Category: Economics: Ch 15

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The Chancellor’s fiscal dilemma

The UK Chancellor of the Exchequer, Rachel Reeves, will present her annual Budget in late autumn. It will involve some hard economic and political choices. The government would like to spend more money on improving public services but has pledged not to raise taxes ‘on working people’, which is interpreted as not raising the rates of income tax, national insurance for employees and the self-employed, and VAT. What is more, government borrowing is forecast by the OBR to be £118 billion, or nearly 4.0% of GDP, for the the year 2025/26. This is a fall from the 5.1% in 2024/25 and is well below the 15.0% in 2020/21 during the pandemic. But it is significantly above the 2.1% in 2018/19.

The government has pledged to stick to its two fiscal rules. The first is that the day-to-day, or ‘current’, budget (i.e. excluding investment) should be in surplus or in deficit of no more than 0.5 per cent of GDP by 2029/30 (or the third year of the rolling forecast period from the 2026/27 Budget). This allows investment to be funded by borrowing. The second rule is that public-sector net debt, which includes public-sector debt plus pension liabilities minus equity, loans and other financial assets, should be falling by 2029/30 (or the third year of the rolling forecast period from the 2026/27 Budget). The current budget deficit (i.e. excluding borrowing for investment) was forecast by the OBR in March to be 1.2% of GDP for 2025/26 (see Chart 1) and to be a surplus of 0.3% in 2029/30 (£9.9 billion). (Click here for a PowerPoint of the chart.)

The OBR’s March forecasts, therefore, were that the rules would be met with current policies and that the average rate of economic growth would be 1.8% over the next four years.

However, there would be very little room for manoeuvre, and with global political and economic uncertainty, including the effects of tariffs, climate change on harvests and the continuing war in Ukraine, the rate of economic growth might be well below 1.8%.

The March forecasts were based on the assumption that inflation would fall and hence that the Bank of England would reduce interest rates. Global pressure on inflation, however, might result in inflation continuing to be above the Bank of England’s target of 2%. This would mean that interest rates would be slow to fall – if at all. This would dampen growth and make it more expensive for the government to service the public-sector debt, thus making it harder to reduce the public-sector deficit.

A forecast earlier this month by the National Institute for Economic and Social Research (NIESR) (see link below and Chart 2) reflects these problems and paints a gloomier picture than the OBR’s March forecast. The NIESR forecasts that GDP will grow by only 1.3 per cent in 2025, 1.2 per cent in 2026, 1.1% in 2027 and 1.0% in 2028, with the average for 2025 to 2023 being 1.13%. This is the result of high levels of business uncertainty and the effects of tariffs on exports. With no change in policy, the current deficit would be £41.2 billion in the 2029/30 financial year. Inflation would fall somewhat, but would stick at around 2.7% from 2028 to 2030. Net debt would be rising in 2029/30 &ndash but only slightly, from 98.7% to 99.0%. (Click here for a PowerPoint of the chart.)

So what are the policy options open to the government for dealing with a forecast current budget deficit of £41.2 billion (1.17% of GDP)? There are only three broad options.

Increase borrowing

One approach would be to scrap the fiscal rules and accept increased borrowing – at least temporarily. This would avoid tax increases or expenditure cuts. By running a larger budget deficit, this Keynesian approach would also have the effect of increasing aggregate demand and, other things being equal, could lead to a multiplied rise in national income. This in turn would lead to higher tax revenues and thereby result in a smaller increase in borrowing.

There are two big problems with this approach, however.

The first is that it would, over time, increase the public-sector debt and would involve having to spend more each year on servicing that debt. This would leave less tax revenue for current spending or investment. It would also involve having to pay higher interest rates to encourage people to buy the additional new government bonds necessary to finance the increased deficit.

The second problem is that the Chancellor has said that she will stick to the fiscal rules. If she scraps them, if only temporarily, she runs the risk of losing the confidence of investors. This could lead to a run on the pound and even higher interest rates. This was a problem under the short-lived Liz Truss government when the ‘mini’ Budget of September 2022 made unfunded pledges to cut taxes. There was a run on the pound and the Bank of England had to make emergency gilt purchases.

