The Economic Challenges for the US, Europe and China in 2025

The increase in US spending will be detrimental to financial stability and to the dollar, while the ECB’s interest-rate cuts will not be enough to stimulate the economy. In China, excess saving is holding back growth.

by Alberto Conca, Investment Director at Lfg+Zest

The excess spending that is helping the economy sustain its growth trajectory in the short term will be harmful to the long-term economic health of the United States. In Europe, our base case is for a slight economic contraction in 2025, despite economists’ optimism. In China, the economy will ultimately continue to grow below potential.

Two consecutive weak jobs reports last summer led Fed members to grow concerned about the health of the labor market and their ability to manage the economic cycle. The message was that inflation was on track to reach the 2% target and that greater attention needed to be paid to the weakening labor market. Even so, after three years of failing to bring inflation back to target, their confidence in the ability to hit the inflation goal has not been shaken. The reality is that the labor market, although not as strong as a year ago, is still highly resilient and inflation is not easing as expected. On the contrary, the sum of the main components is still hovering around 3%.

We believe that the collective judgment of investors is more accurate in assessing the health of the economy, thanks to the so-called "wisdom of the crowd". Market participants always anticipate the Federal Reserve by many months when assessing what the next move will be and should be, or what the appropriate level of interest rates is. Some may argue that forward guidance is decisive in shaping investors’ expectations, but the large lead of market-rate moves is such that this claim does not hold up when tested empirically.

Investors were convinced that the Fed had ended its rate-hiking cycle well before the last increase, and they now regard today’s level as appropriate to support the continuation of economic expansion. This should also bring inflation back toward target, since inflation expectations appear to be relatively anchored around 2.3%. Historically, real rates (2-year yield minus inflation) have averaged 2.0% since World War II. In short, investors’ current view is that the economy has returned to a "normal" operating mode, meaning we are no longer in a post-global financial-crisis economy.

There are several factors that explain the resilience of the US economy, but we would like to focus on just three that we believe are the most significant. US households, supported by strong wage growth and by savings accumulated during the pandemic (now being depleted), are able to increase consumption in line with income growth. In particular, the top quintile of the income distribution (which accounts for about 40% of consumer spending) is in an extremely strong financial position; the 55-and-over age group holds 70% of residential real estate wealth, with an average mortgage cost of around 3.9%. At the same time, these households’ balance-sheet assets are generating returns above 4%. Lower- and middle-income households, by contrast, are struggling against persistent inflation, but as long as the labor market remains solid, they will be able to keep their heads above water.

Secondly, corporate CEOs have conveyed confidence through their outlooks, and their plans for capital spending (Capex) have recently improved. At the same time, manufacturing PMIs are showing the first signs of a recovery. It is hard to say whether this is due solely to the massive boom in AI investments or to a combination of factors such as the rise in new households, AI investments and other elements. The third factor is the "great elephant in the room": government deficit spending, which does not appear likely to be brought under control any time soon. This excess spending is certainly helping the economy sustain its growth path in the short term, but it will unquestionably be detrimental to the long-term economic health of the United States, to financial stability and to the value of the US dollar.

The world’s other two major economic areas, Europe and China, present very different situations. The former is moving at a pace consistent with recession in its main countries, while the latter is caught in a fiscal recession. In Europe, forward-looking indicators still point to the possibility of a mild recession for Germany and France, while the more services-oriented peripheral countries are in a better position. Our base case calls for a slight economic contraction in 2025, whereas economists optimistically expect 1.3% growth. We do not believe that more aggressive rate cuts by the ECB will be enough to stimulate the economy.

China, Europe’s largest trading partner, is a victim of the paradox of thrift. Chinese households, in an effort to put their finances in order, are collectively saving more than is necessary, with the result of harming economic growth. To see this malaise, one only needs to look at the path of long-term interest rates, house prices and imports. Until Chinese authorities implement very aggressive property policies aimed at developers, households and financial institutions, the economy will continue to grow below its potential.