Capital Ideas^TM

As inflation eases and central banks around the world cut interest rates, the outlook for the global economy remains decidedly mixed heading into the new year. Much like the past few years, the United States and India continue to lead the way, driving global economic activity, while weaker economies in Europe and China seek to stimulate growth.

With US labour markets healthy, profit growth solid and business investment picking up, the International Monetary Fund (IMF) recently raised its forecast for US economic growth in 2025 to 2.2%. That prediction offsets downward revisions for other advanced countries, including the largest economies in Europe. China, meanwhile, continues to struggle with a real estate downturn and worries about a broadening trade war following US President-elect Donald Trump’s victory on 5 November.

“I tend to think about the world in terms of tailwinds and headwinds,” says equity portfolio manager Rob Lovelace, “The US has plenty of tailwinds at the economic level, the industry level and the company level. Japan is picking up some tailwinds. And I think both Europe and China are dealing with some real headwinds at the moment.”

Healthy US economy remains a cornerstone of global growth

Welcome to the Benjamin Button economy

Can US strength lift up the global economy and financial markets along with it? The world’s largest economy is striving to do just that.

Odd as it may sound, the US economy appears to be taking a page straight out of the 2008 movie The Curious Case of Benjamin Button. Film buffs will remember that the title character, played by Brad Pitt, ages in reverse, from old man to young child.

"The US economy is going through a similar transition,” says Capital Group economist Jared Franz. “Instead of moving through the typical four-stage business cycle that has defined the post-World War II era, the economy appears to be shifting from late-cycle back to mid-cycle, conveniently avoiding a recession.”

A mid-cycle economy is generally characterised by rising corporate profits, accelerating credit demand, softening cost pressures and a shift toward neutral monetary policy. “We’ve seen all four of those in 2024,” Franz notes. “I believe the US is headed for a multi-year expansion period, perhaps fending off a recession until 2028.”

The U.S. business cycle appears to be aging in reverse

Historically speaking, mid-cycle periods have provided a favourable backdrop for US equities, generating returns averaging 14% a year. That is based on Capital Group analysis of economic cycles and returns dating back to 1973.

As always, it is important to acknowledge that past results are not predictive of results in future periods. “But if the US economy continues to grow at a healthy rate,” Franz says, “that could provide a healthy tailwind for markets."

Franz’s estimate for US economic growth is more optimistic than the IMF forecast. He expects the US economy to grow at an annualised rate of 2.5% to 3% in 2025, potentially higher if Trump is able to quickly cut taxes and slash government regulations, as he promised during his presidential campaign. Trump’s election, combined with a Republican sweep of the House and Senate, will likely translate into generally higher economic growth, Franz notes, but also higher inflation and higher interest rates than previously expected.

Outlook is mixed outside the US

In markets outside the United States, there is more divergence. Some bright spots, including India, are expected to lead the world, generating some of the fastest growth rates. India’s economy should enjoy 6.5% growth in 2025, according to IMF estimates, driven by a young and growing workforce. India also is benefiting from a post-pandemic shift in global supply chains, adding to its manufacturing base in mobile phones, home appliances and pharmaceuticals, among other products.

Europe’s economy continues to ride the edge between expansion and contraction, with expected growth around 1%, weighed down by the war in Ukraine, high energy prices and close ties to China’s sluggish economy. In response, the European Central Bank (ECB) started cutting interest rates this year ahead of the US Federal Reserve (Fed), hoping to kickstart the eurozone economy.

In China, meanwhile, the government has launched a massive stimulus program designed to reverse chronic weakness in the country’s real estate market and slowing industrial production. China’s growth-oriented policies include interest rate cuts, mortgage rate reductions, and a recently announced $1.4 trillion aid package to help local governments deal with growing debt burdens. Looking ahead, a cloud hangs over China’s role in international trade as the incoming Trump administration has vowed to raise tariffs on Chinese imports.

Where to invest in a rate-cutting cycle

Adding fuel to economic growth expectations, the world’s major central banks — the Fed, the ECB, the Bank of England and The People’s Bank of China — have all committed to monetary easing in the closing months of 2024.

The Fed, often considered the central bank to the world, has cut rates twice since September, setting the stage for what could be a favorable environment for financial markets in 2025. Rate cuts when the economy is growing have been a boon for investors in both stocks and bonds.

Of the Fed’s seven easing cycles since 1984, three occurred outside a recession. During those non-recessionary cycles, the S&P 500 Index averaged a 27.9% return from the first cut to the last, with most sectors posting double-digit gains.

Rate cuts have boosted stocks and bonds in a healthy economy

During times when rate-cutting cycles have preceded a recession, stocks have not fared well. But bond returns have been strong in both non-recessionary and recessionary cutting cycles, significantly outpacing cash equivalent investments in non-recessionary periods.

John Queen, fixed income portfolio manager, believes the economy will continue to improve heading into the new year and thinks the Fed is simply looking to normalise interest rates, reducing them to a level where they are no longer restrictive. That was the base case before the US election, and it is even more so now.

“The Fed is cutting rates because it wants to,” Queen says, “not because it has to."