One possibility that might be more acceptable to markets would be to rewrite the investment rule. There could be a requirement on government to invest a certain proportion of GDP (say, 3%) and fund it by borrowing. The supply-side benefits could be faster growth in potential output and higher tax revenue over the longer term, allowing the current deficit rule to be met.

Cut government expenditure

Politicians, especially in opposition, frequently claim that the solution is to cut out public-sector waste. This would allow public expenditure to be cut without cutting services. This, however, is harder than it might seem. There have been frequent efficiency drives in the public sector, but from 1919 to 2023 public-sector productivity fell by an average of 0.97% per year.

Causes include: chronic underinvestment in capital, resulting in outdated equipment and IT systems and crumbling estates; decades of underfunding that have left public services with crumbling estates, outdated equipment and insufficient IT systems; inconsistent, short-term government policy, with frequent changes in government priorities; bureaucratic systems relying on multiple legacy IT systems; workforce challenges, especially in health and social care, with high staff turnover, recruitment difficulties, and a lack of experienced staff.

The current government has launched a Public Sector Productivity Programme. This is a a cross-government initiative to improve productivity across public services. Departments are required to develop productivity plans to invest in schemes designed to achieve cost savings and improve outcomes in areas such as the NHS, police, and justice system. A £1.8 billion fund was announced in March 2024, to support public-sector productivity improvements and digital transformation. Part of this is to be invested in digital services and AI to improve efficiency. According to the ONS, total public-service productivity in the UK grew by 1.0% in the year to Q1 2025; healthcare productivity grew 2.7% over the same period. It remains to be seen whether this growth in productivity will be maintained. Pressure from the public, however, will mean that any gains are likely to be in terms of improved services rather than reduced government expenditure.

Increase taxes

This is always a controversial area. People want better public services but also reduced taxes – at least for themselves! Nevertheless, it is an option seriously being considered by the government. However, if it wants to avoid raising the rates of income tax, national insurance for employees and the self-employed, and VAT, its options are limited. It has also to consider the political ramifications of taking unpopular tax-raising measures. The following are possibilities:

Continue the freeze on income tax bands. They are currently frozen until April 2028. The extra revenue from extending the freeze until April 2030 would be around £7 billion. Although this may be politically more palatable than raising the rate of income tax, the revenue raised will be well short of the amount required and thus other measures will be required. Although some £40 billion will have been raised up to 2028 (which has already been factored in), as inflation falls, so the fiscal drag effect will fall: nominal incomes will need to rise less to achieve any given rise in real incomes.

Cutting tax relief for pensions. Currently, people get income tax relief at their marginal rate on pension contributions made by themselves and their employer up to £60 000 per year or 100% of their earnings, whichever is smaller. When people draw on their pension savings, they pay income tax at their marginal rate, even if the size of their savings has grown from capital gains, interest or dividends. Reducing the limits or restricting relief to the basic rate of tax could make a substantial contribution to increasing government revenue. In 2023/24, pension contribution relief cost the government £52 billion. Restricting relief to the basic rate or cutting the annual limit would make the relief less regressive. In such a case, when people draw on their pension savings, the income tax rate could be limited to the basic rate to avoid double taxation.

Raising the rate of inheritance tax (IHT) or reducing the threshold. Currently, estates worth more than £325 000 are taxed at a marginal rate of 40%. The threshold is frozen until 2029/30 and thus additional revenue will be received by the government as asset prices increase. If the rate is raised above 40%, perhaps in bands, or the threshold were lowered, then this will earn additional revenue. However, the amount will be relatively small compared to the predicted current deficit in 2029/30 of £41 billion. Total IHT revenue in 2022/23 was only 6.7 billion. Also, it is politically dangerous as people could claim that the government was penalising people who had saved in order to help the next generation, who are struggling with high rents or mortgages.

Increased taxes on business. The main rate of corporation tax was raised from 19% to 25% in April 2023 and the employers’ national insurance rate was raised from 13.8% to 15% and the threshold reduced from £9100 to £5000 per year in April 2025. There is little or no scope for raising business taxes without having significant disincentive effects on investment and employment. Also, there is the danger that raising rates might prompt companies to relocate abroad.

