Navigating Economic, Fiscal, and Geopolitical Complexity: Opportunities Amidst Resilience and Uncertainty in 2025

Approaching the latter part of the year, the U.S. economy is currently showing signs of "moderate resilience." Projections indicate a GDP growth rate of around 2.2% for 2024, gradually decreasing to about 2% in both 2025 and 2026. These estimates closely match the long-term equilibrium level of 1.8% and demonstrate a low standard deviation, centered around 2.2%. The consistent GDP figures have created a favorable environment for equities and risk assets this year. Furthermore, there has been a noticeable change in inflation patterns; the core Personal Consumption Expenditures (PCE) inflation rate has dropped from an annualized rate of 4.5% in March to just 2.3% by June.

Although there are positive indicators, worrisome trends are emerging in the labor market. The latest data shows a significant decrease, as evidenced by the ISM Employment Index dropping by 5.9 points in July to 43.4, marking its lowest level since June 2020. The employment data for July highlights a general fragility, sparking concerns about a possible self-sustaining downturn. Past trends indicate that economic downturns typically start with a gradual decline in labor market conditions, which may worsen as weakened job sectors result in reduced overall demand and subsequent layoffs.

When considering countries outside the United States, the macroeconomic conditions are not as positive. Europe, especially Germany, is still facing challenges due to the ongoing conflict between Russia and Ukraine, along with slow growth in China. The German economy has entered a period of decline following years of poor performance. Additionally, the European industrial sector, which heavily depends on machinery and luxury products, is falling behind the United States in terms of technological progress and the integration of artificial intelligence.

Emerging market economies are currently encountering difficulties, primarily due to a combination of factors such as China's economic deceleration, the repercussions of the Russia-Ukraine conflict, and the strength of the U.S. dollar. Additionally, ongoing inflation in the United States has limited the Federal Reserve's ability to reduce interest rates, leading many central banks in emerging markets to uphold high policy rates to prevent significant devaluation of their currencies. To illustrate, Brazil's SELIC rate is at 10.5% in contrast to an annual core inflation rate of 3.5%, while Mexico's Banxico has established its policy rate at 11% despite core CPI inflation hovering around 4%. These levels represent notably elevated real interest rates, especially within the context of emerging market economies.

Outlook on Monetary and Fiscal Situation: Actions by the Federal Reserve and European Central Bank

It is expected that the Federal Reserve will initiate a series of interest rate reductions during its upcoming September meeting in response to a situation characterized by slowly decreasing inflation and consistently low but rapidly deteriorating unemployment rates. The Fed has shown a proactive attitude, aiming to lower rates in advance to prevent any undesired slowdown in both economic expansion and job creation. As the U.S. economy starts its easing phase from a fairly strong position, this context is reminiscent of the Fed's strategy during the 1995 easing period. During that period, the Federal Reserve prioritized addressing downside growth risks over solely reducing inflation from a high level. This approach led to a total of 75 basis points in cuts before pausing when economic risks seemed to be balanced. If there are no unexpected economic shocks, the Fed could potentially proceed with implementing quarterly rate reductions totaling 75 bps as indicated in its Summary of Economic Projections. Nevertheless, a quicker and more decisive rate reduction might be considered if the recent rapid deterioration in the labor market continues into July.

Following an initial rate cut in June, the European Central Bank (ECB) decided to keep rates unchanged in July. The ECB's future rate decisions will depend on their quarterly inflation forecasts and progress towards achieving their end-2025 inflation goal. The latest projections indicate a possible additional reduction of 50 basis points by the ECB before the end of the year, making the total for this year 75 basis points.

Regarding the fiscal aspect, the U.S. deficit has decreased by around 15% from the previous year, yet it is still remarkably high despite considerable nominal GDP growth. Any substantial economic downturn could endanger this advancement by reducing tax income and escalating government spending, especially with a growing unemployment rate, potentially causing the deficit to return to double-digit figures. Adding to the complexity is the absence of fiscal restructuring proposals from either of the current presidential contenders, both of whom have refrained from outlining specific strategies to tackle the deficit, leading to limited hope for fiscal enhancement in the immediate future.

Geopolitical Environment and Possible Market Responses

In the midst of significant macroeconomic changes, we are also navigating a highly charged geopolitical landscape. Recent elections in countries like Mexico, South Africa, the UK, and France, as well as the upcoming U.S. presidential race, are exerting a growing influence on market trends. In the U.S., market responses are being shaped by what are known as the “Trump and Harris trades,” reflecting anticipated policies from each candidate. While Harris has not revealed specific policy shifts from the current administration, her record as a Senator suggests a potentially more progressive approach. Despite the lack of a detailed agenda, the market is largely interpreting a Harris presidency as a continuation of the current trajectory.

