Twilight zone: how to interpret today’s uncertain macro picture

It is so easy to get lost in the weekly market gyrations and constant flow of headlines, but it is worth taking a step back and looking at the bigger macro picture. And that broader perspective suggests that we are currently in a “twilight zone”, caught between two conflicting world views: 

• a dominant market and policy narrative that more stimulus is needed; and
• the actual data pointing to a mature but still robust cycle. 

While the prevailing narrative supports high nominal growth and therefore risk assets, it comes at a price. And the longer it goes on, the greater the risk of a sudden reversal as reality gains the upper hand and markets start questioning the impact of the current stimulus on government debt sustainability. 

A stimulus too far?

All central banks are cutting rates or are expected to do so in the near term. The only market debate is how fast and by how much. Moreover, most major countries are loosening fiscal policy. And, yet as we discussed in our mid-year outlook, more stimulus may not be what the world needs right now, given:

• Substantial private spending growth — Nominal private sector spending in developed markets is growing at its fastest pace in 20 years, leaving aside the anomalous spike that followed the reopening of the economy after the COVID lockdown.
• Stubbornly high inflation — While nominal growth is still booming, it may not feel like that because so much of that nominal growth reflects high inflation. In fact, global inflation rates are the highest they’ve been in 30 years, outside of the COVID pandemic period, and appear to be troughing at these elevated levels.
• Historically high employment — The average unemployment rate across developed market economies remains close to historic lows, suggesting limited slack in the global economy. And, typically, slack is what’s required to stabilise inflation.
• Deglobalisation — Growing divergence with greater trade barriers, fragmenting supply chains and reduced immigration is the hallmark of the new economic era. This reversal of the very forces that have kept inflation low coincides with stalling productivity and the growing impact of a rapidly ageing population.

Could AI and deregulation provide a counterbalance? 

Yes, the world could be “saved” by the rapid investment in AI and a wave of deregulation as both have the potential to raise productivity and give the cycle longevity. There are tentative signs that AI may lead to a rapid improvement in productivity, but it is also likely that some of the capital flowing into AI may be misallocated or that near-term gains may be overhyped. Likewise, deregulation can boost productivity by removing unnecessary hurdles, but we should not discount the risk of unintended consequences that are ultimately negative for productivity. At the same time, the opposing forces of ageing demographics, reduced migration and deglobalisation are gathering pace. It is impossible to tell what the net timing and net impact of these countervailing forces will be.

What we know, however, is that neither fiscal nor monetary policy appears to be overly tight. Yet, interest rates globally are still coming down while governments are conducting the largest and most coordinated fiscal loosening outside COVID since 2010, when global unemployment was double today’s rate and inflation was less than 1%. 

Good for risk assets, but only up to a point

Tariffs are certainly causing macro volatility but ultimately equate to a relative growth shock with differing impacts between countries and segments of the economy. With all large countries loosening policy into still tight labour markets, high nominal growth (and inflation) is likely to stay and that should remain a good environment for risk assets. 

However, inflation-led growth does not constitute a “Goldilocks” scenario as it eventually will necessitate higher rates, especially as governments have failed to let high inflation erode their debts and keep building up deficits. At some point, bond markets will demand higher compensation for this profligate policy. It could also mean that yield curves keep steepening from here. 

Be ready to pivot

There is the distinct possibility that markets move abruptly out of today’s twilight zone and push government bond yields to levels that were unthinkable a few years ago, with major implications for all risk assets. Today, investors can take advantage of the favourable environment for risk assets. However, they may also want to consider preparing their portfolios for a very different environment, by optimising diversification and ensuring they have built in the necessary flexibility to respond to the associated risks and opportunities.