Raise fuel and/or other duties. Fuel duties raise approximately £24 billion. They are set to decline gradually with the shift to EVs and more fuel-efficient internal combustion engines. Fuel duty remained unchanged at 57.95p per litre from 2011 to 2022 and then was ‘temporarily’ cut to 52.95p. The rate of 52.95p is set to remain until at least 2026. There is clearly scope here to raise it, if only by the rate of inflation each year. Again, the main problem is a political one that drivers and the motor lobby generally will complain. Other duties include alcohol, tobacco/cigarettes/vaping, high-sugar beverages and gambling. Again, there is scope for raising these. There are two problems here. The first is that these duties are regressive, falling more heavily on poorer people. The second is that high duties can encourage illegal trade in these products.

Raising one of the three major taxes: income tax, employees’ national insurance and VAT. This will involve reneging on the government’s election promises. But perhaps it’s better to bite the bullet and do it sooner rather than later. Six European countries have VAT rates of 21%, three of 22%, three of 23%, two of 24%, four of 25%, one of 25.5% and one of 27%. Each one percentage point rise would raise about 9 billion. A one percentage point rise across all UK income tax rates would raise around £5.8 billion. As far as employees’ national insurance rates are concerned, the Conservative government reduced the main rate twice from 12% to 10% in January 2024 and from 10% to 8% in April 2024. The government could argue that raising it back to, say, 10% would still leave it lower than previously. A rise to 10% would raise around £11 billion.

Conclusion

The choices for the Chancellor are not easy. As the NIESR’s Economic Outlook puts it:

Simply put, the Chancellor cannot simultaneously meet her fiscal rules, fulfil spending commitments, and uphold manifesto promises to avoid tax rises for working people. At least one of these will need to be dropped – she faces an impossible trilemma.

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Questions

  1. Which of the options would you choose and why?
  2. Should the government introduce a wealth tax on people with wealth above, say, £2 million? If so, should it be a once-only tax or an annual tax?
  3. Research another country’s fiscal position and assess the choices their finance minister took.
  4. Look at a previous UK Budget from a few years ago and the forecasts on which the Budget decisions were made (search Budget [year] on the GOV.UK website). How accurate did the forecasts turn out to be? If the Chancellor then had known what would actually happen in the future, would their decisions have been any different and, if so, in what ways?
  5. Should fiscal decisions be based on forecasts for three of four years hence when those forecasts are likely to be unreliable?
  6. Should fiscal and monetary policy decisions be made totally separately from each other?
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‘Liberation day’: or start of a Trump slump?

On April 2nd, Donald Trump announced sweeping new ‘reciprocal’ tariffs. These would be in addition to 25% tariffs on imports of cars, steel and aluminium already announced and any other tariffs in place on individual countries, such as China. The new tariffs would apply to US imports from every country, except for Canada and Mexico where tariffs had already been imposed.

The new tariffs would depend on the size of the country’s trade in goods surplus with the USA (i.e. the USA’s trade in goods deficit with that country). The bigger the percentage surplus, the bigger the tariff. But, no matter how small a country’s surplus or even if it runs a deficit (i.e. imports more goods from the USA than it sells), it would still face a minimum 10% ‘baseline’ tariff.

President Trump stated that these tariffs are to counter what he claims as unfair trade practices inflicted on the USA. People had been expecting that these tariffs would reflect the tariffs applied by other countries on US goods and possibly also non-tariff barriers, such as the ban on chlorine-washed chicken or hormone-injected beef in the EU and UK. But, by basing them on the size of a country’s trade surplus, this meant imposing them on many countries with which the USA has a free-trade deal with no tariffs at all.

The table gives some examples of the new tariff rates. The largest rates would apply to China and south-east Asian countries, which supply low-priced products, such as clothing, footwear and electronics to the US market. In China’s case, it would a reciprocal tariff rate of 34% plus the previously imposed tariff rate of 20%, giving a massive 54%.

What is more, the ‘de minimis’ exemption will be scrapped for packages sent by private couriers. This had exempted goods of $800 or less sent direct to consumers from China and other countries from companies such as Temu and Alibaba. It is also intended to cut back on packages of synthetic opioids sent from these countries.

Since ‘liberation day’, President Trump has made several changes to these tariff rates. On 9 April he ‘paused’ the implementation of the tariffs above the 10% rate pending trade discussions with individual countries. However, in the case of China, there have been tit-for-tat tariff increases, so that by the end of April, the US tariff rate on Chinese imports was a massive 145% and the Chinese rate on US imports was 125%. The two countries seemed locked in a high-stakes game of chicken.

