Double Trouble

Kellie Wood | Schroders

Trump 2.0 is inflicting a great deal of volatility into global markets as we enter into 2025. Growth is slowing and inflation is likely to rise with the US Fed trying to strike a balance by keeping cash rates on hold for 2025. There are two key risks that may force the US Fed to act. One is the risk that Trump’s various policies and the overall chaotic environment set off a confidence cascade. The second is that tariffs, coming on the heels of pandemic inflation, result in an entrenchment of high inflation expectations over the longer term.

The data is signalling some early signs that both risks might be materialising and reinforcing each other. There are signs that the consumer is reacting badly to the disorderly environment and the expectations for higher prices which could result in a pull back on spending. At the same time, we are seeing a pickup in long-term inflation expectations consistent with entrenchment.

Our current view is that growth will hold up near term. Consumer sentiment surveys have not been good predictors of short-run economic outcomes in recent years. For example, spending has been extraordinarily strong over the last two years, despite choppy and range-bound sentiment. We tend to think that business confidence is a better lead on economic outcomes, especially as it is business leaders that generally make the cycle-defining decisions on hiring, investment, and inventories. Here, the evidence has been decidedly mixed. US manufacturing posted its highest reading in over two years in February, and small business confidence also jumped after the election. However, the services sector has retrenched for two straight months. The US economy is projected to slow below a 2% pace over the course of 2025 and possibly into the low 1%, as tariffs and immigration restrictions impact growth.

Since the election, we’ve believed that the US Fed would find itself in a trade-off between supporting demand in a growth slowdown and maintaining stable long-term inflation expectations. We think this trade-off is becoming more stark and more imminent. Looking ahead, we will need to see how seriously policymakers are taking risks to long-term inflation credibility, and whether these risks are acting as a constraint. The evolution of the labour market remains key for both the outlook for rates and risk assets. The February jobs report will be a key test of economic resilience after a raft of weak confidence and retail reports to start the year.

Back home, the RBA has joined other advanced economy central banks in easing policy by delivering a 25 basis point (bp) rate cut at the February RBA Board meeting. The RBA is not easing into a weakening economy and so in no hurry to cut rates. Growth is picking up as the pressure on households ease. Labour demand has remained resilient, and the unemployment rate is close to full employment. Inflationary pressures are also easing with underlying inflation expected to be within the target band by mid-2025. It is the moderation in inflation which has enabled the RBA to begin to remove restrictive policy. We expect the cash rate to be lowered gradually with a further 50bps of cuts and a cash rate of 3.6% by the end of 2025. For the RBA, the expected easing cycle could be one of the shallowest seen since the late eighties, with rates staying structurally higher for longer in this new regime.

Every advanced economy is in a different stage of the cycle that is providing opportunities in both rates and credit markets. In Europe, there is a need to pay for the ‘price for peace’ where Germany should ultimately ease fiscal policy to become independent from the US. Tariffs create a short-term growth risk to Europe. However, this should not obscure the significantly more lasting impact on the rates market of a shift in European fiscal policy.

Positioning

Against this backdrop of increasing stagflation risk in the US, we continue to like US rates positions that will perform if growth slows and inflation remains sticky, where the front end of the yield curve remains anchored as the US Fed stays on hold and the slowdown in growth is priced into the long end as bond yields fall. US inflation-linked bonds will also be a strong outperformer in a stagflationary environment, and helps the portfolio hedge against upside inflation risk. Whilst bonds have benefitted from the market moving to price in lower growth, we also see several other developments that are supportive of further bond market performance with the US Fed considering an earlier end to Quantitative Tightening (QT) and US Treasury Secretary Bessent’s explicit exertions that he wants to improve the attractiveness of long-term Treasuries for investors.

With the RBA easing cycle underway, the market is already pricing a cash rate of 3.5% over the next year, which is in line with our expectation of policy easing. Given this pricing, we have taken profit on our long Australian interest rate risk and moved our exposure out to the long end of the yield curve to capture the beta to US rates as the growth slowdown starts to be priced into markets. Across the continent, we have maintained our long positions as Europe still remains a target for tariffs and the risk the European Central Bank (ECB) may have to take cash rates lower to support growth. We have reduced exposure to the back end of European curves with the risk of expansionary fiscal policy resulting in more bond supply to fund this spending.

Credit markets have continued to show resilience to bouts of equity market volatility which we see as warranted given more attractive valuations and stable fundamentals. US credit is where we see the biggest risk of repricing, where spreads are very expensive and vulnerable to a repricing of US exceptionalism. We remain underweight US High Yield and no exposure to US investment grade credit. The US Fed cannot afford to be proactively cutting rates in a world of policy uncertainty and above-target inflation. The unexpected downside may be that higher inflation will bring down growth putting US equities and credit markets at risk. We remain constructive on credit markets in both Australia and Europe where valuations are more supportive and both economies will benefit from policy easing and fiscal support through 2025. Australian and US mortgages remain attractive in a higher for longer environment, offering attractive high quality yield and where we are seeing little signs of credit stress in economies.

Overall, high quality fixed income assets are now becoming a better diversifier of equity risk with growing policy uncertainty and slowing growth. Fixed income is now primed for outperformance both from an absolute and relative perspective vs cash and equities. We continue to access high levels of quality yield across the global fixed income opportunity set in those sectors and regions that have more attractive valuations and a supportive economic cycle.

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All prices and analysis at 10 March 2025.  This document was originally published on Livewire Markets website on 10 March 2025. This information has been prepared by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders). The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer.  This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice.  Past performance is not a reliable indicator of future performance.  Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB.  Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.