By
Stefan Löwenthal,
Jürgen Wurzer
07 February 2025
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
Source: Macrobond, Macquarie (January 2012 to November 2024).
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
Sources: Macrobond, Macquarie (Q1 1984 to Q3 2024).
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
Sources: Bloomberg, Macrobond, Macquarie (March 1989 to January 2025).
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
Sources: Macrobond, Macquarie (January 1960 to November 2024).
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
Sources: Macrobond, Macquarie (January 2015 to January 2025).
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
Sources: Macrobond, Macquarie (January 1991 to November 2024).
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
Sources: Macrobond, Macquarie (June 1945 to December 2024). Recession as defined by the National Bureau of
Economic
Research (NBER).
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
Sources: Eugene F. Fama, Kenneth R. French, Macquarie (July 1926 to November 2024).
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
Sources: FactSet, MSCI Barra, Macquarie (December 1995 to December 2024).
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)
Sources: Bloomberg, Macquarie (January 2025).
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
Sources: I/B/E/S, LSEG, Macquarie (November 2024).
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
Sources: Macrobond, Macquarie (January 1962 to Septemeber 2024).
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
Sources: Bloomberg, Macquarie (December 2024).
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, government spending, 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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