The US formula for reciprocal tariffs

As we have seen, the proposed (and then paused) reciprocal tariffs do not reflect countries’ tariff rates on the USA. Instead, rates for countries running a trade in goods surplus with the USA (a US trade deficit with these countries) are designed to reflect the size of that surplus as a percentage of their total imports from the USA. The White House has published the following formula.


where:

When the two elasticities are multiplied together this gives 1 and so can be ignored. As there was no previous ‘reciprocal’ tariff, the rise in the reciprocal tariff rate is the actual reciprocal tariff rate. The formula for the reciprocal tariff rate thus becomes the percentage trade surplus of that country with the USA: (exports – imports) / imports, expressed as a percentage. This is then rounded up to the nearest whole number.

President Trump also stated that countries would be given a discount to show US goodwill. This involves halving the rate from the above formula and then rounding up to the nearest whole number.

Take the case of China. China’s exports of goods to the USA in 2024 were $439bn, while its imports of goods from the USA were $144bn, giving China a trade surplus with the USA of $295bn. Expressing this as a percentage of exports gives ($295/$439 × 100)/2 = 33.6%, rounded up to 34%. For the EU, the formula gives ($227bn/$584bn × 100)/2 = 19.4%, rounded up to 20%.

Questioning the value of φ. Even if you accept the formula itself as the basis for imposing tariffs, the value of the second term in the denominator, φ, is likely to be seriously undervalued. The term represents the elasticity of import prices with respect to tariff changes. It shows the proportion of a tariff rise that is passed on to consumers, which is assumed to be just one quarter, with producers bearing the remaining three quarters. In reality, it is highly likely that most of the tariff will get passed on, as it was with the tariffs applied in Donald Trump’s first presidency.

If the value for φ were 1 (i.e. all the tariff passed on to the consumer), the formula would give a ‘reciprocal tariff’ of just one quarter of that with a value of φ of 0.25. The figures in the table above would look very different. If the rates were then still halved, all countries with a tariff below 40% (such as the EU, Japan or India) would instead face just the baseline tariff of 10%. What is more, China’s rate would be reduced from 54% to 30% (the original 20% plus the baseline of 10%). Cambodia’s would be reduced to 13%. Even if the halving discount were no longer applied, the rates would still be only half of those shown in the table (and 37% for China).

Are the tariffs justified?

Even if a correct value of φ were used, a percentage trade surplus is a poor way of measuring the protection used by a country. Many countries running a trade surplus with the USA are low-income countries with low labour costs. They have a comparative advantage in labour-intensive goods. That allows such goods to be purchased at low cost by Americans. Their trade surplus may not be a reflection of protection at all.

Also, if protection is to be used to reflect the trade imbalance with each country, then why impose a 10% baseline on countries, like the UK, with which the USA has a trade surplus? By the Trump administration’s logic, it ought to be subsidising UK imports or accepting of UK tariffs on imports of US goods.

But President Trump also wants to address the USA’s overall trade deficit. The US balance of trade in goods deficit was $1063bn in 2023 (the latest year for a full set of figures). But the overall balance of payments must balance. There were thus surpluses elsewhere on the balance of payments account (and some other deficits). There was a surplus on the services account of $278bn and on the financial account of $924bn. In other words, inward investment to the USA (both direct and portfolio) and the acquisition of dollars by other countries as a reserve asset were very large and helped to drive up the exchange rate. This made US goods less competitive and imports relatively cheaper.

The USA has a large national debt of some $36 trillion of which some $9 trillion is owed to foreign investors (people, institutions or countries). Servicing the debt pushes up US interest rates. This helps to maintain a high exchange rate, thereby making imports cheaper and worsening the trade deficit. The fiscal burden of servicing the debt also crowds out US government expenditure on items such as defence, education, law and order and infrastructure. President Trump hopes that tariffs will bring in additional revenue to help finance the deficit.

