U.S. economic resilience not driven by Fed policy

Against the backdrop of restrictive monetary policy, the U.S. economy has had the favourable combination of strong real GDP growth, loosening of overly tight labour markets, and falling inflation. It may be tempting to attribute this good fortune to a ”soft landing” engineered by the Fed. However, a closer look suggests that this interpretation may be insufficient.

Rather, continued U.S. robustness may owe more to fortuitous supply-side factors, including higher productivity growth and a surge in available labour. Higher output and lower inflation can generally coexist only when the supply-side forces are in the driver’s seat. These dynamics have altered our baseline U.S. economic outlook and point to the primary risks on the horizon.

While these positive supply-side drivers of growth may continue in 2025, emerging policy risks such as the implementation of trade tariffs and stricter immigration policies may offset gains. Under such a scenario, U.S. real GDP growth would cool from its present rate of around 3% to closer to 2%. These offsetting policy risks may also increase inflationary pressures. Therefore, we anticipate that core inflation will remain above 2.5% for most of 2025. Although we expect the Fed to reduce its policy rate to 4%, cuts beyond that would prove difficult as any weakening of growth would have to be weighed against a potential inflation revival.

Economies outside of the United States have been less lucky on the supply side, and thus unable to achieve the same combination of strong growth alongside significantly reduced inflation. While inflation is now close to target in the euro area, that has come at the price of stagnation in 2023 and 2024, with muted external demand, weak productivity, and the lingering effects of the energy crisis holding activity back. Growth is expected to remain below trend next year, as a slowdown in global trade represents a key risk. Expect the European Central Bank to cut rates below neutral, to 1.75%, by the end of 2025.

In China, policymakers still have work to do despite their coordinated policy pivot in late 2024. Growth should pick up in the coming quarters as financing conditions ease and fiscal stimulus measures kick in. But more decisive and aggressive measures are needed to overcome intensifying external headwinds, structural issues in the property sector, and weak confidence in both the household and business sectors. We maintain our weaker-than-consensus secular view on Chinese growth, and thus expect additional monetary and fiscal loosening in 2025.

Era of sound money lives on, with a new point of tension emerging

Although central banks are now easing monetary policy, we maintain our view that policy rates will settle at higher levels than in the 2010s. This environment sets the foundation for solid cash and fixed income returns over the next decade, but the equity view is more cautious. This structural theme holds even in a scenario where central banks briefly cut rates below neutral to allay temporary growth wobbles. The era of sound money—characterised by positive real interest rates—lives on.

The investment challenge is a growing point of tension in risk assets between momentum and overvaluation. Assets with the strongest fundamentals have the most stretched relative valuations, and vice versa. The economic and policy risks for 2025 will help determine whether momentum or valuations dominate investment returns in the coming year.

Balance of risks favours bonds

Higher starting yields have greatly improved the risk-return tradeoff in fixed income. Bonds are still back. Over the next decade and hedged into Canadian Dollar, we expect 3.2-4.2% annualised returns for U.S. bonds and 3.1%-4.1% for global ex-U.S. bonds. This view reflects a gradual normalisation in policy rates and yield curves, though important near-term risks remain.

We believe that yields across the curve are likely to remain above 4% in the U.S. A scenario where supply-side tailwinds persist will be supportive for trend growth and thus real rates. Alternatively, the emerging risks related to global trade and immigration policies would also keep rates high due to increased inflation expectations. These risks must be balanced with the possibility that a growth shock, and any associated monetary easing or “flight to safety,” would cause yields to fall meaningfully from current levels.

Higher starting yields, which imply a “coupon wall,” mean that future bond returns are less exposed to modest increases in yields. In fact, for investors with the time horizon to see coupon payments catch up, interest rates that rise further would improve their total returns despite some near-term pain. We continue to believe fixed income plays an important role as a ballast in long-term portfolios. The greatest downside risk to bonds also pertains to stocks—namely, a rise in long-term rates due to continued fiscal-deficit spending or removal of supply-side support. These are the dynamics we are most closely monitoring.

Rational or irrational exuberance: Only time will tell

U.S. equities have generally delivered strong returns in recent years. 2024 was no exception, with both earnings growth and price/earnings ratios exceeding expectations. The key question for investors is, “What happens next?”

In our view, U.S. valuations are elevated but not as stretched as traditional metrics imply. Despite higher interest rates, many large corporations insulated themselves from tighter monetary policy by locking in low financing costs ahead of time. And more importantly, the market has been increasingly concentrated toward growth-oriented sectors, such as technology, that support higher valuations.

Nevertheless, the likelihood that we are in the midst of a valuation-supporting productivity boom, akin to the mid-1990s, must be balanced with the possibility that the current environment may be more analogous to 1999. In the latter scenario, a negative economic development could expose the vulnerability of current stock market valuations.

While the median of our U.S. return outlook over the next decade at 1.6%-3.6% appears cautious, the range of possible outcomes is wide and valuations are rarely a good timing tool. Ultimately, high starting valuations will drag long-term returns down. But history shows that, absent an economic or earnings growth shock, U.S. equity market returns can continue to defy their valuation gravity in the near term.

Valuations of non-U.S. equity markets are more attractive. We suspect this could continue as these economies are likely to be most exposed to rising global economic and policy risks. Differences in long-term price/earnings ratios are the biggest driver of relative returns over five-plus years. Over the next decade, we expect developed markets ex-U.S. equities and emerging market equities to return 6.0%-8.0% and 4.0%-6.0%, respectively. However, economic growth and profits matter more over shorter horizons. Over the past few years, persistently lacklustre growth in the economies and earnings outside of the U.S. kept global ex-U.S. equity returns lukewarm relative to the remarkable return in the U.S. market. Within emerging markets, China is the sole reason valuations are below fair value, but the risks of rising trade tensions and insufficient fiscal stimulus in China pose additional headwinds.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modelled asset class. Simulations as of November 8, 2024. Results from the model may vary with each use and over time. For more information, please see the Notes section.