Positioning for tax cuts, tariffs and deregulation

Bottom line up top

Big wins after needles and pins. Investor reaction to last week’s decisive U.S. election showed how emphatically market participants can celebrate the end of uncertainty. Expectations of a tight race and concerns about a delay in declaring a winner failed to materialize. Instead, by the end of last week post-election buoyancy had lifted the S&P 500 Index to its 50th record-high close of the year.

Last week brought another vote as well, but this result was a foregone conclusion: Members of the U.S. Federal Reserve’s policymaking committee unanimously chose to lower the fed funds rate by 25 basis points (bps), to a target range of 4.50%-4.75%. It was the second Fed rate cut in as many meetings, although only half the size of the 50 bps reduction announced in September. We continue to expect another 25 bps cut at the next meeting in December, even though market expectations for future cuts have tempered lately (Figure 1).

From campaigning to governing. With the election over, we can shift our focus to what a Republican-led administration and Congress might mean for the global economy, financial markets — and asset allocation. In the U.S., we anticipate an economic agenda focused on lower taxes, higher tariffs and deregulation. Specifically, we could see a temporary extension of the 2017 Tax Cuts and Jobs Act, a rollback in the top income tax bracket and higher limits on state and local tax deductions. While tax cuts aim to promote growth, reduced federal tax receipts may lead to higher fiscal deficits. Additionally, increased tariffs on imported goods, especially from major trading partners like China and Mexico, are not only likely to exacerbate global trade tensions, but also raise the possibility of reaccelerating U.S. inflation, leading to elevated bond yields.

Such expectations have already contributed to a substantial backup in Treasury yields from their lows following the Fed’s initial rate cut in September through the end of last week. The 2-year yield rose +65 bps, to 4.26% during this period, and the 10-year climbed +61 bps, to 4.31%. In his post-meeting press conference last week, Fed Chair Jerome Powell stated that the election results would not affect monetary policy, but that the Fed will respond as needed to changes in fiscal policy, but only once those fiscal changes are clear. Against this complex backdrop, investors may want to consider allocating to fixed income assets that have the potential to perform well if the incoming administration’s tax, tariff and other fiscal priorities leave the Fed with less room for rate cuts in 2025.

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Portfolio considerations?

Senior loans remain the highest-yielding liquid fixed income asset class at 8.7% (Figure 2), yet investor portfolios tend to be structurally underweight loans. In our view, a strategic allocation to senior loans can be an effective way to increase a portfolio’s risk-adjusted return potential — a function of the diversification benefits senior loans offer thanks to their floating-rate coupon structure compared to longer-duration traditional fixed income.

With the incoming administration expected to focus on U.S. fiscal policies designed to promote economic growth, we anticipate both short-term and overall rates will remain elevated. This should provide a tailwind that enables senior loans to continue delivering high levels of current income while helping insulate investors from interest rate risk.

Within the loan asset class, we believe favorable market technicals could support secondary price levels, while mergers and acquisition activity may bolster new issue opportunities to deploy cash at attractive yields. Net new issue volumes year-to-date have almost doubled from 2023 levels, with further significant growth possible in 2025.

Given their floating-rate nature, senior loans have a low correlation to the Bloomberg U.S. Aggregate Bond Index — just 0.15 over the past 10 years. Meanwhile, their first lien position in a corporate capital structure has produced lower volatility per unit of return, resulting in the highest risk-adjusted return among all other fixed income investment categories, based on Morningstar data.

That said, senior loans are a below investment grade asset class that is best suited to active management and a focus on limiting downside risks. While we expect default rates to remain relatively low in light of the anticipated tailwind from pro-growth policies, active management can help position for potential winners and losers among loan issuers, as specific new policies and potentially higher-for-longer interest rates can have varying effects on different sectors and industries.