- Speaker #0
Welcome to this AXA IAM podcast brought to you by the Investment Institute with myself Herschel Pant, AXA IAM's Chief Economist, Gilles Moec, and the Chairman of AXA IAM's Investment Institute, Chris Iggo. There is no escaping the fact that in the build-up to 5th November, eyes around the world are focused on the US. But beyond the elections, what impact does the US have on the rest of the world? Does the US cold really become a global flu? Today we are going to drill down a bit from a macro and investment perspective with special references to the impact of central banks including the Federal Reserve. Gilles, do you want to kick us off, please?
- Speaker #1
Yes, of course. Hello, everyone. I will start with the Fed because irrespective of who becomes president of the United States in November, we're still dealing with quite a thorny issue on that front. In the second half of 2023, GDP growth in the US was running at roughly twice what is the received potential base. So very, very strong US economy. despite quite a significant amount of monetary tightening. And it should not be too surprising that in this sort of configuration, inflation doesn't slow down as fast as what we were all expecting, what the Fed actually was expecting. So we can now see that maybe there's the beginning of a softening in the US economy. Q1 GDP was disappointing, even if it was still positive. But the acquired speed of the US economy is so high that inflation is trouble, completely normalizing. There has been progress, but we're still far from 2%. While we're dealing with a situation where the market was expecting a significant quantum of monetary loosening by the Fed starting in March of this year, obviously we already know that it didn't happen. And we now expect only two cuts by the Fed starting in September. And the talk of town is the possibility, which I think is remote but not zero, that actually the Fed will be unable to cut at all in 2024. And that obviously is taking everyone by surprise. And the question that everyone has to answer outside of the US is, do I align myself to what the Fed is going to do, or do I decide to diverge? My guess is that we have quite a bit of divergence. I'm pretty convinced that the ECB, for instance, is still going to cut in June, despite the Fed not moving. But this is already having quite a significant impact on the exchange rate. Japan, for instance, is finding itself in a complicated position right now on its exchange rate side. So that is irrespective of whoever becomes president. And then we have the presidential elections. What we learned from the first mandate of Donald Trump is that we have to take seriously what he says. And what he says on trade in particular is extraordinarily simple and easy to understand. He wants to slap a 10% tariff on everything that moves, imports that come from anywhere in the world. To give you a sense of what it means, the current average tariff in the US is at about 3%. So we're talking about more than a tripling of the tariff. And China would have specific treatment, 60%. Obviously, everyone told him, well, if you do that, you're going to end up with a massive inflationary shock, which is going to deteriorate purchasing power for US consumers. And he said, well, it's not a problem because I'm going to slap a tax cut on top of the tariffs to alleviate the impact on purchasing power. If you're the central bank, I always come back to the central bank. and you're told, well, we're going to have more inflation because we have tariffs. On top of that, it's going to be accommodated by an even more expansionary fiscal policy. Do you want to cut rates? The answer is probably no. So, and again, I will finish on this. If you're in Europe or in China, and you're told, well, it's going to be harder to export to the United States, And on top of everything else, the Fed is not cutting. So long-term interest rates on the US market remains high, much higher than what we thought. You find yourself squeezed, you find yourself cornered. You have the direct hit of the tariffs, plus the fact that most of the time when interest rates remain high in the US, that tends to have some contagion effects for the entirety of the market in the global economy. So, yeah, I mean... we are in a complicated, potentially thorny situation.
- Speaker #0
And Chris, perhaps going to you, how is that impacted in terms of investments, both from a... political and the elections that are coming up and wider macroeconomic stuff that Gilles mentioned.
- Speaker #2
Yeah well the economic backdrop is being you know clearly characterized there by Gilles and if you translate that into markets it's positive for equities because of the growth. side of things. And it's been a little bit negative for bond markets for fixed income investors because there's been this pretty significant revision to interest rate expectations, which has caused yields to go up across the whole of the yield curve. And for the more longer duration, more interest rate sensitive parts of the bond market, that's translated again into negative returns in early 2024. And I don't really see this situation changing too much. If you're focused on the equity markets, the economy that's growing quite strongly, and because of the inflation backdrop, companies still have some pricing power, that should translate into continued growth in profits. And indeed, the consensus forecast for earnings per share for the S&P 500 this year is for something like 12% growth. I think that's achievable. and it should sustain very positive equity returns. On the bond side, if we're at the peak of rates and if they stay where they are for some time, that's not necessarily bad news looking forward because it means the bond market gives you a higher yield. Therefore, it can give you higher income into a fixed income portfolio. so if you're managing a balanced fund with equity and fixed income exposure it's still a pretty good outlook i think for the us clearly what happens with the fed is important what happens with the election and the fiscal policy choices that are made after the election will be important as well but investors are not likely to really adjust their portfolios meaningfully until there's more clarity on what those policy choices will be
- Speaker #0
with regional alignment, what's the market pricing in right now?
