Last week’s column laid out why market bulls and boosterish corners of the economics profession are gearing up for a boom in 2025. In the interests of balance, this week will give air time to the Cassandras of the global economy who are preparing for the worst in the coming 12 months.
Economists, infamously, have predicted nine of the last five recessions — a caveat that can equally apply to economics commentators.
In the spirit of self-evaluation, my predictions for 2024 got plenty wrong too. The Houthis did not succeed in sparking another global inflationary shock, as ships diverted to avoid the Red Sea and supply chains quickly adjusted. Goods price inflation even turned negative in many large economies this year. Equally incorrect was the warning that Ukraine’s military would suffer a seismic funding crunch, as the United States Congress eventually signed off on cash injections. Another honourable mention from many economists that did not materialise was the US consumer running out of steam to plunge the world’s largest economy into recession in 2024.
Some of my bearishness was, however, justified. The great democratic experiment of 2024 did prove to be disruptive in the US and Europe, with political elites on the Continent predictably moving towards a slow embrace of the nativist hard right. Bigger tests are on the horizon for France and Germany in 2025. The last mile on inflation could also still end up being the hardest, particularly in the UK, where the outlook for prices and wages is not as clearly disinflationary as in Europe. The European Union is also no closer to finding a sustainable solution to Ukraine’s defence needs after a year of hand-wringing about military spending.
With that in mind, there is a nascent body of contrarians who are ringing the alarm on frothy markets and vulnerabilities in the world economy heading into the new year. As mentioned last week, many market bears have been forced to recant and embrace the upside on US equities, but there are still some who are staying on the sidelines warning of dangers ahead.
The end of the year has given way to more caution about America’s economy, which has become the main driver of market and economic sentiment. There is no escaping the US, with America’s equity market now making up a giant 75 per cent of the global MSCI index — topping the share last recorded in the 1970s.
For the Cassandras, the US has all the ingredients of a mighty stock market bubble: nose-bleed valuations that aren’t justified by earnings potential, an artificial growth boom, and looming central bank surprises.
The bearish case rests on a few key arguments. The first is concentration risk — or the fact that most of the money rushing into American equities has been almost entirely focused on the “Magnificent Seven” tech firms — Apple, Amazon, Meta, Tesla, Alphabet, Microsoft and Nvidia. The seven have returned close to 60 per cent for investors this year, compared with 18 per cent for the other 493 companies that make up the S&P 500. Small caps got a brief boost after Donald Trump’s election but much of that has now faded. The tech mania makes the US stock market surge vulnerable to a rapid reversal if the promised AI productivity gains fail to materialise or if Trump’s hints at an aggressive anti-merger competition policy come to fruition.
The other portent of doom highlighted by contrarians is a coming liquidity crunch. Michael Wilson at Morgan Stanley highlights how the rush of cash into US tech stocks started around April 2023, when the Federal Reserve was pumping money into the financial system to calm nerves after the collapse of Silicon Valley Bank. This cheap cash is now draining out of the system as the Fed unwinds its emergency tools and has indicated only two interest rate cuts in 2025 — keeping financial conditions tight. An abrupt market correction could be on the cards “when the abundance of liquidity subsides”, Wilson says. Albert Edwards at Société Générale, often dubbed a perma-bear, thinks the Fed and the US government, through loose fiscal policy, have been juicing up asset prices and artificially boosting US economic outperformance.
While US dynamics are the main preoccupation of bulls and bears, other parts of the world economy present threats. One of the most under-emphasised is the potential deepening debt deflationary spiral in China, where price growth is tepid as cautious consumers aren’t spending and the Communist Party is struggling to revive their animal spirits. China’s bond yields fell below Japanese equivalents this year, with investors betting that the world’s second largest economy could fall into the same trap as its once-mighty neighbour. Beijing’s authorities may be tempted into a currency devaluation to stoke domestic prices — and at the same time anger an already bellicose Trump, who has raged against China’s widening trade surplus.
In Europe, the music could finally stop in the French bond markets, where borrowing premiums have touched crisis-era highs over the country’s prolonged political stalemate and the lack of plans for fiscal consolidation. In Germany, despite some early hints that the conservatives would loosen debt strictures if they win February’s federal election, they have recommitted to the harmful Schuldenbremse, a fiscal rule that limits the amount of debt the German government can take on.
Finally, one case where the pessimists’ view is close to consensus, rather than bucking the trend, is the potential stagflationary path for the UK. Wage growth has ended the year above expectations and growth has fallen flat. The Bank of England’s new year conundrum will be over how far to cut interest rates to stimulate the economy, while managing inflationary risks. The government’s decision to raise employment taxes and the national living wage has worsened the Bank’s trade-off.
Holger Schmieding, chief economist at Berenberg, says Labour’s policy choices are a mistake that will result in a self-inflicted “supply shock” on the economy, lifting inflation to 3 per cent next year, and slamming the brakes on employment growth.