13 Dec 2024
Ariel Bezalel and Harry Richards examine the prospects for global growth and what that might mean for fixed income markets.
As we enter 2025, many questions about the state of the US economy linger in the minds of investors as it has been one of the key drivers of global economic growth over the past two years.
Some of those questions are: Can the US Federal Reserve, which is well underway with its easing cycle, achieve a soft landing or are recessionary impulses still intact? Does the US economy’s resilience mask underlying problems? How will political changes in key countries affect policies? And what will be the role of geopolitics on commodity prices and inflation?
It's true that policy makers have successfully reined in inflation from its peak in mid-2022 and it's now inching closer to the Fed’s 2% target. But the unemployment rate has increased over the past year. Indeed, the worsening labour market was a key factor that prompted the Fed to kickoff its rate cutting cycle with a 50-basis-point move in September 2024.
While the absolute level of the unemployment rate is still low by historical standards, the speed of increase looks worrying if one goes by the closely watched Sahm rule. The Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rateopens in a new tab rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.
Many market participants say that part of the growth in the unemployment rate came from the expansion in the workforce to which immigration too contributed. They believe the rise in joblessness shouldn’t pose any problems as long as the hiring pace remains robust. However, if one looks more closely at recent trends in terms of payrolls, job creation remains modest if government jobs, healthcare and private education (non-cyclical sectors effectively) are removed from the equation.
Private payrolls ex-Education & Health services - Contribution to total US Payroll growth in the past 12 months
Private payrolls ex-Education & Health services - 6m growth
Source: Bloomberg, as at 31.10.24.
It is fair to say that layoffs have remained muted for now, but once these start to see a more material increase it may be too late to achieve the rarely seen soft landing. It is also important to highlight that in past episodes of soft landing, such as the mid-90s, cyclical employment showed robust growth. The current environment looks different.
US Payroll Employment vs. Cyclical Employment – History
US Payroll Employment vs. Cyclical Employment - Recent
Source: Bloomberg, as at 31.10.24
US consumers are already feeling the heat, as sustained price pressures after the COVID-19 pandemic have squeezed their ability to spend on discretionary items. This is especially true of low and middle-income earners, with anecdotal evidence suggesting consumers are becoming increasingly selective. Delinquency rates on credit cards and auto loans continue to grind higher.
A small subset of very large corporations accounts for most of the growth in profits, driven by a small proportion of wealthy consumers. At the same time, many small and medium-sized enterprises are struggling to cope with high financing costs and diminished profitability. This discrepancy looks unusual and, if anything, unsustainable in the long run.
US Business Net Income: Small and Medium vs. Large*
NFIB US Small Business Optimism Index – Earnings Trend
*Source: Federal Reserve Integrated Macro Accounts. Financial Accounts Guide - Display Table, as at 30.06.24. Small and Medium Businesses: consists of partnerships and limited liability companies, sole proprietorships and individuals who receive rental income. Noncorporate farms are included in this sector. Large Businesses: consists of all private for-profit domestic nonfinancial corporations. Right chart. Source: Bloomberg, as at 30.09.24.
Similarly, there is discrepancy in consumption too. Most of the spending today comes from a relatively small subset of the population. This lopsided consumption pattern doesn’t bode well for economic demand and growth.
US Population vs. Personal Consumption by Income Segment
Source: US Bureau of Economic Analysis, as at 30.09.24.
The US economy has outperformed developed markets since the end of the pandemic. The demand in the US economy was supported by key factors such as strong government spending, excess savings accumulated during the pandemic and the wealth effect created by surging asset prices, including stocks. However, those savings have already dissipated. When it comes to fiscal policy, with US finances now regularly coming under scrutiny, we believe the administration’s ability to increase deficits even further might be limited.
It’s against this backdrop that Donald Trump will take over as President. Among the key reasons cited for his thumping victory was the strong impact of the cost-of-living crisis of the last three years on US households. Headline figures show the economy still seems to be robust, but the verdict of the average US citizen speaks otherwise.
