Multi-Asset 2025 Outlook: Will growth Trump inflation?

As 2024 draws to an end, it seems the impossible has been achieved, with the US Federal Reserve (Fed) delivering a soft-landing for the US economy. US growth remains robust and progress on inflation has allowed the Fed to start its rate cutting cycle, with already 75 basis points of cut delivered so far. The expectations for 2025 was a return to trend growth in the US and for inflation to continue its downward path towards the Fed’s target. However, the sweeping victory of Donald Trump as the 47th president of the United States has caused markets to reprice their expectations of US growth higher. Investors will need to question whether his pro-growth policies will be enough to offset the inflationary forces of his protectionist agenda.

US exceptionalism

The US economy surprised expectations in 2024 as real Gross Domestic Product (GDP) grew between 2.5-3%. This was mostly driven by personal consumption as opposed government spending or net exports, as seen in other countries. This domestic demand is more sustainable but relies on consumers keeping their job and spending their wages. Thankfully, real wages continue to be supportive of consumer spending and point to further consumption ahead. This has led to an improvement in retail sales in absolute terms and even against expectations.

Critics of the US economy have been pointing to weak Gross Domestic Income (GDI), given GDI typically leads GDP down into a recession. However, recent revisions show GDI catching up to GDP, thanks to revisions higher in corporate profits (in terms of absolute dollars and as a percent of GDP), revisions higher in household savings, revisions higher in disposable income, revisions higher in consumer spending, all while household wealth and real wages continue to increase. It is hard to be bearish on the cycle given this backdrop.

Unemployment has risen but remains low at around 4.2%. Most of this rise has come from the increase in labour supply through immigration as opposed to a sustained increase in layoffs. Despite a scare in the July US non-farm payrolls causing the market to believe the recession was nigh, this was distorted due to hurricane Beryl and subsequently revised higher. In fact, private sector job growth has continued to surprise to the upside since, other than the October print which had also been muddied by strikes and hurricanes.

Ultimately, corporates cut staff when earnings are falling and margins are under pressure, which is not the case right now for US corporates. Earning transcripts see the intention to fire staff falling versus a strong uptick in those looking to hire, but likely waiting for more certainty after the US election. Until we see evidence to the contrary, we believe unemployment will remain low, the consumer remaining resilient and will continue to spend in 2025.

The question is, why didn’t we go into recession after the fastest and most aggressive rate rising cycle in recent memory. After all, the yield curve inverted which has a 100% success rate at predicting recessions. If we simplify things, an inverted yield curve is simply showing that monetary policy is tight, and usually causes things to break. However, this time around corporates and consumers were insulated from higher rates. Households de-levered their balance sheets after the 2008 financial crisis and fixed more of their debt, with floating rate debt only 11% of total consumer debt, versus 25% pre-2008. Most households locked in 30-year mortgages at around 3-4% and experienced real wage growth in the years that followed. Household debt service payments as a percent of disposable income is at its best level in 40-years (excluding the COVID distortions).

Simply put, the consumer was robust going into this rate cycle and has the capacity to re-lever coming out. Banking lending standards are easing and banking deregulation is on the table. This could unleash a credit binge for US consumers in 2025 and beyond. At best, it could turbo-charge the US economy and at worst it could sow the seeds for the next financial crisis in the years that follow, but it would be too early to position for the latter. Ultimately, it’s too early to tell if consumers will draw on debt for consumption, but it provides another layer of support to keep consumption going in 2025.

Corporates have also been insulated from higher rates, but for different reasons. US corporates have not de-levered, but their earnings have skyrocketed as they passed on their higher input costs to consumers. Technology companies, which usually suffer from higher rates as price-to-earnings ratios readjust, actually benefited from rate rises as they borrowed at low interest rates and left their billions in earnings in cash accounts accruing over 5%. 35% of US S&P 500 technology companies make more money from their cash interest than they pay out in their debt interest. Companies that rely on floating rate debt undoubtfully suffered, but now cash rates are coming down and bank lending standards are easing. US corporate default rates are falling, while earnings and margins remain strong. With credit spreads tight and bond yields lower than cash rates, corporates have been able to refinance at cheaper rates before the Fed even started their cutting cycle.

Finally, inflation has fallen from a high of 9.1% in 2022 down to 2.5% at the time of writing, only 0.5% away from the Fed’s long-run target. This has given them comfort to start their rate cutting cycle and have already cut rates by 75 basis points at the time of writing. But given they’re cutting rates because inflation is moderating, not because growth is falling, this creates a bullish backdrop not seen since the mid-90s. The Fed is cutting rates with at or above trend growth, unemployment in the low-4s and double digit corporate earnings expectations. What’s not to like?