On the other hand, a Trump administration is expected to bring about significant policy changes in areas such as tax, trade, regulation, and immigration. Trump and his running mate, J.D. Vance, have expressed intentions to pursue substantial reforms. Proposed measures, including tariff increases and immigration reforms, could lead to higher inflation in the short term. This inflationary pressure poses questions about the Federal Reserve's potential responses under a Trump presidency, such as whether to cut rates more aggressively in late 2024 and how to address price increases to prevent inflation expectations from taking hold. As the election outcome remains uncertain, markets are increasingly assessing the potential impact of Trump's policy platform, with estimates indicating a roughly 50% chance of his victory.

Impact of Global Hotspots on Markets

Aside from internal politics, various global geopolitical flashpoints have the potential to influence market stability. In the Middle East, Israel is grappling with escalating conflicts on multiple fronts, such as clashes with Hamas and growing tensions with Iran and Hezbollah. Of particular concern is the risk of further escalation involving Iran, which could unsettle the entire region. Meanwhile, in Asia, a significant but relatively under-the-radar situation is unfolding as tensions mount between the Philippines and China, raising the specter of a broader conflict triggered by the U.S.-Philippines mutual defense pact. This agreement mandates U.S. intervention to protect the Philippines in the event of a Chinese attack, potentially elevating a regional dispute to a global scale.

Given this heightened geopolitical environment, it is crucial to closely monitor these developments and prepare strategic scenarios for potential outcomes. While these scenarios involve uncertainties, anticipating significant downside risks allows for more informed portfolio positioning and can help mitigate the impact of extreme events.

Market Consequences of Recent Macro Events

The mix of steady, almost balanced growth, decreasing inflation, and expected Federal Reserve interest rate cuts has been beneficial for stocks thus far, despite the turbulent start in August. Nonetheless, the increasingly negative labor market data and concerns that the Fed may act too slowly in cutting rates, similar to their delayed rate hikes, are unsettling markets and driving volatility to levels not seen in months. Even prior to the disappointing labor data in July, there were signs of weakness in the market. Notably, there was significant volatility in sector and factor returns. Before the tumultuous events of August, there was a notable shift from large-cap tech stocks to small caps, with the Russell 2000 outperforming the Nasdaq by almost 20% in a two-week span at the end of July. However, a substantial portion of this outperformance was reversed in just three days at the start of August. Until recently, the low VIX levels did not reflect the heightened volatility in individual stocks, which was driven by remarkably low correlations between them.

It is crucial to closely monitor both data and market technicals in the rapidly changing environment we find ourselves in. While the economy remains robust and corporate earnings have been resilient, markets are showing signs of being overextended, potentially leading to sell-offs if data weakens further, especially with the next Fed meeting not until September 18.

There has been a significant shift in Fed rate expectations, with markets now pricing in 110bps of cuts by December. This adjustment is influenced by technical factors and a risk-off induced rates rally. If labor market data continues to deteriorate, the Fed may need to cut rates more than currently anticipated. Looking ahead, the challenge lies in balancing tight monetary policy and a slowing economy against potential inflationary pressures under the Trump administration. Regardless of the outcome, a steepening yield curve seems likely due to record Treasury auctions, potential inflation resurgence, and Fed rate decisions.

Expectations are for the U.S. dollar to rebound and strengthen, except against the yen. Despite the dollar's high valuation, global economic conditions and the USD carry trade provide strong support. While the dollar may initially weaken at the start of easing cycles, it could reverse as other central banks follow suit. The dollar also serves as a hedge against equity weakness and geopolitical shocks. Trump's policies are generally dollar-positive, with monetary policy, trade policy, and geopolitical events being key drivers of currency movements.

An Environment Full of Opportunities Despite its Complexity

Remembering a time as intriguing as the current macro environment is challenging. The economic landscape is currently marked by a combination of moderated growth, decreasing inflation, and intricate geopolitical elements. Although the future looks promising for stocks due to expected monetary easing and a robust U.S. dollar, it is crucial not to overlook potential risks arising from labor market weaknesses and global macroeconomic uncertainties. Investors need to carefully navigate these changes, maintaining a balance between optimism and caution as economic and policy conditions evolve. The convergence of these factors creates a complex yet opportunity-filled environment, requiring strategic vision and flexibility in investment strategies.