The sluggishness of the rest of the world isn’t supportive of growth either. The recovery in the Eurozone has pretty much faded, with recent Purchasing Managers’ Index (PMI) readings showing renewed weakness. Although the UK economy has surprised to the upside in the first half, more recent data has shown some deterioration. The GDP numbers in Australia and New Zealand are very weak by historical standards.
As far as China is concerned, the recent stimulus measures look underwhelming, and the market is disappointed as they were expecting strong fiscal support. We continue to see structural problems in the Chinese economy.
Political developments in Germany and France, the region’s top two economies, mean there could be paralysis on the policy front in Europe for some time. In the UK, there’s been a change of guard and investors will assess the implications of the government’s budget on the nation’s long-term growth prospects. In the US, Trump’s re-election has put the spotlight on the protectionist tenor of the statements he made on the campaign trail. We believe he may use tariffs simply as a negotiation tool to get concessions from global trading partners.
On the inflation front, it is important to highlight structural factors that have been pushing inflation higher in the last couple of years, such as easy monetary policy, strong increase in money supply, fiscal policy and supply side constraints, along with erratic movements in commodity prices, have somewhat dissipated. Therefore, for now, we do not see new exogenous factors exerting pressure on inflation.
Headline inflation looks well behaved and close to target across an increasing number of developed countries. Core inflation remains slightly higher, at least on a year-on-year basis. This comes mainly from the services component of the basket, while core goods are in deflation territory. We continue to believe that inflation across services should glide down as shelter inflation (especially in the US) gradually decreases and wage pressures subside. The danger is that inflation remains a bit above the Fed’s target leaving the Fed hesitant to cut rates further even though the underlying economy is weakening. This could present a period of volatility for bond markets and materially pressure risk assets.
Some in the market wonder whether Trump’s policies, including his promise to implement sweeping tax cuts, could be inflationary. Considering that consumers are still reeling under the effects of price pressures seen over the past two years, it’s difficult to believe that Trump would announce a whole lot of policies that could inflate or reflate the economy. Biden and the Democrats were pushed out of the White House primarily due to inflation.
On the other hand, Trump’s push for less government and deregulation might in fact end up being a source of disinflation. Trump has already chosen Elon Musk and Vivek Ramaswamy to lead a “department of government efficiency,” which among other things will strive to slash spending throughout the government. Elon Musk recently said that the American people may have to go through a period of temporary hardship. One could speculate that the US government finances are now under scrutiny and measures may be implemented soon to rein in government spending.
Furthermore, Scott Bessent, who’s been nominated as the next Treasury Secretary, said in a recent interview that the idea that Trump is inflationary is “absurd”. Deregulation, lower energy prices, the reprivatisation of the economy and a slow phasing in of tariffs would ensure inflation is kept low. Also, he mentioned that any tax cuts would have to be paid for.
Geopolitics is another front that’ll be keenly watched under Trump’s leadership and any resolution of the Ukraine-Russia war, and the Middle East conflict, could be disinflationary as that could help soften oil and commodity prices. Similarly, any deregulation of environmental curbs could increase oil drilling in the US, which could help lower energy prices.
The key consequence of all of this is that rates in the US and in other developed markets remain far too high as of today and more easing is needed. We believe the labour market is already showing signs of cracking, and we are watching data such as continuing jobless claims for evidence of a sharp growth slowdown.
The broader market has pared its expectations for further cuts in the current cycle considerably since the first reduction in September. The terminal rate currently priced by Fed Funds Futures is about 70 basis points above the Fed’s long-term dot of 2.875%.
In this context, it’s important to remember that the US economy witnessed a “hard landing’’ about 80% of the time over the past 120 years, while a “soft landing’’ was achieved about 20% of the time.
Given such empirical evidence and the various forces highlighted above, we continue to believe that markets might be underestimating slowdown prospects, which may necessitate the Fed to cut rates much deeper than currently priced. At approximately 4.5% on the 10-year US treasury we think it’s fair to say that at a minimum this is an attractive hedge to risk in portfolios considering what’s on the horizon.
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