But can growth trump inflation?

The biggest risk to this view is the potential increase in inflation. It’s hard to see increased spending, the re-levering of the consumer, without inflation rearing its ugly head. This is especially true after the sweeping victory of Donald Trump as the 47th president of the United States. While it is not yet confirmed, it looks almost certain Trump will win a red sweep, allowing him to implement his policy agenda almost unimpeded. He has pledged to cut taxes and regulation, while also raising tariffs and restricting immigration, the combination of which will be reflationary for the US economy. Based on our modelling, this will result in a higher nominal US GDP than if Harris won.

However, Trump’s policies can be split into two: 1) pro-growth policies such as tax cuts and deregulation and 2) protectionism (tariffs and immigration) which are stagflationary. The timing of these policies matter, as his protectionist policies can be implemented immediately with the stroke of a pen (executive order), whereas tax cuts require congressional approval. We could see inflation fears hit first before pro-growth policies are enacted later. We are likely in for a volatile ride.

It’s also hard to decipher what campaign policies Trump will actually implement. For reference, during his first term, Trump broke 54% of his campaign promises, with only 24% being delivered without a compromise, so it’s natural to discount much of what he has said. However, given the size of his win, Trump has a mandate to deliver on his promises, so we have to take him at his word.

Trump has suggested 10-20% tariffs on all imports, with a more penal 60% tariff on imports from China. This will naturally push up inflation in the US as cost of imported goods rise.

However, three factors should help to blunt the inflationary impact of tariffs. Firstly, the dollar would likely appreciate, especially against the renminbi, as Beijing would probably pursue a devaluation. Secondly, the widening in corporate profit margins since the pandemic should serve to absorb higher import costs. Thirdly and finally, goods might be routed via countries that are on more favourable trade terms with the US, as China appears to have done since the start of the trade war. It’s also believed that Trump is looking for a deal so the full brunt of the tariffs may never eventuate. Inflation during his first term was not affected by tariffs and despite all the bluster, he did sign four trade deals during his term.

Immigration is hard to offset. Most of the improvement in inflation over the past few months has been from falling wage costs. After 2020, corporates struggled to find staff and had to pay up to attract talent. A spike in wage growth saw increased consumption but ultimately higher goods prices. The increase in supply of labour from immigration (legal or otherwise) has helped reduce wage costs and allowed the Fed to cut rates. In his first term, Trump cut annual net migration from 650k to 200k by enacting some 472 administrative changes. Limiting immigration, or at worst deporting workers from the US, will lower the unemployment rate but push wage growth and therefore inflation higher. Under a ‘full blown Trump’ scenario, inflation will likely rise to uncomfortable levels, ultimately crashing the economy and markets. Thankfully, this is not our baseline forecast, mainly due to his focus on the economy and the logistical impossibility of deporting 15 million people. Trump similarly promised to deport 11 million people during his first term but failed to deliver this, but it is something to keep a watchful eye over.

When it comes to Trump’s pro-growth policies, it is easy to see how cutting personal tax rates will boost consumption and how lowering corporate tax rates will boost earnings. If executed well, even tariffs could help boost domestic consumption, leading to a capex super cycle. Deregulation could also boost borrowing as previously discussed, but also improve productivity. But these policies are not free. Trump’s policies will likely see the fiscal deficit worsen by US$7.5 trillion by 2035, putting upward pressure on the back-end of the curve. This will work as a break on the economy and a potential tipping point for risk assets.

Ultimately, we still see higher US nominal GDP in 2025 and remain positive on the US cycle. However, we believe it will be a volatile ride. In this environment we would prefer US equities to US bonds given the risks to inflation and fiscal deterioration.

Domestic malaise

How about back home in Australia?

Unfortunately the positives mentioned in the US are almost the reverse here in Australia. Household debt to GDP has come down but remains high at 117%, almost double that of the US, and over 80% is floating rate. Households have experienced negative real wage growth until recently, and even now it’s a paltry 0.3%. GDP remains weak, with household consumption dragging on growth but being offset by government spending. Unlike the US, inflation remains sticky at 3.9%, well above the Reserve Bank of Australia’s (RBA) target of 2.5%. Markets are not predicting a rate cut in Australia any time soon, with less than two rate cuts priced in the market to the end of 2025.

