Macro outlook 2025 – Divergence

Three sources of divergence

2025 may be characterized by divergence across the world’s main economic regions, around three dimensions: underlying growth, fiscal policy, and monetary policy.

Let’s start with growth. We predict GDP to gain 2.3% in the U.S. next year, above consensus. We would be tempted to say it also exceeds potential – often estimated at c.175% - but the resilience of the U.S. economy probably also reflects a rise in the country’s potential. Successful investment choices by U.S. corporations 10 years ago, accelerating spending on software and R&D, may explain the uptick in productivity which has outlived the pandemic. Participation rates have rebounded, hitting their highest level since the early 2010s, which, combined with strong immigration, is lifting labor supply.

The stronger U.S. trend contrasts with China’s difficulties. The country is amid a real estate correction. There are many instances across the globe tied to real estate corrections, ones that suggest slumps in residential investment last years. Given China’s poor demographic prospects, and the fact that the catch-up in terms of housing standards has been largely completed, counting on a recovery any time soon is illusory, in our view. At peak, residential capex may have underpinned nearly 1/5 of Chinese growth. With this engine switched off, it is unclear how China could repeat this year’s official target of “around” 5% GDP growth (we expect 4.5% next year). More fundamentally, China is meeting the limits of its capital-intensive growth model. Directing more of the productivity gains to real wages, rather than to profits and competitiveness, would go a long way towards moving the country towards a consumer-based model which, at some point in their development, all mature economies today transitioned to. Yet, for now Beijing continues to focus on its “productive quality” strategy which rests on allocating more capital to export-driven strategic sectors, such as cars, at a time when protectionism is increasingly holding sway at the global level. The Chinese slowdown is mostly structural, not cyclical.

The Euro area is likely to maintain a mediocre growth pace in 2025. We expect GDP gains of 1.0%, below consensus. While nominal wages continue to outperform inflation, the resulting real gains – unlike in the U.S. – tend to be saved rather than consumed. Generic uncertainty probably explains this pattern. Political instability plays a role in this in France. In Germany, the general weakness largely reflects structural shortcomings. While the brunt of the energy price shock is behind us, German industry is still struggling to normalize, with signs of activity relocation and a difficulty to adapt to new demand patterns, in the car industry, for instance. The outperforming cases cannot be easily replicated: Spain continues to do well, but this owes to a steep improvement in supply conditions, with massive immigration flows, notably from Latin America. Across the Euro area, productivity continues to stall which, combined with mediocre labor supply growth outside Spain and hesitant corporate investment, suggest that potential growth probably needs to be revised down from its usual estimate at c.1.2%.

Ill-distributed fiscal stimulus

The U.S. does not need further fiscal stimulus. Beyond its structural prowess, its cyclical position remains sound. The rise in the unemployment rate, now consistent with the “Sahm rule” according to which a rise of more than 0.5 pp relative to trough over the previous 12 months reliably predicts a recession is of course a concern but “this time it may be different”. Indeed, employment growth remains decent, a stark difference with previous instances in which the “Sahm point” had been hit. The uptick in the unemployment rate mostly reflects better labor supply conditions.

Yet, Donald Trump’s platform is consistent with a potential further drift in the fiscal deficit of 2% of GDP in the years ahead, from an already problematic baseline at c.6% of GDP. Some of his measures may necessarily move the dial much in terms of short-term growth dynamics. Taken in isolation, prolonging the 2017 tax cuts would simply keep the fiscal stance unchanged. The cut in the corporate tax rate from 21% to 15% would likely have a limited immediate effect on business spending. Yet, exempting social security benefits from income tax across the board could free up income equivalent to c.0.4% of GDP to some households with a high propensity to spend. Combined with deregulation, notably in the field of energy investment, this could continue to fuel a “feelgood effect” which could lift equity prices, indirectly supporting consumer spending.

