Expectations prior to the US election for a soft landing by the economy in 2025 are being met, or at least the slower growth part, if not necessarily lower inflation. The concern was always going to be that as activity decelerates, it could stall and lead to a recession. Tariffs could yet make it happen.
The disappointing US private non-farm payroll release (38,000 jobs created in August compared to market expectations of 78,000 and 77,000 in the prior months), while a surprise, was not a shock. The market’s comparatively tepid reaction suggests investors were ready to be let down.
The US Bureau of Labor Statistics recently released another (large) revision to the historical data, which showed total job growth from April 2024 to March 2025 was 911,000 lower than previously reported. Full monthly details will be released early next year.
The newly revised data paints the picture of a labour market that has been weak since last summer, suggesting the recent soft data has less to do with the tariffs on imports into the US or a tightened immigration policy and more to do with a chronic lack of dynamism in the labour market that was obscured by high GDP growth rates (and inaccurate data).
On a trailing 12-month basis, the August numbers actually shows an improvement versus the last two months and a run rate that is not much different to last autumn (see Exhibit 1). A bigger worry than the level is the composition of payroll gains. The healthcare and social assistance industry has accounted for the majority of the jobs created, even though it makes up just 17% of employment. Exclude this sector and you have payrolls that have been negative for much of the last year.
The low rate of job creation, particularly in 2024 when GDP growth was high, suggests that productivity was greater than had been appreciated. This bodes well for the US economy if growth accelerates even as labour market supply is constrained.
US GDP revised up
The latest revision to US second-quarter GDP growth shows a resilient consumer and a boom in artificial intelligence (AI)-linked investment. Combine this with expected imminent rate cuts by the US Federal Reserve (Fed) and the outlook for US equities is promising. The US economy has rebounded strongly from the tariff-induced slowdown in the first quarter, swinging from a -0.5% growth rate to 3.3% (seasonally adjusted annual rate; see Exhibit 2). Excluding the distorted net export and inventory figures, and the contribution from ‘core’ demand rose from 1.6% to 1.7%.
There were both good and less good aspects in the details. Consumer demand (personal consumption expenditures) was much stronger than in the first quarter, belying market concerns that the tariffs would lead to a sharp contraction.
That said, the current growth rate is half the long-run average of 2%. While a slowdown was expected this year after the high, government-funded, post-Covid reopening growth rates, it is perhaps lower than is comfortable, particularly as more tariff price increases are yet to come.
The comparative weakness in consumption has been offset by a surge in business investment, driven primarily by software and information processing equipment.
This trend should continue while we await an increase in manufacturing investment as companies look to avoid US import tariffs. While there have been numerous company announcements of plans to invest in production in the US and some anecdotal evidence, the manufacturing sector actually saw disinvestment in the last quarter.
Inflation and the Fed
The payroll data and recent comments from Fed Chair Jerome Powell have led financial markets to anticipate a fed funds rate near 3.25% by the end of the year. The argument for keeping the rate high was the inflationary impact of tariffs. Now that it has been acknowledged that this is likely to be transitory (as the effect of any tax increase would be), there seems little reason for the Fed to keep policy rates in restrictive territory.
Investors may have become too sanguine, however, about the risk from inflation. Core goods inflation was indeed modest in July, but that was because the aggregate figure was pulled down by a sharp drop in IT commodity prices. This may not reoccur.
More worrisome was the surge in core services inflation, driven by medical care and transportation services. But given that wage growth has remained contained (year-on-year growth in average hourly earnings has been below 4% for seven months), the risk does not seem to be great.
Distinct from near-term market worries about inflation, fixed income investors are wondering how much longer the Fed and its policymakers can take decisions based ‘solely on their assessment of the data and its implications for the economic outlook’ and instead find themselves considering the desires of the US president. The implications of a more pliant Fed are lower policy rates and higher inflation and a higher term premium. There is evidence of this in the markets: the 2-year/30-year bond yield spread has risen, though not at a rate or to a level outside of historical norms (see Exhibit 3).
Given the difference in outlook for growth and inflation between the US and the eurozone, it seems more likely to us that US Treasury yields will rise relative to those in the eurozone, which is reflected in our asset allocation (see table).
