Macro questions and market strength
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I think it's fair to say it's been a pretty interesting start to the year with the new Trump administration's policy announcements coming fast and furiously since the inauguration. So what impact do they have on the economy and on markets? I'm Alison Nathan, and this is Goldman Sachs Exchanges. Today, I'm sitting down once again with Jan Hatsias, head of Goldman Sachs Research and the firm's chief economist, and Dominic Wilson, senior advisor in the Global Markets Research Group.

Yandam, it's great to have you back on Exchanges and to continue the dialogue we began last November, soon after President Trump was elected.

Great to be with you. Thank you. On one, I spoke to you and Dom in November. We were discussing your outlook report for 2025. It was entitled with a question, which was, will tailwinds trump tariffs? And I think it's fair to say that the answer at that time was probably. But we've now seen several announcements. We have a better sense, not a complete sense, of course, but a better sense of

of the tariff policy coming through in particular and many other Trump policies. So has your thinking shifted? Would you still answer the question the same way? I would still answer it exactly the same way, both in the sense that I think

the tailwinds are probably going to trump the tariffs, but also that there's still a probably there because we actually still don't know just how pervasive the tariffs are going to be. Of course, there have been some surprises in terms of the details, generally a little bit less focus on China, a little bit more focus on other things. And at the margin, it looks like the increase in the effective U.S. tariff rate

might be a little bit higher than what I would have said three months ago. We were thinking three percentage points or so. I could now certainly see something more in the four, five, six, seven percentage point range. And of course, that has some implications for economic activity and also inflation. But it's not really a major change from a big picture perspective. And I think the tailwinds that...

have been pushing the economy forward are also still very clearly visible. And therefore, our forecast from a growth perspective and from an inflation perspective hasn't changed substantially since the time we recorded the November podcast. We're still looking for about 2.5% growth in the U.S. We still think that

inflation is going to come down, core PCE inflation is going to come down to something like two and a half percent by the end of the year. And in that environment, we still think that the Fed might deliver some additional rate cuts, although we have pushed that out to some degree. But in terms of the overall economic backdrop, I think it's actually

remarkable how little has changed so far. Let me grab onto the inflation point really quickly because I think that is a primary concern in the markets right now. And we did get another set of inflation data that was broadly interpreted as hotter than expected. So that doesn't concern you at all is what I'm hearing. Not if I look at the measure that's most important to the Fed, which is core PCE after the CPI

and PPI data, we think core PCE 0.3%, 30 basis points on the month, which is in line with or even a touch below what we were expecting before the CPI and PPI numbers for January. It is a higher number, of course, than the sequential pace that we've been seeing, but it was predictable that it would be a somewhat higher number because of the well-documented January effect, the tendency

of sequential inflation to be higher and higher than the seasonal factors can necessarily adjust for in months like January when there are a lot of annual price resets following a period during which inflation generally was higher. This is a well-established pattern now. It was much more visible in 2023, 2024. And I think what we're seeing here is consistent with the idea that the catch-up inflation that's

been still a force over the last couple of years, where firms raise prices in order to catch up with previous cost increases, that is gradually petering out. I'd also say if we do get 30 basis points for January, it would come after 11 basis points in November and 16 basis points in December. So that's still a fairly benign pace of inflation.

Dom, if you think about how the markets have reacted to all of this news, so the tariff news and then some of this inflation news, is there anything surprising about how the markets are pricing this? I think mostly what's happened, and it reflects, again, some of the things that we talked about, is that it's become more complicated. I think the

The last few months of 2024 was relatively simple. We were essentially moving towards pricing the kind of growth picture that we've had in our forecasts. And you had a pretty consistent upgrade to growth across a range of assets. You had equities go up, you had yields go up, you had the dollar stronger.

I think what's happened, particularly coming into the beginning of the year, is that the trade-offs across that group of trends has become more complicated. And I think that reflects three things. Part of it is just the uncertainty around policy, the uncertainty around trade policy that certainly created back and forth within equities and asset movements up and down. It's made it a little bit more challenging for people to maintain their conviction that they understand the paths

from here. And so some of that, I think, has probably contributed to a flattening out of that equity uptrend. The second thing which Jan reflected too is that the markets had to focus on a less dovish Fed.