Effects on the USA

If the tariffs reduce spending on imports and if other countries do not retaliate, then the US balance of trade should improve. However, a tariff is effectively a tax on imported goods. It is charged to the importing company not to the manufacturer abroad. As we saw in the context of the false value for φ, most of the tariff will be passed on to American consumers. Theoretically the incidence of the tariff is shared between the supplier and the purchaser, but in practice, most of the higher cost to the importer will be passed on to the consumer. As with other taxes, the effect is to transfer money from the consumer to the government, making people poorer but giving the government extra revenue. This revenue will be dollars, not foreign currency.

As some of the biggest price rises will be for cheap manufactured products, such as imports from China, and various staple foodstuffs, the effects could be felt disproportionately by the poor. Higher import prices will allow domestic producers competing with these imports to raise their prices too. The tariffs are thus likely to be inflationary. But because the inflation would be the result of higher costs, not higher demand, this could lead to recession as real incomes fell.

American resources will be diverted by the tariffs from sectors in which the USA has a comparative advantage, such as advanced manufactured goods and services, to more basic products. Tariffs on cheap imports will make domestic versions of these products more profitable: even though they are more costly to produce, they will be sold at a higher price.

The tariffs will also directly affect goods produced by US companies. The reason is that many use complex supply chains involving parts produced abroad. Take the case of Apple. Even though it is an American company which designs its products in California, the company sources parts from several Asian countries and has factories in Vietnam, China, India, and Thailand. These components will face tariffs and thus directly affect the price of iPhones, iPads, MacBooks, etc. Similarly affected are other US tech hardware manufacturers, US car manufactures, clothing and footwear producers, such as The Gap and Nike, and home goods producers.

Monetary policy response. How the Fed would respond is not clear. Higher inflation and lower growth, or even a recession, produces what is known as ‘stagflation’: inflation combined with stagnation. Many countries experienced stagflation following the Russian invasion of Ukraine, when higher commodity prices led to soaring inflation and economic slowdown. There was a cost-of-living crisis.

If a central bank has a simple mandate of keeping inflation to a target, higher inflation would be likely to lead to higher interest rates, making recession even more likely. It is the inflation of the two elements of stagflation (inflation and stagnation) that is addressed. The recession is thus likely to be deepened by monetary policy. But as the Fed has a dual mandate of controlling inflation but also of maximising employment, it may choose not to raise interest rates, or even to lower them, to get the optimum balance between these two targets.

If other countries retaliate by themselves raising tariffs on US exports and/or if consumers boycott American goods and services, this will further reduce incomes in the USA. Just two days after ‘liberation day’, China retaliated against America’s 34% additional tariff on Chinese imports by imposing its own 34% tariff on US imports to China.

A trade war will make the world poorer, especially the USA. Investors know this. In the two days following ‘liberation day’, stock markets around the world fell sharply and especially in the USA. The Dow Jones was down 9.3% and the tech-heavy Nasdaq Composite was down 11.4%.

Effects on the rest of the world

The effects of the tariffs on other countries will obviously depend on the tariff rate. The countries facing the largest tariffs are some of the poorest countries which supply the USA with simple labour-intensive products, such as garments, footwear, food and minerals. This could have a severe effect on their economies and cause rapidly increasing poverty and hardship.

If countries retaliate, then this will raise prices of their imports from the USA and hurt their own domestic consumers. This will fuel inflation and push the more seriously affected countries into recession.

If the USA retaliates to this retaliation, thereby further escalating the trade war, the effects could be very serious. The world could be pushed into a deep recession. The benefits of trade, where all countries can gain by specialising in producing goods with low opportunity costs and importing those with high domestic opportunity costs, would be seriously eroded.

What President Trump hopes is that the tariffs will put him in a strong negotiating position. He could offer to reduce or scrap the tariffs on a particular country in exchange for something he wants. An example would be the offer to scrap or reduce the baseline 10% tariff on UK exports and/or the 25% tariff on UK exports of cars, steel and aluminium. This could be in exchange for the UK allowing the importation of US chlorinated chicken or abolishing the digital services tax. This was introduced in 2020 and is a 2% levy on tech firms, including big US firms such as Amazon, Alphabet (Google), Meta and X.

It will be fascinating but worrying to see how the politics of the trade war play out.

