Still echoes: Rhyming policies, different aftershocks

7 February, 2025
By Stefan Löwenthal, Jürgen Wurzer 

Executive summary

As 2025 begins, the market consensus has shifted to expect what in essence would be a continuation of 2024: resilient economic growth and benign inflation, paired with supportive monetary and fiscal policy, creating a positive market environment for risk assets. As this was in line with our expectations for last year, we look at the factors that could continue to support this view in 2025, but – most importantly – as we expect more pronounced macroeconomic volatility in the months and years ahead, we also analyse key risks to the new consensus.

Figure 1:
A paradigm shift in macro volatility: inflation before and after COVID-19

Macroeconomic environment

As we anticipated, the two major factors driving growth in 2024 were household consumption and government spending.¹ With labour markets still tight in most regions, consumer spending and demand for services could continue. And specifically for the US, household leverage is at a 50-year low. Even if the excess savings that were accumulated after COVID-19 were fully depleted, a structural releveraging could be a longer-term tailwind for economic activity.

Fiscal policy

Fiscal policy seems a bit more uncertain, however. Many governments around the globe still run sizeable deficits compared with pre-COVID-19 averages. With few exceptions (UK, France), debt sustainability discussions haven’t flared up meaningfully and led to material reductions in deficits. Quite contrary, US government spending typically increases in the year after a presidential election. So far, the Trump administration has sent mixed signals around fiscal policy, between the introduction of tariffs and cutting wasteful government spending.

Structurally higher deficits in recent years were a major yet sometimes overlooked factor driving corporate profits. Sources of corporate profits in the whole economy can be broken down into a mix of business investment and public, foreign, and household savings. The most recent 10-year period has seen US after-tax profits markedly higher compared with the prior 30-year average. As the chart on the next page shows, the majority of that three-percentage-point increase can be attributed to the increase in the budget deficit.

Figure 2:
Using the Kalecki profit equation² to analyse drivers of corporate profits

We don’t expect a meaningful reduction in US government spending this year. Combined with a possibility for deregulation, corporate tax cuts, and incentives for capital expenditures, this could mean that corporate profits may stay at these higher levels.

The relative timing of deregulation versus a potential budget consolidation, however, might turn out to be critical. Banks’ return on equity, the 30-year mortgage spread, and bank lending survey data all suggest they could increase lending activity if there was some deregulation as currently being discussed among Trump’s team. Hence, banks could step in and mitigate some of the liquidity reduction, even if the government eventually reduces the deficit.

Central banks and liquidity

Thus far, the US Federal Reserve (Fed) and other major central banks are still in cutting mode. While that might be justified in different parts of the world amid economic weakness, the US might be closer to a pause (which Jerome Powell more or less indicated in the January FOMC press conference). If the Fed would signal that it is completely done with its maintenance cuts for now, this could have implications for the 10-year rate, as we outline in more detail below. There might even be a discussion to end quantitative tightening (QT) soon, given that the Fed’s balance sheet is now roughly 22.5% of gross domestic product (GDP), well below the COVID-19 peak of 35% and not far from the 20% level that seemed to have caused some liquidity issues in 2018-2019.

Since June 2024, the Fed has reduced the balance sheet at a rate of $US60 billion per month. This $US720 billion per year reduction in liquidity could potentially be offset by the $US600 billion parked in the Treasury General Account and $US175 billion in the reverse repo market, if they were deployed. This pales in comparison to almost $US7.0 trillion sitting in money market funds, a massive increase since the Fed started hiking rates in 2022. The picture looks slightly less extreme when normalising with GDP, but even that metric appears stretched when compared to history.

Figure 3:
Money market fund assets under management: nominal and as a percentage of GDP

The $US2 trillion increase in money market fund assets has predominantly been driven by households – money which could potentially be spent or invested in other assets. In a very comparable dollar amount, the fiscal year ended September 2024 saw the US government budget balance at a deficit of $US1.8 trillion. Since 2022, US Treasury has focused its new issuance activity increasingly on bills, which easily found their way into the system. If the new administration issues more notes and bonds, this could put upward pressure on longer-term rates, particularly if households are not willing to extend their maturities without a steeper yield curve.

Likewise, money market funds might need to tap the reverse repo market more frequently again, if they can’t get enough short-term government paper. And as regional banks burned their fingers with the mark-to-market risk of longer-duration assets in 2023, it’s unclear if they would be happy taking on more bonds instead of bills again. Like communicating vessels, all these sources and uses of liquidity are interconnected, with potential implications on markets more broadly.

