This year has been remarkable in many respects. Economic growth in the US and parts of Europe exceeded expectations. US Inflation – which had been accelerating – appears to have resumed its downward trend. Inflationary pressures in Europe have subsided sufficiently for some central banks to have started their easing cycles. Equity markets have reflected these favourable developments.
The key question in the US at this stage revolves around how the last leg of disinflation will play out, and if the inflation target of 2% can be achieved without a meaningful rise in unemployment and slowdown in growth. The most recent data show that labour market tightness is evaporating rapidly. While the unemployment rate is moved up slightly, job vacancies have dropped sharply. Importantly the rate at which people are quitting their jobs has also declined, suggesting that employees feel less confident about finding new employment.
Current data show a meaningful deceleration in economic growth. Real time data points to the US economy growing at a pace of 2%, but various other indicators suggest that further deceleration is likely. If inflation declines in line with the Fed’s target, this implies that nominal GDP growth going forward will be close to 4%. This level matters because it is nominal growth in GDP that is a driver for growth in earnings for the market as a whole.
The bond and equity markets are currently priced for very different scenarios. Bond markets are pricing in significant rate cuts, consistent with a rate of inflation in line with the fed’s target, and economic growth in line with the potential growth rate of the US economy between 2 – 2.25%. Indeed, the 10-year Treasury bond is trading at a yield of 4.25%, in line with the long-term historical pattern of yields being in line with the nominal GDP growth rate.
Equity markets on the other hand, are priced off expectations of an acceleration of earnings growth to around 17% by Q2 of next year, well above the rate of economic growth. There are a multitude of ways some individual companies can achieve such high growth rates in earnings, but it is unlikely that the market as a whole can meet such lofty expectations, unless we are on the cusp of a substantial increase in overall productivity. There is a compelling narrative around an increase in productivity driven by AI, but data shows that so far this seems to be isolated to a few companies. There is no evidence of economy-wide improvement.
If the developments unfold in line with the scenario priced into the bond market, the equity market is set for some disappointment from current levels. If, however, the equity market scenario plays out, and earnings accelerate, this will likely imply that the economy does not decelerate. In such a scenario, the more likely outcome is that the Fed will not cut rates as fast as currently priced. This would mean some disappointment for bond investors, but given the current level of yields, it is unlikely that returns will be negative. In other words we see an asymmetric opportunity in continuing to overweight fixed income versus equities. Within equities we would prefer to be more defensive and underweight the high-flying equities that have already done very well.
Developments on the political front are likely to have some market implications later this year, depending on the outcome of the US elections.
Unlike developments on the economic front, political developments have been less positive this year. In the UK, the labour victory was expected. However, because of the particularities of the UK electoral system, this victory was brought about by a lower share of the total vote than labour got the last time they lost the election. In France, President Macron succeeded in blocking further gains by the RN, but his victory also exposed the hollowing out of the centre of French politics. In the US, we are at a stage of the electoral cycle when candidates should be debating policies to capture the support of voters. Instead, the news cycle is dominated by a discussion of whether both candidates are suitable for the job.
What do these three developments have in common? To my mind, in all three cases voters are articulating what they are against, rather than enthusiasm for a particular direction. In the UK, Labour won because the Tories were unpopular. In France, the electoral outcome happened because of an alliance to beat the RN. In the US, politics have been exceedingly polarised.
This is an environment in which policy risk is likely to remain elevated. There can be little confidence that policy proposals, in whatever direction, will have sufficient popular support because the politicians are being elected on the basis of being “less bad than the other” rather than because their ideas have broad appeal. This may not be a problem in normal times, but it does leave open questions about much needed reforms to address medium term challenges such as debt levels.
