A look at the bright side — Alpha Sources.CV

I detect a lot of worry about the global economic outlook. This is understandable. Equities are close to, or at, record highs with extended valuations. Growth fears have crept higher on investors’ list of concerns, most notably with signs of softness in the US labour market as well as persistently weak domestic demand in Europe. Add a still-fragile Chinese economy to the mix, despite hopes of stimulus, and the prospect of a leap in economic uncertainty after next month’s US presidential elections, it is no wonder investors are on edge. But what if I told you that global leading indicators are strong and healthy and that combined with falling inflation and falling interest rates, this is one of the best macro-setups for risk assets. I suspect many would reply that such tailwinds already are comfortably priced-in to equity and credit markets. I am sympathetic to that point, but hear me out.

A common question by investors is “where are we in the cycle?” It’s a good question, but also a somewhat misleading one without an agreement about what this “cycle” everyone is talking about actually is. Broadly speaking, the cycle—defined as the quantitative state of some collection of leading indicators—can take four distinct forms. Leading indicators can be positive and rising, positive and falling, negative and falling and negative and rising. Usually the distinction between positive/negative and falling/rising runs along the line of the first and second derivatives of some time series of economic activity. It is important for investors and economists to monitor and understand the difference between these four different states. But what is much less commonly made clear in the discussion about leading indicators is that these four states do not operate like the four seasons. In other words, the transition between them is neither deterministic nor subject to a pre-set schedule. It is important to be pedantically precise about what this means. It is possible to use past data to pin down the average time spent by leading indicators in expansion or contraction, or the usual path which with these indicators move from one state to the other. But analysts must be careful assuming that such averages and historical paths can be applied to out-of-sample forecasts. I am not saying that such forecasts can’t be useful, but they must be used with caution. This is especially the case in the context of expansions, captured by the refrain that “expansions don’t die of old age”. By contrast, downturns do tend to have a more determinist, and short-lived, nature in the sense that they occur in a quantitative environment where what they’re trying to measure—economic output—tends to be rising over time. But even in this case, the distinction between cyclical/temporary and structural forces can lead analysts astray.

With that in mind, let’s try to take an unbiased look at the data.

The three charts below clearly show that global leading indicators are in a decent place. The OECD LEI diffusion index, a classic global macro workhorse model, strengthened further at the end of Q3, and with it, so did the most cyclical parts of the European equity market. A broader measure of global leading indicators, including the global PMI and growth in trade and industrial production, also remain positive, if overall lukewarm. Finally, a diffusion index of central bank policy rates also suggest that the global economy is now benefitting from a broad-based easing cycle, and has been for some time.

The third chart above, plotting a diffusion index of global central bank policy rates, is probably the most interesting as far as goes unlocking the peculiarity of the current “cycle.” It shows that global monetary policy has been easing since the middle of 2023, but has it really? After all, major DM central banks are only now starting to ease with markets expecting the bulk of easing to happen next year. Put differently, an un-weighted diffusion index of central bank policy rates suggest that the global easing cycle is well developed, but looking at the movements of the largest central banks, it is just getting started, or certainly that it will continue well into 2025. You will find plenty of disagreement among analysts about how much major central banks will cut, not to mention how much they should cut, but it’s difficult to deny the direction of travel. Even if we disregard for a moment concerns about fragile economies in the face of a lagged hit from tighter monetary policy, inflation is now coming down, rapidly. The chart below shows that my weighted average of core and headline inflation in the US, UK and Eurozone is now falling steadily. Granted, the September headlines in the EZ and the UK likely undershot the trend, but the direction of travel is clear, all the same.

From a position where central banks first got the transitory story wrong and then had to scramble to catch up with runaway inflation, cooling CPIs currently offer them one thing they haven’t had in a long time; flexibility. Some have more than others—I fear my GBP mortgage will not get as much relief from the BOE as I would like—but the main story is clear enough. Central banks now have room to ease policy from a position of restrictiveness. This then takes us into the perennial distinction and debate between a soft and hard landing. To be absolutely clear; the data currently point to a soft landing in which monetary policy adjusts to a world where the post-Covid and War-in-Ukraine inflation shocks have been defeated without a significant and recession-inducing downshift in economic activity. If, in this context, inflation and employment—which tends to lag leading indicators and asset markets—offer central banks the opportunity to cut by more than economists and markets expect, would that be such a bad thing?

It would be if inflation comes back next year, forcing a U-turn by monetary policymakers, which then could force re-tightening of monetary policy risking to push the global economy into the hard landing, which was avoided in the first place. As I have been trying to explain on several occasions, markets and policymakers are hoping their respective economies settle in a relatively narrow equilibrium in which interest rates come down from their restrictive level, conditional on inflation settling at a low enough pace to declare victory on vanquishing the inflation shock. Threading this needle won’t be easy, and exactly at what combination of interest rates and inflation such an end point would be deemed to have been reached is difficult to pin down ex-ante. Most forecasts, and market pricing, currently imply that interest rates will come down and then settle through any reasonably medium-term forecast horizon. But that’s just another way of saying that whether interest rates fall further or rebound after having declined to what central banks deem to be an appropriate “terminal" or “neutral” level is subject to equally balanced risks.

Bond markets reflect the reality that loosening monetary policy in major developed markets is perceived as a soft-landing adjustment rather than a behind-the-curve scramble to catch up with an incoming recession. Yield curves have un-inverted, but unlike in the traditional market folklore where this happens at the start of recessions with the front-end collapsing more quickly than the long-end, bear-steepening has been a theme too. This, in my view, is exactly what we should expect in a soft-landing scenario where the long end will be more vulnerable to sell offs in response to expectations for more aggressive short-term easing and lower front-end rates.

…but long-term yields have firmed, a tad

Granted, the long bond moves in mysterious ways, so it is not clear that the recent rise in bond yields medium term inflation risks as central banks ease policy. In the US, for example, elevated uncertainty over the outcome of the US presidential election, and more specifically, expectation of an initial flurry of inflationary trade executive orders by a Trump White House likely has contributed to firming long-term yields. Similarly, in the UK, uncertainty over the outcome of this week’s much anticipated and feared budget likely is weighing on Gilts, beyond any upside risks to inflation from 2026 and onwards. Look closer, however, and you can start to see markets pricing in rate hikes in 2026 and 2027 in response to deepening cuts next year. Whether such market pricing survives over the next three-to-six months will be one of the things that I will be paying particular attention too. In the meantime, I am inclined to look on the bright side for the global economy.