However, unlike the US, our fiscal position remains strong and the government could stimulate more if required. The election next year will likely see more consumer support in the upcoming budget. While this will keep inflation anchored and the RBA on hold, any slowdown in growth will allow the RBA to cut rates, which would have an immediate impact on consumers.

Asset class implications

Back in 2023, we released our regime shift work detailing the implications of the ‘Next’ economy, where we aimed to prepare investors for a higher inflationary regime relative to what we’ve experienced since the secular stagnation post the 2008 Global Financial Crisis. We discussed how the 2% target for US inflation will likely become the floor for inflation, and that fiscal imperatives will keep governments spending, keeping inflation sticky and central banks more hawkish to offset these effects. This continues to be our base case, and coming to fruition domestically here in Australia but now even more likely in the US as move into 2025.

We argued that this would be a period of greater macroeconomic and asset price volatility, and that investors would have to be more active in their asset allocation and more prudent in their stock selection. From a more strategic standpoint, this will result in pro-cyclical or unstable correlations between bonds and equities, which reduces fixed income’s diversification benefits through time. The key role of fixed income will be to provide high quality income, and to provide shelter in a weakening global economy. In the most basic sense, the efficient frontier is likely to bear flatten, as the returns of bonds is higher but the diversification benefit reduces.

More specifically, we remain positive on global equities given our view of higher nominal GDP. While inflation and higher interest rates are a risk to this view, we do not see ourselves entering a new inflationary regime like the 1970s, nor even the 9% we saw only back in 2022. Historically, an inflationary regime of around 3% has been healthy for equities assuming growth holds up, which is our base case. We prefer US equities given their higher quality, positive macroeconomic backdrop, and Trump’s America First agenda. It is true that the US is expensive, but part of this is compositional given the concentration in mega-cap tech, but our earnings model suggests the market’s expectation of 10-15% earnings per share (EPS) growth is reasonable.

We believe 2025 will see a continuation of the US rotation trade we’ve seen in the lead up to the election and post the election results, where more cyclically sensitive companies within the US start to play catch up with the ‘Magnificent Seven’. US small companies likely have further room to run, but we prefer to play this theme with the Equal Weight S&P 500, which has a higher weight to sectors like industrials and financials and less in the technology and communication sectors. This is not to say we’re against the ‘Magnificent Seven’, they are phenomenal companies with margins almost double the S&P 500, but we argue for careful stock selection through active management in this space.

Outside the US, we still favour Japanese equities for their relative cheap valuations, continued work on structural reform, linkages to high tech manufacturing and automation, plus a likely weaker yen versus the US dollar, given our view on US growth and inflation. We are less positive on Europe and emerging markets given they will likely attract the ire of Trump’s upcoming trade war. Europe is stumbling out of recession, core countries like Germany remain uncompetitive with higher costs, especially energy costs, and competition from China. We believe periphery countries in Europe are in a better place, such as Italy and Spain, as they benefit from stronger growth and easier than required interest rate policy. The ‘PIIGs’ of the 2010s may become the rising stars in 2025.

We believe China is in a classic balance sheet recession, as household and corporates de-lever. Households poured their money into housing, which has collapsed, and corporates went on a US dollar debt binge, which they’re struggling to pay back. To date, government policies have failed to stimulate the economy, as the economy requires fiscal stimulus to offset the loss in demand, not monetary policy to speed up the repayment of debt. China has tried to export its way out of this conundrum, but this is near impossible given they are already the world’s largest exporter and countries eventually step in to prevent further deterioration of trade balances. Trump’s upcoming tariffs are a clear example of this latter point, and keep us cautious on China and emerging markets in general. However, Chinese equity valuations remain cheap, so downside is more limited than during Trump’s first presidency, so we remain neutral on emerging markets in general.

Finally, we are negative on Australia. Australia is one of the most expensive markets outside the US. The Commonwealth Bank of Australia (CBA) has a higher price-to-earnings (PE) ratio than Google. It seems hard to imagine further appreciation of bank stocks as net interest margins come under pressure and mortgage sales are more competitive and saturated than in the past. We do not see China embarking on an infrastructure binge, which points to weaker commodity demand, and a weaker China during the upcoming trade war will have second round effects on Australia.

The more negative outlook on Australian equities ties into our more positive view on Australian bonds. The weaker outlook for the Australian economy is currently offset by high and sticky inflation. Markets are hardly pricing in any rate cuts for Australia, with less than two cuts priced by the end of 2025. We believe this provides an opportunity to buy Australian duration, as once the economy starts to weaken, we believe the RBA will move to cut rates. We also prefer German duration given the weaker economic outlook. We are more negative on US duration given our view on inflation and growth. However, US yields have repriced higher since the lows in September, with the US 10-year treasury yield rising over 80 basis points since the low. Rate cut expectations in the US are closer aligned now to the Fed’s own view, but we still believe higher rates is likely. We prefer to hold inflation-linked bonds in the US and steepeners in the US curve.

