Mahir Rasheed: Looking at the situation from a high level, the US economy has weathered the high interest rate environment much better than once feared, and it remains on a solid footing heading into the second quarter. For this, we can thank the US consumer and, more importantly, the historically tight labour market that we've seen for some time.
The unemployment rate remains historically low, and elevated wage growth has also bolstered labour income, which is the main driver of consumer spending and also conducive to healing consumer balance sheets.
Importantly, we also experienced a strong rise in immigration flows last year, which has supported labour supply, and that, in turn, has been supportive of the disinflation process that we've seen up until this point.
"We've long held the view that the Fed would be cautious
in lowering its policy rate this year."
Turning to inflation dynamics more broadly, here too we're seeing price pressures easing in an encouraging fashion, even if the path back to 2% has been bumpy. In our view, we are past the worst bout of inflation for the cycle, but we are still some ways away from reaching the Federal Reserve’s (Fed’s) 2% target.
Looking into the drivers of inflation persistence, it is the service side of the economy that will be of particular focus in the next 12 to 18 months as the labour market remains strong. As wage growth remains sticky, we expect consumer spending to remain resilient in those services components.
Finally, on interest rates, bond yields have remained elevated amid robust growth and sticky inflation. We've long held the view that the Fed would be cautious in lowering its policy rate this year. We've seen market pricing bounce around from 150 basis points (bps) of cuts earlier this year to about 75 now, in line with our expectations with the first cut likely coming around mid-year.
To summarise, the US economy remains on a solid footing as growth remains firm and the job market strong, prompting a cautious Fed that will cut rates at a gradual pace.
Mahir: Our main message to markets for the past six months has been to curb your enthusiasm when it comes to rate cuts.
"Those fears of a wage price spiral where inflation pressures
get out of control have not materialised."
The key difference between this cycle and path-cutting cycles that we've seen has, of course, been the sticky inflation backdrop, and the concern from policymakers that the inflation fight has not yet been won.
An encouraging point has been that inflation expectations remain anchored. Those fears of a wage price spiral where inflation pressures get out of control have not materialised, but at the same time, central bankers – whether it's the Fed or the European Central Bank (ECB) – have also been cautious and done a good job anchoring market expectations on interest rates both on the way up and the way down. The luxury that they've had is that growth, at least in the US, has held up quite well despite the strong increase in interest rates.
Mahir: It’s important to recognise that the US has a unique energy dynamic compared to the Euro area, for example – and that was on display after the Russian invasion of Ukraine where we saw global energy prices shoot up, but the impact on growth was felt much more strongly in the Euro area than the US.
Much of that is due to the US' relative energy independence. Oil production in the US has been continuously rising over the past year, keeping US supply steady while other economies have been more vulnerable to changes in oil output from providers such as OPEC.
"Broad concerns about global economic growth have been
offsetting this bullishness."
We expect to see an ongoing "tug of war" in energy markets this year. On the more bullish side for oil prices, you have low inventories, potential stabilisation in the manufacturing sector, the start of a global policy easing cycle, and geopolitical headwinds centred around Europe and the Middle East, which are all threats to the supply side of the oil market.
However, broad concerns about global economic growth have been offsetting this bullishness, particularly with growth weakness in Europe and China. This will also be reinforced by a gradual slowdown in US growth as the year goes on. We, therefore, expect those downside pressures will limit any sharp increases in oil prices while the bullish tailwinds that I highlighted earlier will also keep a floor under prices.
Mahir: The main sensitivity of the US to global growth conditions is through the trade channel.
Let’s start with Europe. The story there has been one of stagnation over the past year, particularly led by weakness in the manufacturing sector in Germany. However, as the year progresses, we anticipate that stagnation will start to reverse and economic conditions should improve, particularly as inflation comes down in Europe and real incomes support consumer spending. We have an optimistic view for Europe as the year goes on.
Moving on to Asia, there are also interesting dynamics going on there. China has been facing these deep structural headwinds over the past year and will increasingly have to rely on policy interventions to offset these challenges, which include a slumping property sector, weak business and consumer sentiment, and a restructuring of government debt.
Finally, Japan is also going to be a key topic this year. We expect the Bank of Japan to continue steadily moving away from hyper-accommodative monetary policy, but they generally face a very different set of challenges to the US and Europe. While in the US and euro area, we're worried about inflation taking off again, in Japan the concern is that inflation is going to revert below 2%, forcing the Bank of Japan (BoJ) to keep policy accommodative.
In our view, we expect the BoJ will proceed cautiously with rising interest rates and, as a result, the impact on the global financial system will likely be limited. However, as Japan's interest rates gradually start to pick up later this year, it's likely to create a modest tailwind for global bond yields in the US and Europe if we assume some level of repatriation of funds going back into the Japanese bond market.
Mahir: It's still early, so we don't have a ton of information on respective policy platforms, but there are certain things that we do know for sure. To start with, Congress will have to decide on whether to extend the 2017 Trump tax cuts past next year, which will have key implications for the federal deficit - a topic that has received a lot of attention as the government's debt has ballooned in the US.
On that topic of debt, if Biden does win again, we've seen the past few years significant fiscal packages come through – it’s unlikely that we'll see the same magnitude of fiscal policies that were passed in the immediate post-Covid years due to mounting concerns over debt levels in the US.
"We've seen that the Biden administration didn't make
any drastic changes to Trump's immigration policy."
Then there is central bank independence. We've seen that the Biden administration has allowed Jerome Powell and the Fed to do their job while Trump was much more vocal and attempted to put more pressure on the central bank to raise policy rates. That will be a theme worth monitoring.
The final point I'll make is on the border and immigration; we've seen that the Biden administration didn't make any drastic changes to Trump's immigration policy. Yet, there have been concerns over this migrant crisis and border security.
Trump has so far been vocal about his plan to ramp up deportations. Given immigration played a key role in expanding labour supply and lowering inflation in 2023 if we were to see deportations pick up aggressively in 2025 and onwards, we think that that has the risk of making inflation worse again if we start to see labour supply move in the other direction, putting upward pressure on wages.
Mahir: CRE is something we've spent a lot of time looking at and we think it's reasonable to be concerned with segments of the market. However, the stress points are very concentrated, in specific segments of the office space, and ultimately it will take years for these problems to be resolved given both cyclical and structural headwinds. We expect smaller financial institutions will remain vulnerable as refinancing pressures pick up in the coming years. But importantly, how the macro-outlook evolves will be key in deciding what happens with CRE over the coming years.
"Overall, we're optimistic that CRE stresses won't become
a material headwind to the outlook."
If inflation dynamics continue to improve, and the Fed lowers policy rates, it automatically reduces those refinancing pressures. Conversely, if growth remains strong, inflation remains sticky, and policy rates remain high, then we could see the opposite as refinancing pressures become more burdensome, weighing on valuations and pressuring loan books at over-exposed financial institutions like small banks.
Overall, we're optimistic that CRE stresses won't become a material headwind to the outlook. It wouldn't be surprising to see additional small bank failures here and there, but the broader financial system is resilient, and we think policymakers will keep a close eye on developments over the coming years.