Equity surprises
Better-than-expected results from the latest earnings reporting season need to take into account the unusually negative sentiment (and negative earnings revisions) that followed the ‘Liberation Day’ tariff announcements. Analysts had lowered their estimates for 2025 corporate earnings by around $150 billion in the weeks that followed.
The increase in goods prices over the last two months relative to the pre-‘Liberation Day’ trend suggests consumers are out of pocket by an additional $20 billion.
The total is not far off the $180 billion in extra revenue the US government is likely to raise thanks to customs duties this year.
The point is that the hit to corporate profits was already priced in when companies began announcing their results. It is nonetheless comforting that earnings exceeded the lowered market expectations, and by an above average amount.
The lowered expectations also explain why corporate guidance on the outlook was so strong; put simply, things were not as bad as feared. The percentage of companies raising their earnings guidance (35%) is significantly higher than the norm (26%) for this time of year.
Importantly, even after the markdowns, absolute earnings growth was good… for some stock markets: 13% for the NASDAQ 100 and 14% for the Russell 2000 small-cap index. Markets suffering more from the tariffs were US Value and Europe, with growth rates of just 1.3% and 0.4%, respectively.
The results of the latest reporting season align with earnings growth expected for major markets over the next year, with a similar divergence between technology and cyclical indices versus goods and value-oriented markets.
It is not only for tech in the US where earnings are expected to continue rising at a robust pace, but also technology sectors in emerging markets.
The Russell 2000 index should benefit from falling interest rates and ever more domestically oriented consumer demand thanks to the tariffs.
By contrast, the earnings path for the Russell Value, Europe and emerging markets excluding technology indices is more modest (see Exhibit 4).
Valuations: US high, Europe average
A critical concern for many investors is high US equity market valuations. One sovereign wealth fund has been short the US and long Europe for this reason. Elevated valuations have supported the reallocation of portfolios away from the US and towards Europe above and beyond the unsettled market sentiment arising from US economic policy.
We share the worries about the implications for returns for US equities over the medium term due to stretched valuations, but it is less clear they will be a factor in the short term. Moreover, valuations are not high for every part of the market, meaning investors have a choice.
The forward price-earnings (P/E) ratio for the broad US S&P 500 index is indeed above average at 22.3x, equivalent to a z-score of 1.8, meaning the P/E is nearly two standard deviations above average.
This compares to a P/E ratio for the MSCI Europe index of 14.5x (z-score 0.1), that is, valuations in Europe are average, though not cheap (see Exhibit 5). And that average valuation comes with a comparatively poor earnings outlook.
Within the US market, however, there is a significant divergence between the tech part of the S&P 500 (proxied by the NASDAQ 100 index) and the value part (proxied by the Russell 1000 Value index). The z-score for the NASDAQ P/E is just 0.3, close to that for Europe, while for the Russell Value, it is 1.5.
Given the similarity in composition between the Russell Value and Europe indices, one could argue for owning European equities due to the valuation gap (though there is also the earnings growth gap). The more interesting part of the US market to us is the NASDAQ, where we see superior earnings growth and reasonable valuations.
Asset allocation views
- In a context where the global economy still appears resilient despite US tariffs and political uncertainty, we are maintaining an overweight position in equities. A solid earnings season as well as the prospects of additional US monetary easing continue to support our preference for US technology and emerging market equities.
- The outlook for monetary policy saw a reversal in August, between the US (a more dovish Fed) and the eurozone (a more hawkish ECB). In addition, budget concerns resurfaced in Europe, especially in France and the UK. We have closed our long position in European government bonds versus short positions in US Treasury notes. In credit, we remain long short duration euro high-yield bonds, which provides an attractive carry with a limited risk. Our duration is globally neutral.
- Our conviction is positive on gold which should remain supported by Fed rate cuts and the steady buying by emerging market central banks.
- The US exceptionalism premium has been taken out of the US dollar since Donald Trump’s re-election. While the bull USD call was consensual at the end of 2024, it completely reversed with bearishness becoming a consensus position earlier this year. Now, with positioning near neutral, the dollar has been trading more in line with interest rate differentials. That should remain the case. It opens the door to more cherry-picking in the currency space: high beta, carry and commodity-linked thematics are areas we continue to explore via AUD and BRL.
