From reflation to rotation

With global and local equity markets on track to record 25-30% returns in calendar 2024, there is no question this was a year of financial market reflation. The big question is what comes next? 

In short, we think the economic environment will support risk asset optimism in early 2025, but ultimately we believe President Trump’s policies will be a net negative for 2025-26 and expect investors to rotate into bonds progressively through the remainder of the calendar year.

The impact of Trump and his policies

It is highly likely that the next four years will bring heightened volatility as markets return to being reactive to Trump’s predilection to make shock announcements.

If Trump’s plan was implemented in full, we believe US inflation would be ~1% higher than the baseline scenario and US economic growth would be ~0.75% lower in 2025-26. The impacts are smaller if the US only impose tariffs on China, but there is no scenario in which an escalation in trade restrictions boosts economic growth and lowers inflation. If fully implemented, we believe Trump’s US$7.5 trillion in election promises will push government debt to economically unsustainable levels over the next decade.

The response from the rest of the world

Trade policy is not a zero-sum game. Increasing tariffs in one country that leads to retaliation in other countries not only lifts the costs of traded goods, it also increases uncertainty and ultimately reduces investment, employment and global economic growth.

Our base case is that tariffs will be selectively applied by the US to Europe as well as China and 5% generalised tariff will be implemented. In response, the ECB will be forced to ease policy further, European governments will be forced to divert more expenditure to its own defence, and ultimately will allow greater access for US products into the European market at the expense other trading partners. This is ultimately a negative story for Europe.

From Australia’s perspective, it is feasible that Australia’s exports to China will be largely insulated from the impact of a US-China trade war. Moreover, Australia will likely be a recipient of cheap manufactured product from China as goods are diverted to countries without tariff restrictions. In this respect, it is not clear that inflationary impact from a US-China trade war will be material for Australia. It is possible that it proves disinflationary depending on just how much excess China production is diverted to our market.

On balance, we expect global economic growth to average 2.8% in 2025, starting the year with solid economic growth momentum before faltering somewhat through 2H25.

Australia in 2025: Improving off a low base but policymakers have been more of a hindrance than a help

This time last year, it was commonplace for forecasters to suggest that there was a high risk of recession in Australia in 2024. Our view was that tepid growth conditions would persist into early 2024 and that growth would see some modest, sequential growth through 2H24. At the time of writing, we are yet to see the hard evidence of this modest recovery, outside of better confidence readings at the consumer and business level.

Disappointing economic data into the close for 2024 confirm the RBA is yet again cum-downgrade for their economic growth forecasts. More importantly, we believe that the RBA is misreading the inflation dynamics in Australia. There are three main reasons:

• Currently, 49% of the items in the CPI basket are expanding at a pace below 2% - the bottom end of the target band of 2%-3%. Typically, the RBA is well into an easing cycle with a distribution of inflation that is this supportive.

• Electricity and rental subsidies have contributed to weak inflation in recent months, but it is important to note that the RBA’s assumption that these subsidies will lapse in 2025 is likely wrong. The Treasurer has repeatedly signalled his intent to extend the subsidies. Thus, the RBA’s forecast for CPI is likely to be close to 1% too high through 2H25.

• The RBA’s primary argument is that private sector services inflation remains too high due to excessive demand. However, just 9% of the basket is discretionary services. Overwhelmingly, the source of high services inflation is in non-discretionary publicly administered prices which is mostly a function of lagged indexation from the prior year. This force of inflation will mechanically fade quickly in 1H25.

We estimate financial conditions are restrictive and to achieve a neutral setting 125bps of easing in the cash rate is required. We continue to expect 100bps of easing in 2025 commencing in February.

Private demand recovery. Public sector headwinds.

Despite the current economic malaise, a private sector recovery is still likely. This recovery will be driven via improved real income growth supporting a modest consumer recovery and ongoing private investment growth. 

There is also evidence that single-home construction is being dragged higher by a sheer scale of the shortage of homes, despite record lows for housing affordability and lacklustre apartment approvals.

Two of the main domestic challenges for 2025 will be largely political in nature. A minority government is possible, if not probable, and that will do little to alleviate investment uncertainty and additional fiscal spending looks unlikely at this stage. 

The biggest swing factor may well come down to the competition between the major parties to expedite a slowdown in population growth. While the intention is to help alleviate pressure on infrastructure and rents, a sharp policy-induced slowdown in population growth could easily become the biggest hurdle to economic growth in Australia in 2025 and 2026.

Tactical positioning: Rotating from equities to bonds as the year unfolds

A modest economic recovery won’t provide the type of cyclical leverage that will drive a material uplift in EPS growth in 2025. After two years of negative EPS growth, Australian market multiples are demanding and equity risk premia is historically low. With bonds closer to fair value, given the prevailing economic conditions, we can see the attraction of carrying a more even weighting towards fixed income and equities as we move through 1H25.

In the nearer term, we expect that loose US financial conditions will inspire some nearer-term economic and EPS upgrades in the US before Trump’s policies ultimately weigh on future growth expectations. As such, equities may remain in favour in the early part of 2025, but we expect sentiment will turn before mid-2025. In the interim, we expect bonds to bake in higher inflation risks and renewed fears of excessive debt issuance in early 2025, providing an opportunity to lift bond holdings in the remainder of 2025.