Sticky inflation concerns that set the tone during most of the first half of the year are now well behind, replaced by greater confidence among investors that the Federal Reserve will lower interest rates starting in September. Incoming growth figures, particularly in the U.S., but also from Europe and China, are surprising to the downside. Prospects of weaker economic activity, however, have yet to morph into recession fears that could dent risk sentiment. On top of these macro crosscurrents, markets will have to grapple with U.S. election noise – one of the defining events of the second half of the year for global markets. The election’s scenarios, potential policy paths, and implications for markets became the main subject of the latest Global Strategy Meeting discussion.
Risk-on into the election
The debate began by highlighting the shift in the global investment narrative towards a more supportive risk-on environment. Over the past couple months, particularly in recent weeks, investors decidedly shelved their concerns over stubborn inflation and higher-for-longer rates. While market pricing for U.S. rate cuts has been roughly stable since mid-April – at around 1.5 to 2 quarter-point cuts by year-end – only recently did investors assign a nearly 100% probability to a September move. This greater confidence that rate cuts are on the way, the speakers agreed, has been a powerful driver of the surge in stocks – including small capitalization companies that until recently were underperforming – to record highs and modest gains in global bonds.
On the growth front, signs that activity is losing momentum are mounting with global economic surprises running at the most negative level since mid-2023. The downside surprises are most pronounced in the U.S., but in Europe and China they are also drifting lower (see Figure 1). The debate yielded a few observations, principally that with disinflation now more firmly established, growth trends need close monitoring. In the U.S., the recent downshift is not morphing into recession fears, which in turn likely reflects its stronger starting point – full employment, expansionary fiscal stance, and easier financial conditions – and the impact of some temporary factors like inventory swings in recent months. China appears to be willing to provide just enough stimulus to prevent any major downside. Growth estimates for the rest of emerging markets (“EM”), meanwhile, are still creeping up.
Last and more relevant for asset prices, markets today appear to be paying more attention to the additional space for rate cuts provided by the growth slowdown. In other words, markets are taking comfort in rising probabilities of monetary easing while, at least for now, putting growth concerns aside. One speaker noted that shifts in cross-asset correlations suggest that the focus may be slowly transitioning towards growth. The critical question is if at some point the U.S. slowdown (if it persists and absent offsets from Europe or China) begins to raise tail risks to global growth.
Election: noise, signal, uncertainty?
Speakers agreed that the November 5 election is shaping up to be the critical event risk for markets in the second half of the year. And recent electoral surprises in major emerging economies are a reminder that elections matter: India and South Africa strengthened on optimism about reform continuity, while Mexican assets keep struggling on concerns over new initiatives that could undermine future investments (see TRG Macro Mosaic - July 8, 2024). Historical evidence, based on volatility and news-based indices of uncertainty, suggests that markets tend to pay attention to the U.S. election starting in September (see Figure 2).
Participants discussed potential policies under four election outcomes: control of the executive and both houses of congress by either party, plus two scenarios of divided government. First, the scenarios yielded a wide spectrum of fiscal outcomes, ranging from a tax and spend approach to an extension of tax cuts without offsets. All cases would leave the U.S. on an unsustainable path, as none of the candidates are considering much-needed entitlement reforms. This suggests that a return of fiscal jitters is only a matter of time (see Figure 3). The last time U.S. fiscal concerns took hold (from August to October of last year), they triggered a global sell-off in stocks and bonds. We believe the two scenarios involving a party shift in the White House are more challenging for EM because of the risk of renewed tariffs and other trade barriers – both trade and immigration policies can be implemented through executive order. Countries like Mexico, Taiwan, and Korea are most exposed because of their direct trade links to the U.S.; participants argued that tariffs, even if more narrowly directed to China, could lead to more generalized pressure on markets.
The last part of the exchange touched on the interaction between uncertainty and asset prices. Specifically, some portfolio managers thought that the “Fed put” is back in full force, which could support risk sentiment even as the election moves closer – a variation of the current dynamic of optimism about Fed easing trumping signs of economic deceleration. Others pushed back, arguing that many assets are already taking a lot of credit for Fed easing, a “soft landing” scenario, and the global export recovery; the risk of tariffs, by contrast, did not seem to be in the price. Even as post-debate polls and online betting odds increasingly favor the Republican candidate, most speakers agreed that a lot can still happen between now and November – consistent with the mixed track record of some popular “Republican” trades so far (like a bear steepening of the U.S. yield curve or long oil and gas companies). As uncertainty rises, portfolio managers once again stressed the importance of selectivity, including positioning in names offering valuation cushion with exposure to secular themes (TRG Macro Mosaic - February 29, 2024).
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