- Speaker #2
We've known for a number of years now that what's driving US policymaking is this attempt to reduce reliance on China. And this goes to... aspects of the Inflation Reduction Act and other policies that the Biden administration have put in place. But it also goes to this desire to make sure that the US maintains its global leadership position in technology. And with artificial intelligence getting a lot of news over the last year or so, this is extremely important for America. And it creates lots of investment opportunities in the US. But it also has global repercussions. We're seeing supply chains being readjusted. We're seeing foreign direct investment flows being driven by this anywhere but China kind of theme, Japan being a beneficiary of that in the last year or so. So, you know, the economic trends, the investment opportunities do to some extent reflect these geopolitical big picture themes. And I think that will... you know, that could even be accentuated under the next administration.
- Speaker #0
Gilles, is there any incentive to align with the US if political alignment is not there?
- Speaker #1
I think the problem for Europe is going to be how to potentially deal with the extension of the trade war to European products, because we haven't really had to deal with it the last time he was president. By the way, we seem to assume that it's going to be elected. It's not yet necessarily the outcome. During the first trade war, it was really directed at China. There were some threats to Europe, but it was very contained. This time, this idea of the sort of 10% universal tariff, Europe is definitely also in the crosshair. So we will need to make decisions. And this is where economic theory can tell you some very counterintuitive stuff. Economic theory tells you, you should not retaliate. Because down the road, who pays the price for protectionism? It's the consumer of the country which engages in protectionism, which pays the price. Obviously, it's bad for exporters in the rest of the world. But ultimately, it's the consumer who pays the tariff. A tariff is a tax. It's another way of taxing consumption.
- Speaker #2
So in theory,
- Speaker #1
if Europe is faced with tariffs in the US, you should... take it on the chin really and say, okay, it's bad for my exporters, but if I retaliate, what I'm going to do is that I'm going to engage in sort of war, which will cost my consumers. as well as my producers. So you probably don't necessarily want to engage. The problem there is game theory. It's that if you do not respond at all, if you don't retaliate, the message you send to the rest of the world is that you can slap any kind of tariff on the European product. These guys are never going to respond. It's really thorny. So you might end up being forced into some measure of retaliation, but retaliation is not about creating a level playing field. I guess it's the way it would be sold politically to public opinion. In reality, what you do is that you accept some pain because you don't want to create more incentive for others to engage in RF hikes. It's definitely an uncomfortable position to be in.
- Speaker #0
And how are clients reacting? Chris, perhaps to you first around these challenges.
- Speaker #2
Clients have gone through a lot in the last three years. We've had COVID, we've had the energy shock, we've had higher interest rates, and all of these things have impacted meaningfully on investment returns. So there isn't a lot of conviction out there amongst clients. There are a number of things. First of all, interest rates. are still relatively high. And as we've discussed already, in the US are likely to stay high for some time. Secondly, you know, there has been uncertainty about how economies would respond to the monetary tightening. And it's only really in the last couple of quarters that it's become a widespread view that actually the global economy has been more resilient than we expected to this monetary tightening. But at the same time, equity market valuations have tended to go higher. So making the jump into equities today... is quite difficult given where valuations are. So I think, as always, investors are looking for diversification. They have to see the US as being the market that provides the greatest opportunity just because of the macro performance of the American economy. But there are opportunities elsewhere. And I think we're starting to see maybe a more balanced global growth picture with evidence of some... pick up in activity in other parts of the world, even China, which has been disappointing recently. But other regions have got a long way to go to catch up with the US, not only in terms of GDP growth, but also in the narrative behind expected investment returns. If we look at just the technology sector, for example, there are good technology firms outside of the US. but the weight of what's happening in technology is in Silicon Valley, is in the U.S. And if you look at the population growth that the U.S. has been able to experience through immigration in the last couple of years, the ability to adapt to changing supply chains, and the first mover advantage that the U.S. has in technology, it's hard to see any other region matching the investment performance.
