Summary
Euro growth pessimism is overdone
Euro growth glass is half-full, not half-empty
There is no doubt that both industrial production and domestic consumption have suffered in Europe since 2022, battered by a combination of sharply higher energy costs, a surge in inflation and higher interest rates. But most of this is now in the rear-view mirror.
Third quarter growth was encouraging at 1.5% on an annualised basis, representing the best performance since mid-2022, led by Spain, France and Ireland. US Q3 growth was similarly robust at 2.8% annualised, led by personal consumption.
Growth over the next few quarters should be supported by a combination of rising domestic consumption (correlated with falling inflation) and recovery in both industrial activity and loan demand as interest rates continue to fall.
No real signs of US employment weakness
Concerns that the US economy would fall into recession by early next year are based on a continued deterioration in employment, and a consequent hit to household demand. While US wage growth continues to moderate and the number of unfilled job vacancies declines, private sector employment remains robust judging by the latest ADP survey, while weekly initial jobless claims are falling, not rising.
If anything, US economic momentum has accelerated since September, according to the Citigroup economic surprise index.
A rare bird: improving business cycles with a rate-cutting cycle
The big picture is this: we are experiencing a rare positive economic phenomenon – the coincidence of an improving business cycle (rising leading economic indicators) and an increasing number of central banks cutting rates. According to Pictet Asset Management, this combination only happens 10% of the time.
Key messages: the combination of improving business cycles and rate-cutting cycles is a heady cocktail for risk assets, including stocks, commodities and corporate credit. Favour cyclical sectors including capital goods and financials.
Lower oil prices and interest rates boost consumers and corporates
Lower oil price is good news in Europe
Despite the heavy tax burden paid by consumers and companies on petrol and diesel at the pump, there is still a close relationship between the crude oil price on the one hand, and European inflation on the other.
Despite the ongoing conflict in the Middle East involving Israel, Gaza, Lebanon and Iran, Brent crude oil has eased lower to USD 74/barrel on weak global demand and growing supply. With the OPEC+ nations preparing to end temporary quote cuts and hike oil production, the downwards pressure on oil prices should not abate over the next few months. These lower energy costs are a huge contributor to driving the Eurozone inflation rate down to 2%, even as services prices decline only gradually.
Less money spent on petrol and diesel should translate directly into higher discretionary consumer spending in areas such as travel & leisure.
US core inflation should slow as shelter CPI eases
It is well-known that the shelter component of US CPI is very lagged versus more real-time measures of rent inflation. The sharp drop in new tenant rent inflation to just 1% y/y suggests that US shelter inflation should return to pre-COVID levels in the months ahead. Given a near-40% weighting for shelter in US core CPI, this should also drag overall US CPI lower in the months ahead on a simple mathematical basis. A second reason to expect lower US core CPI ahead is slowing of overall wage growth to under 4% y/y, which should also cool services inflation going forwards.
Central banks accelerate rate cuts
While we focus largely on the US Federal Reserve and the European Central Bank, we should not ignore the accelerating rate-cutting momentum in other central banks around the world. The Bank of Canada has already reduced its benchmark interest rate by 1.25% to 3.75% as of end-October, with the latest reduction a larger 0.5% move as CPI ex-volatile items dropped to just 1.6% y/y in September. Equally, the Swiss National Bank should reduce rates again in December, with the market split between a 0.25% and 0.5% rate reduction after a surprisingly sharp drop in core October inflation to 0.8%. By late 2025, the SNB’s policy rate could even return to 0%, as it struggles under the weight of a persistently strong Swiss franc.
Rising bond yields cool stock markets
Sharp surge in US bond yields cool markets
In recent weeks, both US stock market and bond market volatility measures surged, reflecting the increased uncertainty around potential post-election shifts in economic policy. While the Presidential election triggers short-term volatility in financial markets, as we are not short-term event-driven traders, we should only concern ourselves with the longer term.
In general, I believe that investors tend to exaggerate the importance of national legislative elections such as the US Presidential election on medium- to long-term investment returns. The fact is that US stocks have generally fared equally well under Democrat and Republican presidents over the last 96 years.
Seasonality: volatility generally peaks in October
On a seasonal basis, stock market volatility in the form of the VIX index tends to peak by the end of October, at which point the stock market enters its seasonally strongest six-month period of the year (from November to April).
If we were to follow the average S&P 500 performance observed over the last 30 years, then we could expect the S&P 500 to rise another 4% over November and December. However, seasonality is even more marked for US mid- and small-caps, which on average have gained 6% over these two months over the last 20 years. Of US sectors, housebuilders exhibit one of the strongest late-year seasonal trends, typically gaining 7% over November-December.
European stocks exhibit stronger seasonality
Interestingly, European stock markets tend to be more sensitive to seasonal variations than US indices, with worse performance over the summer but a stronger “Halloween effect” from November to April/May. For example, the German DAX index gains on average 5% over the last two months of the year, and almost 10% on average from November to the end of May.
Maintain positive view on stocks: we still favour US mid-/small-cap stocks over mega-caps, we also prefer cyclical sectors such as Financials and Capital Goods, which should benefit from lower short-term rates and which show pronounced seasonal trends.
