What Will 2025 Bring – A Fiscal Hangover From Elections

Granted that it is year end, I am often caught up in the swirl of ‘2025’ prognostications on the economy and politics, and while not a great fan of short-term forecasting I thought I would lay out a few themes that will condition markets and economies into 2025.

I wouldn’t start from here.

Financial markets – which are dominated by US equities (over 65% of world market cap), are starting 2025 from a vertiginous place.

Retail investor surveys have never been so optimistic, stock market concentration is at levels last seen in 1929 (the top ten stocks account for 40% of the market) and valuations are stratospheric (a simple measure, the price to earnings ratio, has only been higher in 2020 and 2001). In that respect, many investors might pose the question ‘when is the crash?’. My sense is that absent a damaging trade and supply chain war between the US and China in Q1, we will likely see a very meaningful rotation from US equities to cheaper markets in parts of Asia, but more so Europe (the election of Friedrich Merz as German Chancellor in late February might be the catalyst for this).

The Plaza Problem

A further reason for this is the strength of the dollar, which makes foreign assets cheaper for US investors. Following the election of Donald Trump, a range of key currencies have weakened noticeably – the yen, Brazil’s real, the Indian rupee, renminbi and the euro. Whilst the new Treasury Secretary Scott Bessent will see the benefits of a strong dollar, the weakness of ‘foreign’ currencies is anathema to the worldview of Donal Trump, who dreams of another Plaza Accord (a ‘Mar-a-Lago Accord’) that might reset the competitiveness of the dollar.

The problem with this view, as we head into 2025, is that the weakness of Asian currencies and the euro, relative to the dollar, is driven largely by diverging economic performance. In that context, a Trump administration that runs the economy ‘hot’ risks postponing a grand currency accord. It also risks a resurgence in inflation (and bond yields), which I suspect will be a story for next summer.

China – Japan or Greece?

The one factor that could temper inflation is China, a very large political economy that we know increasingly less about. My bet is that commentators will spend much of 2025 debating whether China is ‘Japan’ or ‘Greece’, in the sense of how the deleveraging of its economy materialises. China will become the risk factor for 2025 – economically, geopolitically and commercially in the way it will respond to the onset of tariffs from Washington.

Despite a recent, aggressive financial stimulus, the Chinese economy is gripped by deflation – in house prices, activity and a fall in entrepreneurial activity. Underlying this is a generalized demand problem.

This year’s plenum on economic policy has not done much to repair the structural creaking of the economy and the worry is that internal ‘reform’ (i.e. a political crackdown) further saps the willingness of entrepreneurs to invest, and equally that Xi is shaping China in the form of a more closed state, that curbs the will of those inside, adopts a singularly selfish approach to those outside, and relies on several great strides in technological industrialisation for the prolongation of the ‘China Dream’.

The contradiction here, and specifically between the three strands to emerge from the plenum, is that in its policy making and economy China needs innovation but is creating a socio-political system that smothers it.

In this respect, the third plenum and the recent liquidity boost missed a trick in not outlining a Keynesian style stimulus for the economy (or even longer-run structural one). The property market is slowing, entrepreneurs are very cautious and the risks associated with local government debt are rising. While China has so far managed to duck a major recession, the government may have become too complacent about the deleveraging process, and the possibility that this accelerates downwards, dramatically so as was the case for Greece, or tortuously as was the case for Japan.

Bond markets – suffering the hangover from elections

As China slows, the key variable to watch is the Chinese long bond yield, which has been compressing lower in recent months as investors take a dim view of the economy. Elsewhere, there should be plenty of action across bond markets, driven by the fiscal aftershock of elections across the world.

We still have a general election in Japan and the prospect of an election in Germany next February (23rd). In the cases of the US, UK and France, elections have seen bond yields rise in the context of near record indebtedness and very large deficits.

In that respect, the fiscal hangover begins. Governments across regions will find themselves reined in by bond markets and under pressure to curb spending and in some cases to raise taxes. This pressure alone may eventually tilt economic policy more towards supply side changes, and also change the kinds of issues that politicians focus on such as immigration and identity politics.

Fiscal rectitude may only come to reign after a few bond market tantrums. There are two countries in particular worth watching – France and the US. First, the French budget process has been very drawn out, and with France having to cut its deficit in half over the next three years, it is unlikely that France’s political class, not to mention its public, are ready for deeper austerity. In that way, higher French bond yields will be a fixture in markets and might periodically push much higher.

The other market to watch is the US bond market, which in 2025 may become the limiting factor for equity and other riskier assets. Since the Fed cut interest rates by 50 basis points in September, bond yields have risen and remain stubbornly high. With growth in the US economy strong, and other economies steadying, the risk factor is that inflation rises (though lower oil prices and deflation from China can offset this), driving bond yields higher, or that the desire of the Trump administration to run the economy ‘hot’ provokes a rise in yields. In this sense, the bond market may become Trump’s nemesis. The market reaction to this week’s Fed meeting is a sign of things to come.