Jon Cunliffe has recently joined the firm to lead our investment office, which supports our Investment Managers' robust decision making process with market and economic insight. He will also play a strategic role in guiding the direction of our fund investing. This quarter, in place of our usual guest editorial, we have the first of our new In Focus quarterly Prospects series, where Jon covers a roundup of global markets.
The biggest surprise to most economic commentators this year is just how resilient the US economy has proven to be. The consensus at the start of 2024 was that the unprecedentedly rapid 5.25% of interest rate hikes during 2022/3 would almost inevitably precipitate a US recession. It was felt that sharply higher borrowing would close the door on the soft landing scenario by jolting households and the corporate sector into a sharp retrenchment.
Instead, it seems that the sensitivity of key actors in the US economy to higher interest rates has proven to be somewhat less than feared. Homeowners had already locked in low borrowing rates, whilst households and corporates have paid down debt in recent years, with high levels of liquidity built up during the pandemic providing a significant cushion. Elsewhere, several government programmes (CHIPS Act, Inflation Reduction Act, JOBS Act) have continued to provide significant fiscal support to the economy.
Stringent curbs on immigration and the imposition of tariffs are likely to be growth negative.
On a more negative note, the persistent inversion of the US yield curve for much of the last two years has garnered much attention as a recession signal. However, over recent years central banks have been active participants in bond markets, buying up huge swathes of securities to lower market interest rates and increase the provision of liquidity into the financial system. In our view, the market distortions created by this have made the bond market a much less reliable predictor of future economic conditions.
With Donald Trump’s decisive victory in the US Presidential Election, focus has shifted to the impact of his strongly reflationary policies on the economic and financial market outlook. The prospects of deregulation and lower corporate taxes are growth positive and supportive for business sentiment. Stringent curbs on immigration and the imposition of tariffs are likely to be a headwind to growth and will temper what has been a disinflationary trend this year. The broader effect of Trump’s measures on US growth however should be net neutral, but for its trading partners it is reasonable to expect less robust global economic activity next year. The effect of tariffs is to create a form of supply side shock which will be most keenly felt in China, but also in the Eurozone – and the key risk is whether we see a tit for tat trade war.
Another concern is the sustainability of public finances, particularly in the US. The baseline scenario before the US election was for publicly held US debt to rise to 125% of GDP by 2034. Under Trump, estimates are that this figure could rise to 145%. At this level of indebtedness, the US Central Bank would not be able to set interest rates without having one eye on their impact on the budget deficit. In our view, the way around this problem would be for the US authorities to engage in currency debasement, by limiting any undesirable increase in bond yields by mandating its central bank to use its balance sheet to buy US treasuries. This type of reflationary policy is likely to be a tailwind for risk assets such as equities.
During the year, most of the world’s key central banks have been able to begin the process of bringing interest rates back down as inflation has cooled rapidly. With monetary policy generally restrictive, we feel that the Federal Reserve, European Central Bank and Bank of England will continue to reduce interest rates at a measured pace until they reach a more neutral level towards the end of 2025. As a group these central banks believe the downside risk to growth and financial stability outweigh any medium-term upside risks to price stability, and, whilst the effects of Trump’s trade policy and fiscal laxity are a concern, this is a view we share. In the round, we remain optimistic that we shall see the fabled ‘soft landing’ scenario for the global economy and would note that historically equities have performed well when rates have been cut in such an environment.
The Federal Reserve, European Central Bank and Bank of England will continue to reduce interest rates at a measured pace.
Another worry this year has been a downshift in global goods demand, with most manufacturing surveys slipping into contractionary territory. Japan and the UK have been holding up relatively well, but the Eurozone (particularly Germany) and China have been disappointing. Within the Eurozone much of the focus has been on the German economy, which has seen its manufacturing sector contract sharply. The German economy is highly sensitive to the global trade cycle and the effects of higher energy prices. Furthermore, it seems to us that the costs of the green energy transition, weaker Chinese growth and increased competition, a challenging environment for the automotive sector and unfavourable demographics are a structural rather than cyclical headwind to growth. Taken together, the scenario for the Eurozone economy remains ‘muddle through’, with growth in 2025 likely to be modest. However, we must remain cognizant of the potential effects of US trade policy under Trump which do pose downside risks to this outlook for moderate growth.
Offsetting the weakness in global manufacturing has been an improvement in final demand as consumer spending has reaccelerated, with retail sales surprising on the upside in the US, UK and Japan. Elsewhere, in Emerging Market Asia (ex-China) the picture has been brighter, with growth likely to be solid – helped by strong export growth and high real interest rates providing scope for more monetary easing.
In Japan, developments in the economy have been generally positive, and whilst headline growth has been anaemic (reflecting the ageing population), GDP per capita has been growing strongly after the pandemic-related decline. After a sluggish start to the year, wages have been rising in real terms and consumption growth has picked up. Furthermore, it looks like the economy has finally exited the deflationary trap it entered in the 1990s. Recent Japanese Yen strength needs to be watched carefully given its impact on domestic financial conditions, but the Bank of Japan is likely to tread carefully in raising rates whilst the Fed eases. As highlighted in our editorial, the unwind of cross shareholdings to facilitate business portfolio restructuring and increased business investment is a long overdue positive for the economy.
The key regional focus remains on disappointing incoming activity data from China, which remains mired in a domestic economic environment characterised by a Leninist obsession with production and export-led growth, without a western consumer model. As a result, industrial production growth has been consistently outstripping consumer spending, exerting downward pressure on the rate of inflation and dampening consumption growth.
There is a mixed picture - with generally better growth and lower inflation this year offset by the uncertainties around the impact of Trump’s policy agenda.
Elsewhere, in the absence of the creation of a real estate resolution fund to provide a safety net for the housing market and allow real estate developers access to legitimate funding, the negative wealth effects from the property sector will be felt for several quarters to come. The recent monetary policy stimulus from the People’s Bank of China, the increase in bank capital and liquidity support for local authorities have provided welcome respite for investors in China, but we would like to see more material countercyclical fiscal stimulus. At best China is a cyclical play, with structural headwinds remaining strong and the threat of tariffs dampening sentiment.
All the foregoing paints a mixed picture, with generally better growth and lower inflation this year offset by the uncertainties around the impact of Trump’s policy agenda, and that is before we factor in the potential impact of elevated geopolitical risks.
However, there has been a significant shift in the thinking of policymakers around the globe. In the post-Global Financial Crisis period the focus of policymakers was on shrinking debt-to-GDP ratios. Now policy is set to boost GDP, with monetary and fiscal policy aligned to support nominal growth and inflate away the government’s debt burden. In the round, this policy mix is reflationary and generally supportive of broad-based asset price reflation as we head into 2025.
