Monday Digest

Posted 16 December 2024

The Tatton Outlook 2025 – Overview

Donald Trump is the ‘known unknown’ for 2025, and the range of possible market outcomes is wide. Markets are predicting US outperformance, thanks to pro-growth domestic policies and anti-global trade policies. Economists are less certain. ‘America first’ is a plausible story, but we worry this underplays US risks and potential non-US benefits. Short-term US outperformance is likely, but the outlook is clouded beyond that.

Tariffs are the biggest threat to global trade. The consensus is that the figures Trump has thrown around are negotiating tactics, but anything close to them would dwarf Trump’s first-term levies and depress global trade flows. That could actually be disinflationary in the short-term, as shipping costs fall and businesses work through inventories built up ahead of tariff imposition.

Europe and China are weak, due to the global manufacturing recession caused by Chinese overproduction. Europe’s problems are compounded by high energy costs and, recently, political instability. These problems could continue in early 2025 but improve thereafter. Beijing will support its domestic economy and the ECB will be more accommodative than most.

Global economic divergence will intensify, thanks to Trump’s tariffs. This could push up the dollar and possibly hasten the use of other currencies (like China’s renminbi) in trade. Bond investors will likely prefer more stable policy regimes and, despite recent upheaval, underlying debt dynamics favour Europe over the US.

Markets think divergence will just mean US exceptionalism, but it could go the other way if the Fed has to have tighter policy than others and the dollar is too expensive to use. This isn’t bad for investors, just uncertain. There are risks and rewards to be found across most regions and asset classes. Diversification is crucial in 2025.

Regional breakdown

The US is strong but has more risks than markets seem to appreciate. Key to watch is the sequencing of Trump’s policy implementation, how the Fed will respond and whether foreign governments retaliate. A more aggressive Fed could undermine Trump’s pro-growth plans and set up a nasty fight over central bank independence, while China could respond with its own tariffs or by withholding key materials. Markets are taking a very positive view about how these will play out and they might be right. But if any of those factors go wrong, US assets could be volatile.

Europe is in a very weak period, but its potential upside is arguably being ignored due to political turmoil. The collapse of the French and German governments has thrust the ECB into economic crisis leadership once again, and it is expected to cut rates more sharply than elsewhere. Businesses need cheaper energy, which could come from easing Russian tensions, while elections might deliver better results than expected. Markets are pessimistic on Europe, when they should be realistic.

China might be coming out of the doldrums, but questions about government effectiveness and US tariffs remain. Beijing is seriously stimulating the economy, but not with the ‘bazooka’ of previous eras. Tariffs would undermine the benefit to Chinese stocks – which will likely remain volatile. China’s biggest impacts could come from its own tariffs or trade barriers in response to Washington.

The UK could benefit from international investment flows. The government is perceived as stable compared to European turmoil, which could benefit bonds. The BoE is more hawkish, though, which doesn’t make sense given the similar inflation pressures for the UK and Europe. Either more inflation is incoming, or the BoE should get more dovish.

Japan is seeing structural improvements to corporate profits. This, combined with a fundamentally cheap yen, makes it a good long-term play. Politics could be a stumbling block after the government lost its majority, but the profit fundamentals are strong.

Emerging Markets could suffer from Trump’s tariffs, but stronger Chinese demand could help. Latin America thought it would benefit from “friendshoring”, but Trump now wants to undo his previous trade agreements. Energy producers could struggle as the US produces more, but metals producers could benefit from rebounding Chinese demand.

Asset classes

Bonds will react to interest rate expectations, which slope down everywhere except Japan. Eurozone rates are expected to fall hardest, reflecting weak European growth. The projected trough for UK rates – 3.5% in 2026 – is significantly higher than Europe, despite similar inflation prospects. That could give the BoE greater scope to cut rates and, since UK yields have stayed higher than elsewhere this year, that could make UK bonds one of the better markets in 2025.

In general, risk perceptions of government bonds have increased this year. But recent signals of tighter fiscal policy have caused buying of long-dated bonds, which could continue into next year. Corporate bonds look expensive – but that’s really about increased riskiness of government bonds. It’s a good sign that European corporate credit isn’t distressed. US corporate credit is healthy – but corporate yields could go up if there’s mergers and acquisitions next year, as you would expect in a pro-growth environment.

Equities look well supported in 2025, with significant regional dispersion, driven by economic prospects rather than central bank policy. US stocks are expected to fare better, but we think this might be underrating US risks and non-US benefits. Positivity is still focussed on big US tech stocks – and Google’s quantum chip announcement stock surge last week showed that the AI investment theme still has momentum.

We wonder how long AI can promise future productivity without delivering it across the broad economy. No one doubts the power of technology, but when the hype is this huge, results have to come fast. 2025 might be the year investors demand those results. US tech giants service sector profits might also be vulnerable to trade wars if global policymakers retaliate against Trump tariffs.

Stocks outside the US are cheaper, but provide less profit growth. Chinese stocks keep bouncing around in response to whether or not markets like the government’s latest announcement. Despite that volatility, domestic economic momentum is building – but that has to be traded off against potential tariffs.