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Questions

  1. What is the law of comparative advantage? Does this imply that free trade is always the best alternative for countries?
  2. From a US perspective, what are the arguments for and against the tariffs announced by President Trump on 2 April 2025?
  3. What response to the tariffs is in the UK’s best interests and why?
  4. Should the UK align with the EU in responding to the tariffs?
  5. What is meant by a negative sum game? Explain whether a trade war is a negative sum game. Can a specific ‘player’ gain in a negative sum game?
  6. What happened to stock markets directly following President Trump’s announcement and what has happened since? Explain you findings.
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Investment set to fall as business is baffled by Trump

Economic growth is closely linked to investment. In the short term, there is a demand-side effect: higher investment, by increasing aggregate demand, creates a multiplier effect. GDP rises and unemployment falls. Over the longer term, higher net investment causes a supply-side effect: industrial capacity and potential output rise. This will be from both the greater quantity of capital and, if new investment incorporates superior technology, from a greater productivity of capital.

One of the biggest determinants of investment is certainty about the future: certainty allows businesses to plan investment. Uncertainty, by contrast, is likely to dampen investment. Investment is for future output and if the future is unknown, why undertake costly investment? After all, the cost of investment is generally recouped over several months or year, not immediately. Uncertainty thus increases the risks of investment.

There is currently great uncertainty in the USA and its trading partners. The frequent changes in policy by President Trump are causing a fall in confidence and consequently a fall in investment. The past few weeks have seen large cuts in US government expenditure as his administration seeks to dismantle the current structure of government. The businesses supplying federal agencies thus face great uncertainty about future contracts. Laid-off workers will be forced to cut their spending, which will have knock-on effect on business, who will cut employment and investment as the multiplier and accelerator work through.

There are also worries that the economic chaos caused by President Trump’s frequent policy changes will cause inflation to rise. Higher inflation will prompt the Federal Reserve to raise interest rates. This, in turn, will increase the cost of borrowing for investment.

Tariff uncertainty

Perhaps the biggest uncertainty for business concerns the imposition of tariffs. Many US businesses rely on imports of raw materials, components, equipment, etc. Imposing tariffs on imports raises business costs. But this will vary from firm to firm, depending on the proportion of their inputs that are imported. And even when the inputs are from other US companies, those companies may rely on imports and thus be forced to raise prices to their customers. And if, in retaliation, other countries impose tariffs on US goods, this will affect US exporters and discourage them from investing.

For many multinational companies, whether based in the USA or elsewhere, supply chains involve many countries. New tariffs will force them to rethink which suppliers to use and where to locate production. The resulting uncertainty can cause them to delay or cancel investments.

Uncertainty has also been caused by the frequent changes in the planned level of tariffs. With the Trump administration using tariffs as a threat to get trading partners to change policy, the threatened tariff rates have varied depending on how trading partners have responded. There has also been uncertainty on just how the tariff policy will be implemented, making it more difficult for businesses to estimate the effect on them.

Then there are serious issues for the longer term. Other countries will be less willing to sign trade deals with the USA if they will not be honoured. Countries may increasingly look to diverting trade from the USA to other countries.

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Questions

  1. Find out what tariffs have been proposed, imposed and changed since Donald Trump came to office on 20 January 2025.
  2. In what scenario might US investment be stimulated by Donald Trump’s policies?
  3. What countries’ economies have gained or are set to gain from Donald Trump’s policies?
  4. What is the USMCA agreement? Do Donald Trump’s policies break this agreement?
  5. Find out and explain what has happened to the US stock market since January 2025. How do share prices affect business investment?
  6. Which sector’s shares have risen and which have fallen?
  7. Using the Data link above, find out what has been happening to the US Policy Uncertainty Index since Donald Trump was elected and explain particular spikes in the index. Is this mirrored in the global Policy Uncertainty Index?
  8. Are changes in the Policy Uncertainty Index mirrored in the World Uncertainty Index (WUI) and the CBOE Volatility Index: VIX?
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Risk aversion in late-cycle slowing economies: the US experience

In recent months there has been growing uncertainty across the global economy as to whether the US economy was going to experience a ‘hard’ or ‘soft landing’ in the current business cycle – the repeated sequences of expansion and contraction in economic activity over time. Announcements of macroeconomic indicators have been keenly anticipated for signals about how quickly the US economy is slowing.