Conversely, in Europe, the fiscal stance is turning restrictive. Based on the budget plans for the three largest economies of the Euro area, 2025 could be the steepest net fiscal tightening since 2012, at nearly 1% of GDP. This would add to the general softness of aggregate demand. True, political difficulties in France may dampen the initial adjustment plans, but we think that any significant drift could be “punished” by a further widening of the sovereign yield spread. Germany could use its fiscal firepower to deal with some of its structural issues. The terms of the debate seem to be changing over there. The leader of the Center-Right, who according to the polls is likely to become the next Chancellor after the early elections scheduled for late February 2025, has indicated his openness to some reform of the “debt brake.” It is however a qualified openness, and building a coalition – let alone reach the two-thirds majority in parliament needed to change these constitutional rules – will be tough. We would not expect a significant loosening of Germany fiscal policy to come before the second half of next year, if at all.

China seems to be contemplating a wider use of stimulative policies, but the room there is tight: public debt in China already exceeds 100% of GDP. Measures aimed at shoring up financial stability should not be confused with stimulus “proper.” The extra bond issuance allowed to local authorities in the autumn of 2024 is a way to “officialize” hidden debt resulting in the exposure to the real estate sector via local governments’ special vehicles but will not directly lift ordinary spending.

Monetary policy divergence

Monetary policy, as usual, will be the “valve of adjustment” balancing those contradicting forces. In the U.S., we expect the Fed’s ongoing “restriction removal process” to be stopped well into restrictive territory early in 2025 (Fed Funds cutting only once in 2025 at 4.25%) by renewed inflationary pressure. On top of the usual impact of a fiscal push on prices, the Fed will need to take on board the rise in trade tariffs touted by the new administration. The announced crackdown on immigration, even mass deportations including immigrants already in the U.S. workforce, would probably re-start wage pressure. Even if we do not expect the hike in customs duties or action on immigration to be as radical as what has been presented during the campaign, even a moderate version would probably prevent a further convergence to the central bank’s inflation target against a background of still lingering endogenous pressure (as services prices still have not normalized).

Symmetrically, we think the ECB will have to move more decisively into accommodative territory, given the weak economic conditions exacerbated by the impact of U.S. tariffs on European exports, from the perspective of net fiscal tightening. We predict the terminal level for the depo rate to land at 1.5%, 50bps below the consensus estimate of the neutral rate in the Euro area. The widening of the transatlantic policy differential would fuel a further decline in the euro towards parity, which could offset some of the impact of the U.S. tariffs.

Despite clear signs that deflation is a major risk in China, the People’s Bank of China (PBOC) is often hesitant to take radical decisions. The deterioration of Chinese banks’ interest margin, in the context of monetary loosening, is a cause for concern at the central bank since it impairs the accumulation of profit buffers which help absorb mounting non-performing loans. A natural adjustment avenue could be to allow a significant depreciation of the renminbi. While offsetting a 60% U.S. tariff would entail a magnitude of depreciation, which would probably trigger financial stability risks for China itself, allowing the renminbi to weaken relative to the euro and other key “non-dollar” currencies could help Chinese exporters replace their lost market shares in the U.S. with new ones in the rest of the world.

How far is too far?

A key uncertainty in our scenario is the extent to which Donald Trump will deliver on his fiscal and trade platform. The nomination of Scott Bessent, a pragmatist, as Treasury Secretary and the Republican senators choosing a moderate, John Thune, as their leader could be indications that a significant discount rate could be applied to the campaign version of Trumpnomics.

Yet, even under a “moderate version,” we expect U.S. growth to slow down in 2026 (1.5%), falling below potential. Supply-side constraints combined with restrictive monetary conditions could ultimately prove too much to bear, especially since we believe overall financial conditions may get tighter as the bond market would react adversely to the additional fiscal drift. Once the slowdown comes, the Fed would be in position to resume cutting, which would improve financial conditions for emerging countries, but only after going through a difficult patch in 2025, between lower Chinese demand and disappointing capital flows. How governments outside the U.S. develop their own macroeconomic strategy while they embark on “surviving Trump” will, of course, be key. Trade war escalation is ultimately in no-one’s interest – especially not for regions such as Europe and China which are more reliant on outside traction than the U.S. Designing strategies which will lift potential growth could be a better approach. Yet, another source of uncertainty lies in the interplay between the U.S. macroeconomic stance and geopolitical risks. The U.S. growing energy autonomy makes Washington increasingly tempted to tolerate further escalation in the Middle East. Beijing could respond to tariffs by getting even more assertive towards Taiwan.

Source: All data from AXA IM, as of November 2024 unless otherwise indicated