Among the three biggest economies, the US, China and Europe, the US seems the most significant source of market volatility at this point. Its tariff policy is creating uncertainty in the US that is spilling over to global markets. Asia has so far provided a partial offset to tariff-induced inflation.
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However, Chair Jerome Powell of the Federal Reserve argued last week that further interest rate cuts in the US should not be taken for granted.
Meanwhile, China and the US reached another trade war détente. This should – at least temporarily – reduce the geopolitical risk premium on global assets.
China’s deflation already priced in
With China reporting 4.8% year-on-year growth in the third quarter, Beijing should still be able to achieve its 5.0% target for this year, if its economy were to grow by only 4.5% YoY in the fourth quarter.
Nevertheless, deflationary forces remain entrenched in China’s economy. Third-quarter nominal GDP rose by only 3.7% YoY. This was less than the real (inflation-adjusted) growth rate of 4.8% and indicates that China is in the longest period of deflation (10 consecutive quarters) since the 1990s (see exhibit 1). It also implies that the measures Beijing has implemented so far have not been enough to stabilise prices.
Turning things around will take more than just policy easing. Beijing appears to have come to terms with the need to maintain its two-pronged approach:
- Structural reforms to improve systemic efficiency
- Fiscal and monetary easing to keep domestic demand from faltering under the deflationary pressures of structural reforms.
The policy was reflected at the Communist Party’s 4th Plenum over a week ago, where the guiding principles and major objectives for the upcoming 15th five-year plan were announced. The focuses are on sustaining economic growth, boosting private consumption, and enhancing economic resilience through self-sufficiency in key technologies and materials.
Despite another truce in the Sino-US trade war (for one year), the countries look set to remain in a strategic stalemate. The latest flare-up of tensions before last week’s détente served as a catalyst for a correction in Chinese equity prices as investors reassessed the country’s outlook on the back of the two-pronged policy.
Europe’s upside surprise
The latest purchasing managers’ indices (PMIs) for the eurozone presented an upside surprise: the main gauge came in at 52.2 for October vs. the consensus expectation of 51.1. The bloc’s 1.3% YoY growth in the third quarter can be taken as a sign that Germany’s substantial stimulus is having a positive effect, even if, on a eurozone level, it was offset somewhat by weakness in the French economy.
The ECB struck a confident note on economic resilience and kept its rates unchanged at last week’s policy meeting. President Christine Lagarde argued that downside risks including US-EU and US-China trade tensions had receded.
Meanwhile, domestic demand appears to be stable, and the EU’s billion-euro defence spending and Germany’s considerable infrastructure investment should start trickling through the system to counter some of the headwinds from weak exports.
Europe’s growth and policy outlook looks balanced at this point. The means there should be no big upside or downside surprises, with many players now expecting no rate cuts from the ECB in the rest of 2025.
US two-way tail risk
The US is a different story. There, we see a two-way tail risk.
On the upside, the latest available data shows that consumer spending (which grew by 2.5% YoY in the third quarter) and capital spending (notably artificial intelligence-related spending) have remained solid. It appears that households have continued to spend, and AI investments has remained robust even amid a volatile business environment.
On the other hand, the latest labour market data showed continued deceleration, with real (inflation-adjusted) labour income falling since early this year (see exhibit 2). Since wages are a key driver of spending, this trend does not bode well for overall growth, spelling a downside risk.
Less-than-expected inflation from tariffs
Tariff-induced inflation will likely further erode consumers’ purchasing power. Consumer inflation (CPI) data shows that the feed-through from tariffs continues, with both headline and core inflation rising slightly to above 3.0% YoY in September.
The debate over who ultimately pays these tariffs has not helped clarify the outlook. Supporters of President Trump argue that foreign exporters absorbed most of the costs (thus, keeping a lid on US inflation), while opponents counter that American importers and consumers had borne the bulk of the burden (thus, weakening spending and labour market momentum).
The truth likely lies somewhere in between. At this point, evidence shows that some major Asian economies have responded to Trump’s tariffs by cutting export prices (see exhibit 3), thus reducing the pass-through impact of tariffs on US inflation.
The US remains the dominant force in the global economy, especially in bilateral trade (negotiations), whether at the national or corporate level. This leverage gives American importers greater pricing power, enabling them to shift tariff burdens onto their suppliers.
The upshot is a smaller-than-expected tariff pass-through to US inflation, and a deflationary shock for some emerging market countries, particularly export-driven, manufacturing-intensive emerging Asian economies.
The market implications are complex and were reflected at the Federal Open Market Committee (FOMC) meeting last week. The policymaking body cut US rates by 25bp, as expected. However, Fed Chair Powell said afterwards that the FOMC was split over the future path for rates and argued that the market should not conclude that another rate cut in December was preordained.
The two-way risk
If inflation remains sticky, but does not rise, and the US labour market continues to soften, the Fed will likely stick with its rate cut ‘insurance’, prolonging the equity market’s steady advance.
If however inflation increases and the US economy stabilises, the Fed will likely switch back to an anti-inflation stance under its dual policy mandate, delivering fewer or even no rate cuts in the coming year.
The current situation appears to favour the rate-cut narrative, with inflation being less of a problem than a slowing economy for the Fed thanks to Asian exporters absorbing some of the import tariff impact on US prices and deflation in China continuing to put prices under pressure globally.
The question is how long this can last.