Such heightened uncertainty is a common feature of late-cycle slowing economies, but uncertainty now has been exacerbated because it has been a while since developed economies have experienced a business cycle like the current one. The 21st century has been characterised by low inflation, low interest rates and recessions caused by various types of crises – a stock market crisis (2001), a banking crisis (2008) and a global pandemic (2020). In contrast, the current cycle is a throwback to the 20th century. The high inflation and the ensuing increases in interest rates have produced a business cycle which echoes the 1970s. Therefore, few investors have experience of such economic conditions.

The focus for investors during this stage of the cycle is when the slowing economy will reach the minimum. They will also be concerned with the depth of the slowdown: will there still be some growth in income, albeit low; or will the trough be severe enough to produce a recession, and, if so, how deep? Given uncertainty around the length and magnitude of business cycles, this leads to greater risk aversion among investors. This affects reactions to announcements of leading and lagging macroeconomic indicators.

This blog examines what sort of economic conditions we should expect in a late-cycle economy. It analyses the impact this has had on investor behaviour and the ensuing dynamics observed in financial markets in the USA.

The Business Cycle


The business cycle refers to repeated sequences of expansion and contraction (or slowdown) in economic activity over time. Figure 1 illustrates a typical cycle. Typically, these sequences include four main stages. In each one there are different effects on consumer and business confidence:

  • Expansion: During this stage, the economy experiences growth in GDP, with incomes and consumption spending rising. Business and consumer confidence are high. Unemployment is falling.
  • Peak: This is the point at which the economy reaches its maximum output, but growth has ceased (or slowed). At this stage, inflationary pressures peak as the economy presses against potential output. This tends to result in tighter monetary policy (higher interest rates).
  • Slowdown: The higher interest rates raise the cost of borrowing and reduce consumption and investment spending. Consumption and incomes both slow or fall. (Figure 1 illustrates the severe case of falling GDP (negative growth) in this stage.) Unemployment starts rising.
  • Trough: This is the lowest point of the cycle, where economic activity bottoms out and the economy begins to recover. This can be associated with slow but still rising national income (a soft landing) or national income that has fallen (a hard landing, as shown in Figure 1).

While business cycles are common enough to enable such characterisation of their temporal pattern, their length and magnitude are variable and this produces great uncertainty, particularly when cycles approach peaks and troughs.

As an economy’s cycle approaches a trough, such as US economy’s over the past few months, uncertainty is exacerbated. The high interest rates used to tackle inflation will have increased borrowing costs for businesses and consumers. Access to credit may have become more restricted. Profit margins are reduced, especially for industrial sectors sensitive to the business cycle, reducing expected cash flows.

The combination of these factors can increase the risk of a recession, producing greater volatility in financial markets. This manifests itself in increased risk aversion among investors.

Utility theory suggests that, in general, investors will exhibit loss aversion. This means that they do not like bearing risk, fearing that the return from an investment may be less than expected. In such circumstances, investors need to be compensated for bearing risk. This is normally expressed in terms of expected financial return. To bear more risk, investors require higher levels of return as compensation.

As perceptions of risk change through the business cycle, so this will change the return investors will require from the financial instruments they hold. Perceived higher risk raises the return investors will require as compensation. Conversely, lower perceived risk decreases the return investors expect as compensation.

Investors’ expected rate of return is manifested in the discount rate that they use to value the anticipated cash flows from financial instruments in discounted cash flow (DCF) analysis. Equation 1 is the algebraic expression of the present-value discounted series of cash flows for financial instruments:

 
 
Where:
V = present value
C = anticipated cash flows in each of time periods 1, 2, 3, etc.
r = expected rate of return

For fixed-income debt securities, the cash flow is constant, while for equity securities (shares), expectations regarding cash flows can change.

Slowing economies and risk aversion

In a slowing economy, with great uncertainty about the scale and timing of the bottom of the cycle, investors become more risk averse about the prospects of firms. This this leads to higher risk premia for financial instruments sensitive to a slowdown in economic activity.

This translates into a higher expected return and higher discount rate used in the valuation of these instruments (r in equation 1). This produces decreases in perceived value, decreased demand and decreased prices for these financial instruments. This can be observed in the market dynamics for these instruments.