Inflation

The one key risk to the Fed’s expected target rate trajectory continues to be inflation, in our view. Inflation largely stabilised in 2024, albeit at still-elevated levels. Service inflation hasn’t returned to its pre-COVID-19 levels (not even close!), and goods inflation started to reaccelerate in the second half of 2024. Both components could be influenced by policy measures of the Trump administration in various ways and in either direction. And while the Fed’s focus shifted to labour market dynamics in late 2024, we think stubborn inflation figures in 2025 could see the Fed again emphasise the price stability component of its mandate as a result.

Figure 4:
US core inflation breakdown of goods and services

We break down the various policy proposals into three categories:

1. Potentially inflationary:

• Tariffs and trade restrictions clearly fall into this category. The most direct link is to be expected for goods inflation. Even if it’s just a one-off tariff introduction, the price of imported goods would go up as a result. During the first Trump administration, core goods inflation moved from an average -1% closer to 0%. Individual product groups like laundry equipment faced price increases of 60% and more. If tariffs this time are higher and applied more broadly, this could lead to goods inflation reaching escape velocity again.


• Changes to migration and potential deportations of illegal migrants might be inflationary. Particularly since COVID-19, data suggest that migrant workers have filled a structural gap in the US labour force, suppressing wage growth from climbing even further. Amid the challenges to find enough workers in the service sector, any reduction could lead to a reacceleration of wage growth and hence service inflation.

2. Limited impact/undecided:

• A potential corporate tax cut might unlock additional capital expenditures, or help corporate profits; however, the impact on inflation is less clear. The tax cuts during Trump’s first term have basically brought the US in line with the Organisation for Economic Co-operation and Development (OECD) average corporate tax rate, so one could argue the biggest effects might already have been observed.


• Reshoring and policies to incentivise investment into the US might be an important part of Trump’s agenda in his second term. This should be a net positive for economic activity but would not necessarily have immediate firstround effects on inflation.

3. Potentially dis-inflationary or deflationary:

• The US became a net energy exporter quite a while ago. Since the Russian invasion of Ukraine, US liquefied natural gas (LNG) and oil exports were one of the main components stabilising EU energy security. If the Trump administration makes it easier to produce energy – and doesn’t put additional restrictions on exports – energy costs could decline globally, thus limiting headline inflation.


• While it seems unlikely that large-scale government consolidation happens soon, the proposals to save trillions of US dollars in the public sector would likely be a headwind to economic growth and thus ultimately to inflation.

Net-net, while there is still a lot of uncertainty, at least a short-term inflationary impact could be expected from the Trump administration. At the same time, some structural challenges remain: the ageing population in the US means that roughly 340,000 workers aged 65 or older are retiring and thus leaving the labour force each month. Even without additional restrictions on illegal immigration, increasing labour scarcity could be a longer-term tailwind for service inflation.

Last but not least, geopolitics also seems destined to be more inflationary compared with the past 20 years. Since China entered the World Trade Organization (WTO) in 2001, global trade has helped keep inflation in check. China faces many internal challenges (more on that below) but is also becoming more isolated globally.

Europe

Many of the broad themes outlined above for the US apply to Europe as well. However, the region faces additional challenges, making it an unpopular choice among investors. The Russian invasion of Ukraine and the implication it had on energy cost has started a deindustrialisation process in some areas. Companies are shifting their production to the US for cheaper and more reliable energy. Some sectors, such as the automotive industry, are particularly threatened by the ongoing tariff discussions, while at the same time facing increasing competition from China.

Figure 5:
Germany day ahead baseload electricity spot price

With economic activity deteriorating and some countries already in recession, the European Central Bank (ECB) might cut interest rates considerably more compared to the Fed. However, as price stability is the ECB’s only mandate, it can only hope that inflation is not returning anytime soon. It’s difficult to see a near-term catalyst for European economic outperformance. Better visibility on any tariffs and a turnaround in China seem to be necessary preconditions.

China

As we entered the Year of the Snake on January 29, the Chinese economy continued to face significant challenges with its macroeconomic outlook. It is remarkable to note that Chinese consumer confidence has been depressed for almost three years, with few signs of quick improvement. It is estimated that Chinese households shifted more than renminbi (RMB) 50 trillion (about $US7 trillion) into cash-like assets since 2021 (sources: Bloomberg, Wind, KKR). This situation hampers the efforts of policymakers to shift the economy from being export-driven to consumption focused.

Figure 6:
China – Consumer confidence and selected sub-components

For decades, China experienced growth through a booming real estate market, infrastructure spending and strong exports, which fostered optimism and increased wealth. However, the current scenario is different. Chinese citizens are experiencing losses in real estate investments, there is growing international reluctance about purchasing Chinese products, and local policymakers have taken only limited actions to stimulate the economy. More substantial intervention from policymakers (as opposed to only announcements) might be needed to change the prevailing negative sentiment. If it were to happen, a turnaround in consumer confidence might be a catalyst for more sustained Chinese equity market performance.

