Peering into 2025: it could be bumpy!

Fiscal policy has given the us economy an edge since the pandemic

The US economy has certainly outperformed Europe over recent decades. However, much of that was explained by population growth, with annualised real GDP¹ per capita growth from 2000 to 2023 almost the same in the EU² (1.22%) as in the US (1.21%), based on PPP (purchasing power parity) conversions to US dollars³. Nevertheless, since the onset of the pandemic, the US has outperformed the EU, with annualised growth since 2019 of 1.33% versus 0.87% (though China has done much better at 5.15%). In my opinion, much of the outperformance by the US is due to the fiscal support offered by the US government during and since the pandemic. For example, US government gross debt to GDP rose from 108% in 2019 to 121% in 2023, while in Germany the gross debt ratio fell from 68.5% to 65.4%⁴

But the us consumer is running out of steam and the fed is not helping

The fiscal transfers in the US allowed household excess savings to rise way beyond what was seen elsewhere. Not only have US households spent those excess savings, but they have also reduced the savings rate to close to historical lows, while in Germany the savings rate is close to historical norms. I believe this explains why US consumer spending excelled but then ground to a halt during the first half of 2024: with very little real income growth and savings depleted, the US consumer has no way to boost spending.

This is why I think the Fed may already have committed a policy error: with core inflation on the way towards its target rate, waiting so long to start easing increases the risk of recession, in my view. Hence, I think there is a risk that we start 2025 preoccupied by the spectre of US recession.

Of course, there may be a change of US president and it is expected that a second term for Donald Trump would bring tax cuts and an even larger fiscal deficit. Even if that fiscal largesse boosts the economy, it is unlikely to be implemented in the first half of 2025, so could come too late to avoid recession. Even worse, it is possible that markets react negatively to the prospect of an increased fiscal deficit, as seen in the United Kingdom (UK) with the Truss/Kwarteng budget debacle and in the Eurozone when an expansive extreme French government looked a possibility.

A bumpy road ahead for cyclical assets and the us dollar

What would a weak US economy mean for financial markets? First, of course, a US recession would dampen the global economy, so the problem would spread throughout the world. Second, recessions are usually bad for cyclical assets, meaning that I would expect assets such as equities, high yield and industrial commodities to suffer. In particular, profits tend to follow economies downward, so I would expect default rates to rise at a time when high yield spreads are very narrow (they usually widen when economies weaken). Third, I would expect central banks (and especially the Fed) to cut rates aggressively, which usually brings bull steepening of yield curves, outperformance of government bonds versus equities and the favouring of duration.

I would also expect the US dollar to weaken, which could help non-commodity related emerging market assets. Further, to the extent the Chinese economy can plough its own furrow, it could suddenly look like a sea of tranquillity. This could help Chinese stocks, which I believe are compelling value (at some times this year, my calculations suggest its cyclically adjusted price earnings ratio fell to the same level as in the US in March 2009, when we thought the world was heading for financial collapse and depression).

If the dollar weakens, I think the Japanese yen is a good candidate to be strongest major currency. The yen has fallen to an extreme low in real trade weighted terms because its central bank maintained a very accommodative stance while nearly all others tightened aggressively. The BOJ⁵ is now tightening (gently) as other central banks are easing, so I think we could see a reversal of that yen weakness.

Could artificial intelligence come to the rescue?

Of course, I could be wrong and the global economy may accelerate into 2025, with cyclical assets favoured. The obvious refuge for those seeking reasons to be optimistic is Artificial Intelligence (AI). I certainly believe it could boost productivity and economic growth over the medium to long term but doubt its benefits could be felt broadly enough to impact economic outcomes over the next 12 months. Of course, if AI does boost trend growth, I would also expect it to lift real interest rates and we all know how it felt when real rates rose sharply in 2022.

¹Gross domestic product.
²European Union.
³Source: Own calculations based on International Monetary Fund data.
⁴Source: Organisation for Economic Co-operation and Development.
⁵Bank of Japan (Central Bank of Japan).

Paul Jackson, Global Head of Asset Allocation Research, Invesco