“Interplay between economic optimism and macro risks should keep investors on alert”

Marco

The recent elections have injected a wave of optimism into US markets. Investor sentiment remains buoyant, reflecting confidence in the economy’s resilience. Persistently high equity valuations underscore this positivity, but a cautious approach is warranted as inflation and labor data are likely to be an area of focus for the first quarter of next year. While a seasonal year-end rally is typical, the interplay between economic optimism and macro risks should keep investors on alert.

President-elect Trump’s proposed policies signal a structural shift in inflation expectations. Tariffs on Chinese imports and tightened immigration rules could drive up costs across supply chains and labor markets, potentially anchoring a higher long-term core inflation rate. Early signs of corporate adaptation include record-high import volumes at the Port of Long Beach and an uptick in average hourly earnings, suggesting companies are preparing for tighter labor conditions. These inflationary pressures also support a stronger dollar, with implications for global asset flows and US competitiveness.

US consumers remain a vital pillar of economic stability, giving the Federal Reserve room to maintain higher interest rates for longer. September retail sales data indicate stable growth across consumption categories, echoing patterns seen in late 2022 and early 2023 when high personal savings buoyed spending. This resilience further reinforces the Fed’s capacity to combat inflation while supporting broader economic activity.

As we enter 2025, investors must adapt to a higher baseline for inflation and prolonged elevated interest rates. The return of inflationary policies, coupled with a resilient consumer backdrop, presents both risks and opportunities. Emphasising inflation-resistant assets and reassessing traditional equity exposures will be critical in navigating the year ahead.

Fixed Income

Firm US core CPI suggests the upcoming core PCE print may be elevated, risking a more hawkish December FOMC decision and in the near term reinforcing upward momentum of Treasury yields. Data flow continues to indicate the US economy remains resilient, with labour markets appearing less vulnerable to a sharp loosening. The new administration is likely to announce tariff measures soon after the January inauguration, potentially boosting core inflation. An extension or expansion of tax cuts would lead to a further deterioration in the fiscal outlook. Markets appear pricing these risks to a partial extent only. We are inclined to reduce duration of bond portfolios.

Among Asia-Pacific banks, Australia and Hong Kong Tier 2 screen as the few segments which still offer attractive spreads, both on an outright basis and on a multiple relative to Additional Tier 1 securities. The multiple between Australia bank AT1 / T2 spreads has fallen to 1.2x from the average of the last 12 months at 1.5x, while the multiple for Hong Kong bank AT1 / T2 spreads has compressed heavily to 1.3x from the 12-month average of 2.1x. Fundamentals remain sound, with improved deposit funding profiles, ample capital ratios and steeper rates curves feeding into NII expansion, while NPL exposure is manageable. We are inclined to Position in Australia bank and Hong Kong bank Tier 2s.

The China property HY 2024 year-to-date default rate has reached ~48%. The high defaults occurring so far this year reflects a variety of credit events i.e. payment default from performing names (e.g. Agile), bond exchange (e.g. Road King), and payment default from issuers that had earlier conducted bond exchanges (e.g. Guangzhou R&F). This brings to 92% the cumulative notional amount of China property HY and non-rated bonds that have either defaulted or conducted distressed exchanges. Meanwhile, new home sales appear to have temporarily bottomed out in October with a 5% increase year-on-year, which coincides with a month-on-month pickup in land buying by the top 100 developers. Nine of the top 10 land buyers were state-owned developers, and 6 have links with the central government. This suggests stresses among private sector developers likely continue to emerge. Therefore, we are inclined to maintain up in quality positioning within China property credit until firmer signs of broad-based recovery for the sector.

Land Buying by China Top 100 Developers Picked Up in October

Source: Bloomberg Finance L.P.

Equities

We believe the U.S. is poised to deliver stronger growth compared to other developed economies. This view is reinforced by the latest earnings season, where valuations remain well-supported by robust corporate performance. However, a key concern for many investors centres around the inflationary nature of policy proposals from the Trump administration. If implemented, these measures could strain U.S. consumers and limit the Federal Reserve’s flexibility to ease monetary policy, potentially creating headwinds for equity markets.

That said, we believe there are reasons for optimism that inflationary pressures may turn out to be milder than expected. For one, the implementation of high inflationary tariffs remains uncertain. These proposals may serve more as a negotiation tactics than actual policy, as the Trump administration may have less leverage compared to his prior trade negotiations. The current macroeconomic environment is also significantly different from 2018, with higher core inflation and 30-year mortgage rates. This leaves less room for aggressive policy actions without risking further pressure on U.S. consumers, suggesting a more cautious approach may prevail. Second, when tariffs are imposed on goods, their impact on prices is typically a one-time adjustment, unless there is retaliation or a continued escalation of tariffs. All else equal, once a one-time tariff is implemented, after a month or a year, the rate of comparison will again be zero. Third, history shows that prices often normalize over time. One real-world example is the washing-machine that occurred back in January 2018. The administration had imposed tariffs of 20% – 50% on large residential washing machines. After a brief surge in prices in Jan 2018, consumer prices on these goods fell, and tariffs had no noticeable effect longer term.

In addition, there is a notable predictive relationship between the U.S. job quits rate (shifted nine months forward) and trends in wage growth (measured by the 3-month moving average of nominal wage growth). Currently, the U.S. job quits rate—an indicator of worker confidence and mobility—is declining. This suggests that wage growth could fall below 4% in the coming months. Such a development would likely ease inflationary pressures, aligning with the potential for the Federal Reserve to adopt a more accommodative policy stance.

As for S&P 500 valuations and returns, the overall index is trading near its 3-year historical price-to-earnings (P/E) average. Most sectors are similarly aligned with historical P/E levels, including technology and communication services, where we maintain a positive outlook due to secular growth themes and strong earnings prospects. One sector that stands out as a laggard is industrials, which includes companies trading at a discount compared to historical averages. As market leadership broadens, the industrial sector presents an opportunity for greater upside potential and diversification. Moreover, the industrial manufacturing sector is positioned to be one of the key beneficiaries of a potential corporate tax cut, further bolstering its attractiveness.

A significant component of Trump’s campaign promises involves the extension of provisions under the 2017 Tax Cuts and Jobs Act (TCJA). While S&P 500 companies as a whole generate roughly 60% of their revenue domestically, small- and mid-cap companies, as well as value-style investments, derive an even greater proportion from U.S. economic activity. As a result, these smaller cap companies are positioned to benefit more from stronger domestic growth and potential reductions in tax rates. Moreover, they currently trade at more attractive valuations and are expected to experience greater earnings acceleration in the months ahead, further enhancing their appeal.