Asset class implications

Equities

If the market narrative was too optimistic about economic growth, what might that mean for equity returns? It is quite clear that valuations seem stretched in some areas, e.g. the cyclically adjusted price-to-earnings (P/E) ratio (CAPE) for the US stock market is in the high 30s, a level that was only exceeded during the tech bubble in the 2000s. Similarly, Tobin’s Q (equity market cap in relation to the replacement value) and the so-called Warren Buffet indicator (market cap divided by gross national income) are at all-time highs.

However, longer-term returns are well within one standard deviation of their historic averages, and only another strong year of 20%+ performance (that last happened in the 90s) would take the 10-year z-score to a level of just over 1.0 at the end of 2025. Also, when comparing the current bull market to post-WWII cycles, it’s neither particularly long nor particularly strong yet. As the technicals don’t look overly excessive, we can dive deeper into the fundamentals.

Figure 7:
Long-term returns and their z-scores

Growth and Value

Equity markets have been dominated by mega-cap US tech stocks. While the rally became somewhat more broadbased in the first half of 2024, growth still outperformed value by almost 20 percentage points last year, almost solely driven by the information technology sector. Value has lagged for quite some time now, with only a few relatively short catch-up periods, putting question marks around the long-term trajectory of the value-growth pair.

Figure 8:
Value-growth long-term relative performance trajectory

However, while having lagged, value is not cheap on a standalone basis compared to its own history, either. This makes the valuation spread, measured by the median P/E ratio of the highest versus lowest quintile of stocks, sit in the middle of its historic range. But as the chart below shows, that’s also where the subsequent return variation is the biggest. This means at the current spread level, both value and growth are equally likely to outperform, and the risk of being on the wrong side of the pair is significant, making it a “high-conviction neutral” for us.

Figure 9:
US growth-value valuation spread and subsequent relative returns

There are several other factors driving the value-growth relative performance. Value was historically more sensitive to the business cycle, as earnings declined more significantly in a slowdown or downturn. At the same time, growth is now more contingent on the performance of the Magnificent Seven. So far, they have been able to deliver strong earnings growth and live up to expectations with almost zero gravity, moving from one record high to the next and increasing their relative weight in various benchmarks. But is this earnings growth sustainable?

Figure 10:
Necessary earnings growth to arrive at specific P/E levels (S&P 500^® / Mag7)

The table above shows how much earnings growth is needed on a continuous basis to arrive at specific P/E levels. For an S&P 500 Index P/E around 20, this growth could be achievable. Historic data show that more than 50% of “hypergrowth” and “quality growth” companies have been able to sustain growth rates of more than 10% per annum (p.a.) for longer time periods (source: UBS HOLT). If the current economic trajectory turned out to be akin to the mid-1990s, and earnings growth becomes more broad based, this could provide support for a longer-term rally. However, it’s been two years without a meaningful pullback, and with lofty valuations as a starting point, it might not be the worst time to take a more neutral stance.

US vs. rest of the world

European equity market valuations have been comparably cheap for a long time and only became cheaper in 2024. This is particularly acute in structurally challenged sectors such as automotive, where multiple dispersion has reached extreme levels compared with the US. Much of the growth discussion above applies to US versus the rest of the world as well, as the US is growth-heavy versus the rest. If earnings broaden out and economic activity is sustained, Europe and other regions should benefit disproportionately. However, lacking an immediate catalyst, for investors that want to increase diversification, a more detailed look at a country and sector level should provide some insights.

Figure 11:
Valuation and profitability overview across countries

If valuations are viewed through a profitability lens, several markets in Europe, such as Austria, Italy, and Switzerland, look interesting (not only because it’s ski season), while Belgium and Portugal seem to be expensive compared with the profits the companies have delivered. Australia falls into that latter category as well. Looking at sectors instead of countries, financials, utilities, and consumer staples seem to be good starting points to explore investment opportunities overseas, as here the valuation gap between US and the rest of the world is the biggest.

Similarly, while there are some pockets of attractiveness within emerging markets, the elephant in the room remains China. Without a meaningful policy turnaround in China, we find it hard to envision any lasting outperformance of the broader emerging market asset class.

