoring, for example, is a theme that has come about due to the shifting geopolitical landscape. Sandrini has upped exposure to places such as Mexico and Indonesia in order to “play the new political equilibrium”. So while factoring in macro movements and geopolitics into investment decision making can help avoid risks, it shouldn’t be framed purely as that.

“The universe of opportunities is much more scattered than it was a few years ago, but geopolitics is not just a risk,” Sandrini said. “Because we’re in this change of equilibrium where we are moving away from a purely US-centric multilateralism to a more multipolar world, geopolitics is creating interesting investing opportunities. You have to see it with this double metric in order to take advantage.”