- Speaker #0
And Gilles, you've been speaking to clients as well. How are they navigating?
- Speaker #1
I think there's a big case of waiting to see what actually happens. I don't see a lot of preemptive moves because we have a number of binary problems really. Just to talk about the elections is an obvious one. If you look at distribution of probability based on polls, it's basically 50-50 at the moment. But it's not just about that. Think about military policy in the US. We all spend an enormous amount of time thinking about the Fed, and it's going to be key for everyone. And it's still open. I still believe that they will have some capacity to cut at some point this year. Other economists believe that it's gone, and there's not going to be any. Any cut on this side of the election? Honestly, it's data dependent. I don't think it would take that many months of improvement on the inflation side and softness on the real economy for the Fed to cut. But we're still waiting for a smoking gun. The piece of data that is going to tell you, well, it's really time to change the stance. And so far, we've been disappointed. So that's very binary, will they cut or not. Election is very binary. Where things are less binary, maybe a... tad more predictable. It's in Europe where obviously, you know, we have elections as well, but they're not as central as the US presidential elections. The picture on the inflation side is clearer than the US. unfortunately, the picture on the real economy as well. We're definitely not doing as well as they are. So it's probably at the moment a bit easier to navigate in Europe than it is in the US. But again, the US is so central. EM, just think about that. What will be the capacity of central banks in emerging countries to cut rates significantly in 2024 if there's no cut from the Fed? So everyone's waiting. And the difference in the situation today related to where we were a few years ago is that cash pays. And as long as cash pays, well, you can afford not to make decisions.
- Speaker #2
I think the other consideration for investors, just looking slightly further ahead, is what kind of regime are we in now after the shocks to the global economy in the last three or four years? Because we got used to interest rates being super low and central banks being super involved in bond markets. And that's gone. and there is a strong argument, I think, that we're looking at a future where the level of rates in general is going to be higher than it has been over the last decade. Before the global financial crisis in 2008, it wasn't unusual to have US 10-year treasury yields in this around 5%. It was quite normal. And we could be going back to that kind of regime. There's lots of arguments about the cost of the green transition. leading to higher demands for capital, pushing up long-term real interest rates, the fiscal position in a number of countries doing the same thing. Inflation may not settle back below 2%. So all these things do tend to push us to thinking over the medium term, we have to accept that rates will be higher than they were in the 2000s and 2010. It's not necessarily a bad thing, particularly if you're managing bond portfolios, if you're investing in credit. because you're going to get higher yield. And that probably is still something that investors are coming to terms with.
- Speaker #1
It's definitely something I would want to print on a T-shirt. I survived the 1990s. It's okay. We went through this. Unfortunately for Chris and myself, we were there professionally active in the 90s. It's okay. You can live with interest rates between 5 and 6. It's livable.
- Speaker #0
One of the other challenges our clients are navigating is sustainability. And along with these macro challenges that Chris and Gilles have outlined, could you give us some thoughts around sustainability and particularly what's happening in the US?
- Speaker #1
It's also a potential collateral victim of the US elections at the end of the year. Even if I would end on a note of positivity, even under the first mandate of Donald Trump, the cabinet intensity of the US fell. So, no. everyone, even Trump, has limits when it comes to going after this kind of trends.
- Speaker #2
Yeah, and you look at states like Texas, which have, you know, the state government's been very vocal about responsible investing, but Texas is one of the states that's benefiting the most from decarbonization and the shift in the production of energy towards more renewables. As ever, it's a nuanced story.
- Speaker #0
Thank you, Gilles and Chris, for a fascinating discussion. It'll be interesting to see how things develop in the build-up to November and indeed beyond. On a more personal note, this would be my last podcast as host, but I'm very excited to hand over to Gilles, who's going to take you through all these relatively easy topics for our clients from economics to sustainability and way beyond. Thank you, everybody. Thank you to our listeners. Please do take care of yourself and, if you can, of the planet too. This marketing communication does not constitute on the part of AXA investment managers a solicitation or investment legal or tax advice. This material does not contain sufficient information to support an investment decision. The value of your investment can fall as well as rise and you may not get back the amount originally invested. Past performance is not a guide to future performance. Please see the website www.axa-im.com forward slash sound progress for full disclaimer.