I would say most of that shift really started with the December FOMC, where the Fed signaled more reluctance than before to think about easing. But the uncertainty around policy is, as Ian mentioned, making it easier to envisage that the Fed

postpones the start of easing further and that we're in an environment where rate cuts are slower in coming. That's not a major obstacle. The growth environment, the growth picture looks fine, but I think, again, it complicates the risk picture. The market now is more likely to see upside surprises to growth as something that

stops the Fed from cutting and there's more of a balancing act taking place there. I think the biggest thing and the thing that has changed, I think, relatively more in the markets than in the macro is just pricing. And so the challenge is not that the outlook has changed in a dramatic way, but that relative to when we spoke in November, the market has moved closer to a view that growth is going to be good, that recession risks are

relatively low that felt like a debate we were having with the market for a lot of the last couple of years and it's just less of a debate at this point and so part of the challenge is that baseline still pretty friendly but also reasonably well priced and you've still got these tail risks that you need to balance against that and

And I think that is inherently just a more difficult structure to invest around. What we've seen is essentially as those risks or the deep risks don't appear, markets are finding room to relax in places around that. And then you have the periodic but ongoing fear that the environment is going to change more significantly, which you still have to be cognizant of and wary of.

If we think about how the markets have digested a lot of the tariff news, one thing that I think has been pretty clear has been the strength of the dollar. That seems in some ways to be the easiest asset to own in this uncertain environment. But it's run a lot, a little volatile, but run a lot. So where are you in that thinking about where the dollar goes from here?

Yeah, it has a lot of the same elements that we talked about before in terms of just the challenge being the pricing. We've had a view and we had a view back in November when we talked about it that there were good reasons to think that this policy mix would continue to drive the dollar stronger, both the outperformance of the US economy and just that macro differential, but also the tariff policies that were coming and then the tail risk that's there.

As you said, the challenge is not that any of that story has really changed. The challenge is just that the market has reflected that story to a greater degree. And I would say we're clearly pricing reasonable divergence between the U.S. and non-U.S. kind of growth and rate paths. And there's some tariff risk premium priced. It comes in and out, obviously, with the news, but the market is expecting tariff action to some degree. And so

You've got a little bit more two-sided risk, which we've seen already. If tariffs aren't delivered, you get some relief. And so I think to a greater degree, a much stronger dollar, so real strength from here, probably does depend more on that tariff tail coming more prominently into focus. I think

You know our view has been that there's value in the dollar from that perspective that the prospects of a significant weakening in the dollar given this backdrop of a relatively low and That detail is still one that is worth protecting against but I think that the case for that strength relies more on that balance and what we've seen is that the

the risk that's priced into non-US markets in China and Europe, when you were thinking about surprises and the question you asked earlier, that because we've already priced a lot of risk in that, you've had a relatively low bar for those markets to do better on the absence of some of the bad news that might be coming. So as long as we avoid the worst tales as well, there is some upward repricing. I think that's more an equity story than an FX story. And that's what we've seen so far this year with...

outperformance in Chinese and European equities being pretty meaningful already. But it does mean that the dollar's a more balanced proposition, but we think that deep tail on the tariff side, that it's still the primary place to get exposure to that, and it offers value within a portfolio to have that against your baseline positions. And if some of that deep tail does get realized beyond the dollar, are there other assets that you think could move significantly?

Yeah, I think, again, from a market's perspective, the nice things about all the volatility and the ins and outs of this is we keep getting dry runs of what asset market reactions might be to more significant versions of things. And I think what we've seen is if there is significant and broad-based trade action, broad-based tariffs, very significant tariffs against major trading partners of the kind that were threatened against Canada and Mexico and those

stuck and were delivered for any meaningful period of time. I think beyond the dollar, we've seen that is something the market is likely to treat as an equity negative, both for the US and outside the US. There were meaningful reactions to that news until it was clear that it was going to be reversed. And that downside tail, I think, is also worth protecting against, but probably also underpriced.

The rate side is more complicated. You're seeing upward pressure on near-term inflation views, which makes sense. That's where the direct translation goes through. What you saw, though, in the recent tariff reactions, which we think makes sense, is that the curve, essentially the yield curve inverts, that the market thinks that the Fed may be slower to cut in the near term, but actually that the growth risks and inflation risks further out may end up pushing yields

lower. So I think there are a bunch of places where the market is vulnerable if we move down that route in a much more aggressive way. And that is, in some sense, the opportunity and the challenge in terms of designing a portfolio that can withstand that, but also positions you for the central case.

Dom, I just have to ask though, does it surprise you at all that the equity market is basically still at near record highs amid all of this uncertainty? And we have had Fed cuts, but not nearly as many as we expected at one point. What are your thoughts? I think people are always surprised at the resilience, other than equity investors who expect it. Macro people are always surprised at the resilience of equities to all sorts of things. I think as

As I said, the reality is the equity market's flattish since the end of November. So we've definitely altered the trajectory in terms of the uncertainty. But I think what we're seeing is a couple of things. One, going back to where we started, there are tailwinds. So the basic macro environment is still a pretty friendly one.

