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Themes for 2025
Throughout 2024 the global economy has been tracking our forecast of a soft landing. A strong US economy has been offsetting weak growth in Europe and China. The strength in the US economy has also compensated somewhat for high global interest rates as central banks fought to bring inflation under control. With inflation falling on a sustained basis, most major central banks began cutting interest rates, building the foundations for a gradual recovery in global growth to around trend over 2025.
In financial markets, bonds were establishing higher long run yields in response post-Covid shifts in the global economy. Compared to the decade following the GFC up to Covid, inflation risks have shifted to the upside rather than the downside, and the risks to economic growth have become balanced, rather than skewed to the downside. As markets adjusted to this new configuration of inflation and growth, our view was that bond yields were close to our fair value estimates, unlisted assets of real estate and infrastructure had adjusted to the higher interest rate environment, and in the process, eliminated most of the overhang in valuations that had persisted in the 3 years since Covid. In contrast, listed equity markets, driven by an overoptimism on the prospects of technology stocks to support exceptionally high earnings growth rates, look to be overvalued and a disorderly correction in the US market that spreads to other markets presents one of the most significant risks to the economic and financial market outlook.
Turning our attention to economic and market themes that may emerge over 2025, much will depend on the policies of the new Trump administration. While Donald Trump’s policies are well known – tax cuts, deregulation, tariffs and reduced migration – what is not known is exactly how much of these policies will be enacted; particularly tariff hikes. And therein lies the problem. The 2025 themes could be radically different depending on which Trump administration turns up in the New Year. The most benign version would be Trump 2016 revisited: a Trumpian Goldilocks. In that world, we would get a policy mix similar to that of his first term: heavy on tax cuts and light on tariff hikes and deportations of undocumented immigrants.
Alternatively, we could get the Trumpian Bear, where he pushes harder on tariffs and deportations of undocumented migrants. The sustained rhetoric around tariffs and his key appointments of tariff advocates Scott Bessent to Secretary of Treasury, Howard Lutnick to Secretary of Commerce and Jamieson Greer as US trade representative raise fears that tariff hikes will be greater than experienced in Trump’s first term. In the Trumpian Goldilocks, the positive impact of tax cuts and deregulation on economic growth would probably more than offset the hit to growth from modestly higher tariffs and labour shortages. Pressure would remain on inflation and interest rates, with tax cuts blowing out the budget deficit and leading to rising term premia. But with only a modest rise in inflation, the Fed can continue its easing cycle, albeit with just two or three 25bp rate cuts over 2025.
What about the Trumpian Bear scenario, where tariffs are raised to 60% on China imports and to 10% on all other imports and 11 million undocumented migrants are deported? In this scenario, the impact of the full force of Trumpian policies would be devastating. The lift in tariffs and drop in labour force from migrant deportations leads to a surge in inflation and interest rates. Caught in the cross hairs of higher costs, labour shortages and higher interest rates, the economy tanks and falls into a deep recession.
The stark dichotomy between the two scenarios is played out in financial markets. In the Trumpian Goldilocks, the modestly higher inflation rate hurts most assets, but the cut to the corporate tax rate cushions some of the overvaluation signal in the US listed equity market. Shortening the duration of the portfolio should help protect against a further rise in interest rates and the tailwind supporting private debt should also continue as the floating rate protects against higher rates. Taking the opportunity to diversify away from overvalued listed equities to alternative growth assets such as infrastructure, real estate and market neutral hedge funds may also help protect portfolios in the Trumpian Goldilocks world. In contrast, in the Trumpian Bear scenario, the only safe haven is cash and cash substitutes. Those assets with the longest duration, and hence, the greatest interest rate risk and the highest beta to growth are penalised the most. Equities fit into that category. Shorter duration assets and those with lower betas to growth fare best, with private debt, again, providing protection if the inevitable escalation in defaults is contained. Unlisted infrastructure and real estate play somewhere in the middle between listed equities and cash.
So, where are we at with the Trumpian scenarios leading into 2025? Up until the start of December, market moves were consistent with the Trumpian Goldilocks. Interest rates had risen from the start of September (as Trump’s Presidential campaign gained momentum), but not by enough to derail the equity market or to shake investors’ faith that the Fed would continue to cut rates. However, interest rates have extended their rise over December on fears that inflation is not falling quickly enough for the Fed to sustain the number of rate cuts expected by the market over 2025. No doubt, the strong rhetoric emanating from the Trump camp on tariffs is contributing to these concerns.
As this is our last Brief before Christmas, the Economics & Research team would like to thank our readers for their support over the year. We wish you a Merry Festive Season and a Happy New Year.