Fixed income

Long-term rates

Amid the more constructive economic backdrop in the US, market expectations for additional rate cuts have changed markedly again after the December 2024 Fed meeting. Over very long time periods, there used to be a connection between nominal GDP growth and the level of long-term rates. However, with the advent of unconventional policy measures after the 2008 financial crisis, that relationship broke down. If we continue to see both real GDP growth and inflation at the upper end of their 2-3% ranges, this could mean further re-rating of the 10-year rate and a steepening of the yield curve. The liquidity discussion in the macro section above could add to those pressures.

Figure 12:
10-year US Treasury rates and nominal GDP growth

Shorter term, market expectations for Fed cuts predominately have driven rate volatility. And, like usual, there was a tendency to move from one overreaction (expecting too many cuts) to the next (expecting almost no cuts). The Fed itself has increased its own expectation of where its target rate will be in the long run from the 2.25-2.50% range to now 3.00-3.25%, a value last observed in 2015. As long as neither the Fed nor the market has settled on what the “new normal” for interest rates is going to be, we expect those swings in the 10-year yield to continue. This creates tactical opportunities, while the defensive option to stay in short-term bills still delivers relatively attractive yields.

While not fully decoupled, the drivers for other regions are somewhat different than the US. While GDP growth remains challenged in Europe, taking duration risk there seems more compelling compared with the US. Some of the peripheral countries in Europe might be a good way to get exposure amid the additional spread they pay over German bunds.

Corporate bonds

Corporate bond spreads continued to tighten throughout 2024, and to trade close to or at their all-time lows in many segments of the market. Amid considerably higher indebtedness of sovereigns, there is a debate if investment grade (IG) spreads could go markedly lower. Some say for firms like the Magnificent Seven even a negative spread might be justified, something that happened in Italy during the European sovereign debt crisis, as some corporates were perceived as safer to repay their debt than the Italian government in 2013.

Figure 13:
Risk-adjusted valuation within fixed income

While we don’t expect spreads to tighten much further, the economic backdrop seems solid enough to avoid a material widening. From a total return perspective, IG corporate bonds still offer a compelling all-in yield. Conversely, we continue to be cautious about the riskier parts of the credit markets, reducing allocations to high yield corporate bonds and emerging markets debt. Spreads are very tight, leaving little margin of error.

Other asset classes

With the S&P 500 Index posting returns in excess of 20% for two consecutive years, a correction is becoming more likely. There are a few assets or investment strategies that could help diversify investors' portfolios. From a style factor perspective, the rally has been driven by beta and momentum. The market could now transition to create more alpha opportunities where active security selection and portfolio construction could add important diversification.

As the artificial intelligence (AI) hype continues despite the recent DeepSeek volatility, and inflation and macro volatility seem here to stay, real assets could continue to be a good diversifier as well. US data centres increased their share of total electrical consumption from 1.9% in 2018 to 4.4% in 2023, and it is projected that they will account for 6.7- 12% by 2028.³ This could be a considerable tailwind for real estate investment trust (REIT), infrastructure and natural resource companies. And these companies often have their revenues linked to inflation, an interesting feature if inflation were to surprise again.

Real assets are also a prime candidate for investments in private markets. While private market valuations are not immune to rises in interest rates, and are connected to public market valuations too, there are two noteworthy aspects of private assets that could help navigate the coming months. First, the smoothing of returns in private markets significantly affects the reported volatility figures. An analysis in the Journal of Portfolio Management⁴ indicates that the actual economic volatility of private equity is approximately 30%, as opposed to the reported figure of 10%. Second, smoothing is suggested to help shield investors from their own behavioural pitfalls, such as the tendency to sell after a correction. The authors estimate that behavioural bias to cost investors an annualised return of 1.7% over a 10-year period.

Interestingly, the Morningstar report that was used for the study above⁵ makes a compelling case for multi-asset strategies, because these funds are diversified across multiple asset classes and regularly rebalanced, reducing the need for investor maintenance and helping to avoid common behavioural mistakes. This cohesive strategy mitigates the risk of mental-accounting and other errors by combining separate strategies into a single, balanced holding. Diversification is famously regarded as the only free lunch in financial markets. And as we believe we are in a structural bull market, those behavioural mistakes can be more easily avoided by adding such ballast to the portfolio.

Conclusion

As we enter 2025, the market consensus foresees a continuation of the economic resilience and benign inflation observed in 2024, supported by favourable monetary and fiscal policies. However, the landscape is expected to be marked by increased macro volatility, necessitating a careful analysis of potential risks. Key factors such as household consumption and fiscal policy dynamics will play critical roles in shaping economic outcomes. The interplay between central bank actions, inflation trajectories, and global geopolitical developments will be pivotal. This environment underscores the importance of risk-based portfolio construction, prioritising probabilistic outcomes, and enhancing the potential for resilience and growth through diversified strategies.

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