First, there may be a ‘flight to safety’. Investors attach a higher risk premium to risker financial instruments, such as equities, and seek a ‘safe-haven’ for their wealth. Therefore, we should observe a reorientation from more risky to less risky assets. Demand for equities falls, while demand for safer assets, such as government bonds and gold, rises.

There is some evidence for this behaviour as uncertainty about the US economic outlook has increased. Gold, long seen as a hedge against market decline, is at record highs. US Government bond prices have risen too.

To analyse whether this may be a flight to safety, I analysed the correlation between the daily US government bond price (5-year Treasury Bill) and share prices represented by the two more significant stock market indices in the USA: the S&P 500 and the Nasdaq Composite. I did this for two different time periods. Table 1 shows the results. Panel (a) shows the correlation coefficients for the period between 1 May 2024 and 31 July 2024; Panel (b) shows the correlation coefficients for the period between 1 August 2024 and 9 September 2024.

In the period between May and July 2024, the 5-year Treasury Bill and share price indices had significantly positive correlations. When share prices rose, the Treasury Bill’s price rose; when share prices fell, the bill’s price fell. During that period, expectations about falling interest rates dominated valuations and that effected the valuations of all financial instruments in the same way – lower expected interest rates reduce the opportunity cost of holding instruments and reduces the expected rates of return. Hence, the discount rate applied to cash flows is reduced, and present value rises. The opposite happens when macroeconomic indicators suggest that interest rates will stay high (ceteris paribus).

As the summer proceeded, worries about a ‘hard landing’ began to concern investors. A weak jobs report in early August particularly exercised markets, producing a ‘flight to safety’. Greater risk aversion among investors meant that they expect a higher return from equities. This reduced perceived value, reducing demand and price (ceteris paribus). To insulate themselves from higher risk, investors bought safer assets, like government bonds, thereby pushing up their prices. This behaviour was consistent with the significant negative correlation observed between US government debt prices and the S&P 500 and Nasdaq indices in Panel (b).

Another signal of increased risk aversion among investors is ‘sector rotation’ in their equity portfolios. Increased risk aversion among investors will lead them to divest from ‘cyclical’ companies. Such companies are in industrial sectors which are more sensitive to the changing economic conditions across the business cycle – consumer discretionary and communication services sectors, for example. To reduce their exposure to risk, investors will switch to ‘defensive’ sectors – those less sensitive to the business cycle. Examples include consumer staples and utility sectors.

Cyclical sectors will suffer a greater adverse impact on their cash flows and risk in a slowing economy. Consequently, investors expect higher return as compensation. This reduces the value of those shares. Demand for them falls, depressing their price. In contrast, defensive sectors will be valued more. They will see an increase in demand and price. This sector rotation seems to have happened in August (2024). Figure 2 shows the percentage change between 1 August and 9 September 2024 in the S&P 500 index and four sector indices, comprising companies from the communication services, consumer discretionary, consumer staples and utilities sectors.


Overall, the S&P 500 index was slightly higher, as shown by the first bar in the chart. However, while the cyclical sectors experienced decreases in their share prices, particularly communication services, the defensive companies experienced large price increases – nearly 3% for utilities and over 6% for consumer staples.

Conclusion

Economies experience repeated sequences of expansion and contraction in economic activity over time. At the moment, the US economy is approaching the end of its current slowing phase. Increased uncertainty is a common feature of late-cycle economies and this manifests itself in heightened risk aversion among investors. This produces certain dynamics which have been observable in US debt and equity markets. This includes a ‘flight to safety’, with investors divesting risky financial instruments in favour of safer ones, such as US government debt securities and gold. Also, investors have been reorientating their equity portfolios away from cyclicals and towards defensive securities.

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Questions

  1. What is risk aversion? Sketch an indifference curve for a risk-averse investor, treating expected return and risk as two-characteristics of a financial instrument.
  2. Show what happens to the slope of the indifference curve if the investor becomes more risk averse.
  3. Using demand and supply analysis, illustrate and explain the impact of a flight to safety on the market for (i) company shares and (ii) US government Treasury Bills.
  4. Use economic theory to explain why the consumer discretionary sector may be more sensitive than the consumer staples sector to varying incomes across the economic cycle.
  5. Research the point of the economic cycle that the US economy has reached as you read this blog. What is the relationship between bond and equity prices? Which sectors have performed best in the stock market?