At a glance:
- Global reflation has started and growth should accelerate into 2025.
- The Fed is indicating that 2% inflation is now a floor rather than a target – a very significant change!
- Interest rates are falling but markets may be too optimistic on quantum and speed.
- Trump 2 should be positive for nominal US growth, equities and the Dollar, but less so for US Treasuries and bonds. The surprise could be easing geopolitical tensions.
- Equities are in a bull market and breadth should continue to broaden out over the next year or so, both within and beyond the US.
- Long-term inflation remains key – the pendulum is swinging towards “Fire” but we can’t rule out “Ice”.
- Key risks are Middle East escalation, Trump policies, a US bond sell-off and a deflationary China bust.
- Core themes remain compelling but are evolving. Need all levers and flexibility given the macro backdrop.
As we approach year-end, it is increasingly evident that the global economy continues to “normalise” after an unprecedented and extraordinary post-pandemic period. The resilience of the US economy, which has been strengthened by the Republican election victory, together with a new cycle of interest rate cuts from developed economies and a much-welcome round of additional policy stimulus from China should be supportive for both global growth and markets over the next year or so. The biggest threats to this rosy scenario are the escalating conflicts in the Middle East and a US bond market sell-off caused by the prospect of a soaring fiscal deficit and the threat of higher long-term inflation.
US Economic resilience and consumer confidence
Despite concerns over a softening US employment market, recent data confirms that US growth remains robust and may actually be moving away from its “soft patch” or the risk of recession. US consumers, which account for almost two-thirds of economic activity, remain in good shape having significantly deleveraged their balance sheets since the global financial crisis, which has made them more resilient to higher rates, at the same time as plentiful savings, a positive wealth effect and rising real incomes have supported spending. A very loose fiscal policy also helps of course, and the US looks set for a prolonged period of large and growing deficits as Trump assumes the presidency next year and embarks on a “go for growth” policy. Another positive is a new cycle of increased capital investment by businesses, where the combination of “onshoring”, US reindustrialisation, changing supply chains, rising costs and new technologies are encouraging companies to embark on a capital spending boom, which boosts productivity and long-term growth potential in a non-inflationary way.
Federal Reserve policy shift: 2% as the new floor
Falling inflation, which is being driven by a normalisation from the pandemic and war-related shocks together with a recovery in goods and labour supply (rather than weaker growth), is enabling the Fed and other central banks to ease monetary policy, even if it is proving difficult for inflation to return to the 2% target. Goods deflation will likely persist with falling import prices from China, which continues to face a cyclical and structural growth problem as well as the threat of deflation. The good news is that China seems to be stepping up its fiscal and monetary easing. The Fed has rightly shifted its focus from fighting inflation to supporting employment and the economy, which is part of its dual mandate. There is clear evidence that households are refocusing on building their savings due to concerns over a softer employment market, a higher cost of living and weakening growth and the Fed has recognised this. It is also clear from the US election that consumers at the lower end of the income spectrum are really struggling. The Fed is cognizant that real rates have moved higher as inflation has fallen, which is a threat to the growth outlook.
Election results and the economic implications
The US election proved to be less close than many people expected and is likely to have a profound effect on the US and global economies, geopolitics and policy over the next four years. In the end, the election came down to “the economy”, housing and immigration, as the polls had been highlighting. The significant swing to the Republicans across all ages, geography, race and gender showed how dissatisfied the electorate is with the policies of the Biden government as well as the role of the US in the world today. This was less about the popularity of Trump as a person – in fact, the majority of voters do not like or trust him – and more about their faith in Trump to make things better and bring about the desired change.
It looks likely that the Republicans will control both the Senate and the House, although the latter is yet to be confirmed. This combination would certainly be positive for US nominal growth as Trump pursues his strategy of tax cuts, deregulation, cheaper energy prices, bigger fiscal deficits a revitalised US manufacturing industry and a smaller trade deficit. If the Democrats retain control of the House, then some of these policies will be “watered down”, especially tax cuts, spending plans and regulations. In addition, some of the growth benefit could be lost should Trump proceed with his threat of imposing significant tariffs on trade with China and other trading partners whilst also clamping down on illegal immigration. These actions would likely add to inflationary pressure as well, although some of this could be offset by lower energy prices should Trump manage to bring a swift end to the Ukraine war and ease tensions in the Middle East. Higher inflation would make it more difficult for the Fed to cut rates as much as the markets currently expect. Indeed, markets have already reigned in their expectations for where rates will trough for this cycle.
Trump continues to talk tough on the prospect of hiking tariffs on China and other trade partners. Whilst this will continue to be his negotiating stance as he seeks to revitalise US manufacturing and industry, there is room for a major surprise here and there is precedent. When he won the presidency in 2016, he promised to build a border wall with Mexico and “rip up” the North American Free Trade Agreement with Canada and Mexico. A year later, the agreement had been renegotiated and rebranded and Mexican bonds and equities recovered strongly.
There are plenty of reasons why Trump may seek to negotiate a deal with China. For example, China could help bring Russia to the negotiating table over Ukraine, keep North Korea in check and even assist with Iran in the Middle East. It would also be beneficial if China adopted policies to revalue the Yuan relative to the Dollar and buy some US-produced goods. In turn, China would benefit from reduced tariffs and semiconductor restrictions, cheaper energy prices, increased US trade and de-escalated geopolitical tensions. A second surprise could be if Chair Powell decides to resign from the Fed. He is due to leave in May 2026 but he knows he won’t be re-appointed and may face a tough battle with Trump given the president-elect’s plans. If this were to transpire, markets would be unlikely to take the news calmly.
