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Investment outlook
The economy and markets
Section 3: The economy and markets
Key points to know
The home stretch can be a winner
Unlike a typical contest of speed, the economic race against recession has no pre-determined finish line. The shortest expansion in post-war U.S. history lasted just 12 months, from 1980 to 1981. The expansion that ended with the pandemic recession lasted a record 128 months. Since the last recession in April 2020, the U.S. economy has raced forward at an impressive pace. Spectators should now ask: Is the finish line approaching or is there ample runway? And what should we do about it?
We think a mild recession in 2025 is the base case for the U.S. and global economies. That means we’re in the final stretch of the expansion, but it’s still too early for investors to position aggressively for a risk-off scenario. Historically, equity markets have rallied until just two months before the onset of recession (Figure 2). While the economy is likely in the home stretch, the current macro environment warrants a healthy degree of risk exposure.
Labor market cracks are deepening
As tight policy continues to bite, U.S. labor market cracks grow deeper and wider. Already, the pace of job creation has dropped below its pre-Covid trend, with unemployment also ticking higher. Part of the increase is due to positive, supply side dynamics, with prime-age labor force participation touching its highest level in more than 20 years. But it also reflects a negative deterioration in demand for labor. Hiring has slowed, and more people are spending longer periods of time unemployed. Some of the best leading indicators for future labor market conditions have softened, including the number of job openings and the rate at which people voluntarily leave their jobs. We expect unemployment to move higher in the quarters ahead, weighing on overall growth.
Moving past inflation fears
Overall core inflation is approaching the Fed’s 2% target on a three-month annualized basis due to several dynamics. First, tight policy has put loosening pressure on the labor market. Wage inflation peaked around a 6% annualized rate and has now declined to around 4%, leading to softer core services prices. Second, though housing continues to run at an above-target pace, it has moderated substantially during this year, and leading indicators point to further improvements. Third, global growth has softened overall, with Europe expanding around 0.5% year-over-year and China posting its weakest growth since the 1990s (excluding the Covid-era lockdown). Finally, while geopolitical concerns remain a risk, they have not escalated in recent months, allowing global shipping prices to quietly drop around 40% from their December peak.
While the economy is likely in the home stretch, the current macro environment warrants a healthy degree of risk exposure.
A gradual, not rapid move for the Fed
With growth softening, inflation approaching target and recession risks rising, it makes sense that the Fed started cutting interest rates. However, markets may be too optimistic about future rate cuts, even after the strong 50 bps cut to start the cycle. Fed officials have indicated a preference to move steadily, which means they will likely cut 25 bps per meeting, while retaining the flexibility to accelerate or pause cuts. This allows time to gauge the impact of rate cuts as the central bank moves toward a neutral policy stance of around 3.25% to 3.50%. We expect the Fed to eventually get back to that level in the middle of next year.
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All market and economic data from Bloomberg, FactSet and Morningstar.
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