Similar to duration, we are also positive on Australian and European credit. Credit spreads have tightened dramatically over the year, with US spreads at the lowest point in years. This means there is limited chance for further price appreciation. Given our view on the US economy, we do not expect to see spreads widen materially, so investors can still benefit from carry. However, European and Australian credit spreads are wider and offering better value, with better carry opportunities and the potential for spread compression. We also like securitised credit, where newly issued AAA-rated government guaranteed agency mortgage-backed securities in the US offer a higher spread than A- rated corporate bonds. Similarly, Australian residential mortgage-backed securities are offering a pickup over senior secured Australian bank paper.

Conclusion

We believe 2025 will be another year of US exceptionalism. Growth is likely to remain strong as other economies stumble out of their doldrums. The election of Donald Trump as the 47th president of the United States will turbo-charge the America First agenda. We are cautious that inflation is likely to rise and will create volatility, arguing for more active asset allocation and stock selection as markets decipher the winners and losers of these new policies. We prefer to take risk through US equities and believe the US rotation will continue into 2025. We are more concerned when it comes to the economies in Europe, Australia and emerging markets. This means we’re more positive on fixed income in these markets, preferring German and Australian duration and corporate credit due to valuations. We advise investors to stay nimble as 2025 will mostly be pro-growth, but filled with policy uncertainty and sequencing risk between growth and inflation.

Key Views Summary

🟢 Long / positive

🟡 Neutral

🔴 Short / negative

🟢 EQUITIES

Economic activity continues to improve, especially in the US. The US election should see higher nominal growth in the economy and tax cuts will boost corporate earnings. The US Federal Reserve are starting a rate cutting cycle with real GDP at 3%, double digit earnings growth expectations, solid consumers who have increased their appetite to spend, and full employment. We believe this offers a positive backdrop to risk assets in general, particularly in the US. Our main risk is an increase in inflation in 2025 as opposed to a recession. We prefer the US for quality earnings and Japan due to cheap valuations and likely JPY depreciation against the USD. We remain cautious on Europe and EM given the likely upcoming trade war under a Trump presidency and negative on Australia given stretched valuations and weaker economic outlook.

🟡 INVESTMENT GRADE CREDIT

Credit spreads have tightened meaningfully so remain unattractive, but we do not expect spreads to widen. US corporate credit spreads are very tight (16th percentile), so prefer EU credit where spreads are wider (43rd percentile) and Australian credit (34th percentile). Within the US, we prefer securitised credit, such as agency mortgages, given they offer a higher spread than US corporates but with far higher credit quality. Despite tight US spreads, Trump tax cuts and stronger GDP growth should see them continue to grind tighter.

🟢 HIGH YIELD CREDIT

Similar to investment grade credit, spreads are very tight across the high yield universe. However, with default rates falling and the cycle remaining supportive for the US economy, we do not expect spreads to widen, so are happy to take the carry. European high yield is moderately more attractive than US high yield. However, given the likely tariffs we see potential for spreads to stay wide in Europe. We like Australian higher yielding credit, which is a blend of BBB corporates and subordinated debt, given the attractive yields and expected further spread compression.

🟡 SOVEREIGN BONDS

The market has repriced sovereign bond yields higher on the back of strong growth and a likely worsening fiscal position under a Trump presidency. We believe there will be continued pressure upwards on US bond yields, but the move higher does present better value. We are more concerned with inflation rising than the economy rolling over into recession, so recommend steepeners and inflation-linked bonds in the US. However, sovereign bonds provide quality yield in portfolios and will still provide protection should the economy weaken. We prefer nominal bonds in Europe, where the economy is weaker, and Australia, where less cuts are priced but progress with inflation is improving.

🟢 FOREIGN CURRENCY

We continue to hold higher levels of US dollars as we believe this is a good hedge in portfolios. A Trump presidency will likely see the dollar appreciate given higher bond yields and a stronger economy. Within foreign currency, we prefer the Japanese yen as a hedge but expect it to depreciate on the margin, so offset this with a short in the euro. We remain long certain high yielding emerging market currencies, but remain selective given the potential for further trade negotiations under Trump.

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Read all the Australian Investment Outlooks for 2025 here.