UK and Europe: Economic growth and inflation
The growth and inflation story in the UK and Europe is similar but for partially different reasons. Growth concerns and easing inflationary pressures have encouraged the European Central Bank (“ECB”) and Bank of England (“BoE”) to cut rates with further reductions expected over the next few months. This will lead to an improving growth outlook as the year progresses, especially as global activity strengthens. However, caution is also required here since the recent Labour UK budget is more expansionary than expected, which will mean that monetary policy may have to remain a bit tighter than it would otherwise have been. Indeed, the BoE cut rates this week, as expected, but cautioned against the potential inflationary impact of the budget and a bigger fiscal deficit and raised their own inflation forecasts. As a result, both the BoE and markets have revised lower their expectations for rate cuts over the next year or so. In Europe, the growth outlook is starting to look quite worrying, especially in the two biggest economies, Germany and France. A Trump presidency will add to these pressures and fiscal policy will almost certainly follow the lead of the US and UK as European governments relax fiscal rules and turn to bigger deficits in order to target stronger nominal growth. The ECB’s job is also about to become much tougher.
Long-term inflation: Fire or ice?
Looking beyond the next year or so, one of the key questions for investors remains the trajectory of inflation and whether the global economy is transitioning back towards disinflation (“ice”) or higher and more volatile inflation (“fire”). Whilst both scenarios remain possibilities, I am still leaning towards the latter camp for several reasons. In addition to demographic-related wage pressures, and as already explained, it is likely that many governments will need to operate a looser fiscal policy and bigger deficits as they tackle the challenges of a fracturing global economy (energy and food security plus increased defence spending), climate change, an ageing demographic (more spending on healthcare, pensions and welfare) and income and wealth inequality. Indeed, we are already seeing clear evidence of this in the US and Trump will continue this trend whilst the UK and Europe will likely follow suit in time. In addition, elevated geopolitical risks and the changing world order will increase the threat of higher energy and commodity prices over the next few years.
If developed country governments are running bigger fiscal deficits, then this will present a real challenge for central banks given the record levels of debt in the global and individual economies. In a heavily indebted economy, there is a natural ceiling beyond which interest rates can’t go without breaking something, causing a debt deflationary or inflationary bust. We have seen clear evidence of this with the UK pension crisis in September 2022, US regional banks in early 2023 and a significant move higher in US and UK sovereign bond yields over the past few weeks, post the UK budget and US election. Given this, central banks may need to practice financial repression and keep interest rates lower than the macro backdrop would naturally dictate, thus adding to upward pressure on inflation.
Global equities and bond market outlook
This macro environment is positive for global equities but not necessarily for bonds. Solid and accelerating growth is good for earnings while lower interest rates and bond yields are positive for valuations and profitability. Liquidity should also improve as monetary policy is eased and the credit cycle improves at the same time as valuations for many markets look reasonable. As the global growth outlook improves, the equity bull market should continue its recent trend and broaden out both within and beyond the US with cyclicals, value and small-cap stocks outperforming, although the more expensive mega-cap growth stocks should also do well.
The Trump government is also unambiguously bullish for equities, especially in the US and if the Republicans have full control of the House. The outlook for non-US markets is mixed, since the benefits of a stronger US economy could be partially negated by higher US bond yields, a less dovish Fed and increased US/China tensions. Emerging markets, which have underperformed for most of the past decade, should also benefit from a stronger China, accelerating global activity and an easier Fed, especially if this results in a weaker Dollar. However, although Trump would like a weaker Dollar to reduce the trade deficit and revitalise manufacturing, this will not be easy to achieve. Indeed, the currency is more likely to appreciate in the near term, particularly if the Fed is forced to run a relatively tighter monetary policy than other developed-economy central banks. A significant China stimulus could help here.
The implications for bonds are less clear. Whilst disinflation will prevail for now, Trump’s policies are expected to strengthen growth, put upward pressure on inflation and increase the fiscal deficit over the medium term. This will likely result in a tighter monetary policy than would otherwise have been the case and, as has been evident over the past few days, result in higher US treasury yields, especially on longer-duration issues. We are also seeing some signs of this in the UK Gilt market. In addition, whilst yields across most fixed-income sectors look attractive at current levels, markets may be disappointed about both the quantum and speed of rate cuts over the next year or so.
Should inflation expectations rebound due to strengthening activity and the pendulum swinging towards the "fire” scenario, then the Fed and other central banks will be unable to cut rates as much as the markets are currently expecting. In addition, Trump’s policies and free-spending governments will continue to necessitate a plentiful supply at a time when central banks and many foreign investors are still reducing their holdings. Credit markets will benefit from an improving profits outlook, but spreads (excess yield over equivalent government issues) are tight and if rates disappoint and sovereign yields rise, this would be problematic. In the meantime, it makes sense for investors to remain in shorter-dated maturities as yields are relatively attractive and longer-dated issues will be more sensitive to the inflation risks.
A reflationary environment
A new cycle of global reflation is positive for markets, especially equities, and the return of Trump supports this outlook. Beyond the near term, however, the outcomes could be very different depending on how Trump’s policies evolve, how geopolitical risks shift, whether the disinflationary trends prevail, or inflation makes an unwelcome return. As nobody can be certain where we are headed, it makes sense to continue to ensure that portfolios are positioned to benefit, or at least not lose out, whichever scenario dominates. The main threat is a widening of the Iran-Israel conflict causing a spike in the oil process above the $100 level, in which case both bonds and equities would need to adjust downward to the rising risk of inflation or stagnation. Other risks revolve mainly around the direction and impact of Trump’s policies and a deflationary China bust. Although the macro environment is gradually returning to some form of normality, it is also evident that some things will be very different. Adaptability, flexibility, an open mind and a proven process will be key to investment success.