US elections – First reactions
Key messages
The election outcome at this stage
Donald Trump is the new US President, and the Republicans have won the Senate. Republicans have won the majority in the Senate with 51 seats out of the 100 from 2025, up from the current 49.
As largely expected, they have won the seat in West Virginia, where Democrat Joe Manchin did not run for re-election. They have also won a seat in Ohio, where incumbent Sherrod Brown lost to his Republican challenger.
Concerning the House of Representatives, the result is still uncertain. A party needs 218 seats to secure the majority. At the time of writing, the Republicans are in the lead with 204 seats. The outcome could remain uncertain for several days or even longer.
Potential impact on the economy
Trump’s victory will very probably lead to a new round of US import tariff increases. An extension of the 2017 tax cuts and further fiscal stimulus are expected in a Red wave scenario.
In such scenario, we think that the medium-term impact is likely to be negative on US economic activity and lead to higher inflation. Tariffs are likely to have bigger effects than the potential changes to fiscal and immigration policy.
We expect an initial positive impact on growth from the business sector, while the full extension of individual tax changes should matter more for consumer spending in a second phase. However, the negative effects from tariffs and the higher uncertainty should offset any positive impulse from a more expansive fiscal policy. We also expect a higher public deficit.
The election win for Donald Trump, in our view, implies a downside risk to eurozone growth. We see four main channels through which the US election outcome could affect the eurozone economy:
Depending on the outcome for the Congress, we may review our eurozone economic forecasts.
Little change to monetary policy expected
It is unlikely that the FOMC will react to the election result. We still expect a 25bp cut at the meeting taking place this week. Our initial scenario implies two consecutive 25bp rate cuts in 2024, followed by a quarterly cadence until the policy rate reaches 3.25% in early 2026. This outlook will be under review if the scenario of a Red wave is confirmed. Indeed, in that case, inflation would likely rise again later in 2025, and this would imply higher rates than our existing scenario for 2026.
The higher uncertainty will probably prompt the ECB to stick to a more gradual, meeting-by-meeting approach. We still look for a 25bp cut in December, March, June and September with a terminal rate of 2.25%. The ECB could even go to 2% or less if the economic environment deteriorates further.
Immediate market reactions
2- and 10-year US bond yields have risen about 10bp. The US dollar is up given the higher probability of a Red wave and potentially higher inflation and a higher terminal rate. If such scenario is confirmed, we will also review our outlook for the dollar. US stock markets have welcomed the election outcome and the fall in uncertainty. They should be supported by the election outcome in the coming months, but we need to follow the risk of higher medium-term inflation.
The Big Issue: Structurally high fiscal deficits
Heavy post-COVID sovereign debt burdens
The one long-term issue that is not overtly addressed in the stated manifestos of either of the two US Presidential candidates is the elevated budget deficit (the gap between US federal government tax receipts and spending). At 6% of GDP, this overspending relative to tax revenues is resulting in a 7% annual increase in the total amount of US government debt outstanding, which must then be financed through increased issuance of US Treasury bonds.
Today, total US federal debt represents 120% of GDP, a sharp increase since mid-2008 when this debt/GDP ratio stood at only 64%.
The era of fiscal dominance is upon us
Fiscal dominance occurs when national debt has reached levels at which a country is unable to pay it down with tax revenues, and thus requires monetary policy support (from the central bank) to stay solvent and to continue to operate.
Given the outstanding levels of government debt today in the US, Europe and Japan, I believe that we have entered a post-COVID era of fiscal dominance.
What this means in practical terms is the following:
a) central banks such as the Federal Reserve and the ECB cannot simply set benchmark interest rates according to prevailing economic conditions. Raising interest rates too far, too fast can raise the government’s cost of financing the national debt too much for comfort. This can potentially create doubts over debt sustainability in bond markets. In turn, bond yields could increase sharply as the risk premium demanded jumps and thereby threaten financial market stability – one of the main underlying goals of central banks. So, benchmark interest rates may have to be maintained at lower levels than would otherwise be the case.
b) it suggests that governments have a reduced capacity to support demand via heavy government spending at times of crisis such as the 2008 financial crisis and the 2020 COVID pandemic.
c) Central banks may have to tolerate inflation moderately higher than their 2% target, to allow slow erosion of the value of this debt in real (after-inflation) terms. They may also have to act as the buyer of last resort of government bonds via quantitative easing, in fulfilment of their financial market stability mandate.
US federal debt levels become an issue periodically due to the existence of a legally-defined absolute debt ceiling. This ceiling must be explicitly raised with the agreement of Congress whenever it is reached, to avoid a federal government shutdown. The US debt ceiling is currently suspended but will automatically come back into effect in early January 2025. At some point in early 2025, once Treasury cash reserves are exhausted, debt ceiling concerns may resurface.
Growing US debt is a driver of gold prices: the era of fiscal dominance underlines the importance of gold in a diversified portfolio, as a form of globally-accepted “sound money”.
Edmund Shing, PhD
Global Chief Investment Officer
