Fairy Tales and Reality

While the Federal Reserve joined the rate-cutting party in mid-September, competing narratives about the path of the US economy and inflation remain.

Persistently high equity valuations imply markets currently are pricing in a Goldilocks scenario. In this version, corporations continue to shoulder most of the tariff-related price burdens—insulating consumers from the worst of the impacts—while at the same time ramping capital expenditures thanks to tax breaks that encourage the expansion of domestic production capabilities. This dynamic gives the Fed room for additional rate cuts amid massive fiscal deficits, leading to a further steepening of the yield curve that supports equity markets, GDP growth and corporate earnings.

A more bearish viewpoint likely would suggest that tariff-related inflation pressures have yet to fully work their way through the system. Corporations likely will begin to pass along a larger share of higher prices to consumers as margins continue to compress, however, further weighing on lower-income consumers already feeling the effects of a sluggish “no-hire/no-fire” labor market. The Fed’s hands tied by persistent price pressures the potential for stagflation emerges amid faltering corporate earnings.

The outlook abroad, in contrast, appears less path dependent. With price multiples more consistent with historical averages and visible catalysts for earnings growth, a number of non-US markets, in our view, may present attractive alternatives for equity investors.

In Europe, for example, increased defense spending across the continent should bolster growth broadly. Notably, Germany has taken steps to leverage its fiscal space by permanently exempting defense spending from its constitutional debt brake and creating a €500 billion infrastructure fund; leading companies subsequently pitched in with a “Made for Germany” investment drive worth at least €100 billion by 2028.¹ In Asia, corporate reform in Japan continues apace and Korea more recently has introduced its own plan to improve governance. Certain emerging markets, meanwhile, are demonstrating classic outperformance amid Fed easing and the potential for a reemergence of the carry trade in the face of softer US dollar.²