Growth is good. The Fed is still in a position to cut if growth stumbles. The inflation environment is not yet challenging in a way that really changes that. Earnings have been strong. Earnings have been strong. We've had some, obviously, some challenges on the AI side, but the general view has been that's more of a reallocation within the equity market and may change the mix of profitability, but doesn't change the overall performance.

optimism there. And I think one of the things you're finding is there's a little bit of a wall of worry dynamic. There is some reticence and acknowledgement that some of these trade and tariff risks might appear. And as of this point, we have not realized any of them in a major way. We have some tariffs against China, which were by and large expected and perhaps a little less than what's ultimately expected. And most of the others we've seen threats, but we've not yet seen realization. And so I'd

I think in that environment, with some hesitancy priced into the market, the natural tendency will be, if that continues for the market to drift slowly higher. As I said, we've really not made that much progress. The real progress has been made this year. China and Europe, at least offshore China,

are up more than 10%. That tells you where the scope for relief is there. And I think you are getting an indication that the US is priced for more good news already when you see that mix. But I do think our base case is still at least moderately friendly for equities. And the longer you keep avoiding those tails, the more you're going to have this gradual upward pressure, I think, on risk markets.

Yeah. Let me ask you about something else that I find somewhat surprising, which is we do have 10-year yields above 450. They've been volatile, very volatile right now, but ultimately they're still very high and higher than we had expected. And at some point when I was having all these conversations, that was viewed as potentially very problematic for the economy. But we haven't seen that, or have we? I mean, is that not

concerning at all that yields are as high as they are and we expect them to come down a bit, but generally stay high. I would look more at overall financial conditions probably than just the level of interest rates and the level of interest rates is still high. That's true at the short end. It's true at the longer end, but in part because risk markets have been quite resilient.

the RFCI is still pretty accommodative. And that, I think, again, is a reason for why the Fed's in no hurry. We're in an environment where the equity risk premium is quite low, valuations are high, that's supportive for activity. And it also means that even though we still have a forehandle on the funds rate,

which is above basically all estimates of longer term nominal R star neutral rate,

could be sustainable for quite a bit longer. We still have a couple of cuts in our baseline for 2025, but we've pushed them to the middle of the year and end of the year. And they might move further because it is quite optional. It's an environment where the unemployment rate is stable at about 4%, and we continue to get growth in the low to mid twos. There's just no real urgency for the Fed to move.

at least until they've gotten a clearer sense of how these policy risks are shaping up. But I think it could be sustainable. I think it's more likely that rates come down over time. Again, that's true at the short end. It's true at the longer end. But much stranger things have happened than these things going sideways for potentially quite a while longer.

But a key part of the tailwinds is the consumer. It's held up remarkably well. And you aren't seeing any cracks in the consumer, essentially, at these sort of higher for longer rates. No, because the higher for longer rates are not... That's not a major rate increase. It's not a negative shock to the consumer. And there's still the tailwind of...

price inflation having come down a lot more quickly than wage inflation, i.e. real wages increasing. If you combine that with some employment growth, still pretty good employment growth, if you take the average of the last three to six months, still close to 200,000 and some other sources of income growth, we're getting real disposable personal income rising 2.5%. And then your best guess, if you

don't have a major change in the drivers of the saving rate is that consumption also grows by 2.5%. And when I then look at all of the other components of GDP, the 30% of GDP that are not consumption, that sort of balances out and we've got GDP growth at about 2.5%. It's a less exciting kind of call than it has been at times in the past, because while that's still above consensus,

It's only above consensus by a few tens. And I think it's probably fair to say that many market participants have a somewhat more optimistic view at this point than the Bloomberg consensus. But at the same time, it's still pretty, it may not be all that exciting. It's still pretty solid. And it's backdrop for, yeah, maybe continuing to climb the wall of worry.

Not exciting, but I think interesting. And that explanation, I think, was quite interesting. And, Don, if I kind of turn that question back on to you in the sense that we have 4.5% plus 10-year yields, we also have the stronger dollar. At one point, we were worried about

equities when we were seeing a higher dollar and such high yields. That's not a concern I'm hearing. Yeah, look, it's less of a concern for us, I think. There are definitely people concerned about that, more concerned than we are. When I step back, I think the mix, it's similar to what Jan said with regards to the economy on markets that

The notion that there's a level of yields that is unsustainable and that you can define that, I think that is just a very complicated thing to know where yields belong over the medium term, both in terms of our ability to understand where neutral rates belong for the economy, but also in financial markets to understand what the appropriate pricing is.

I think for me, there are two or three things that it's better to ask about in terms of understanding whether they're a problem or not. The first is what's driving it. Are we mostly pricing higher yields because the growth environment is supporting that is better or is there some other problem, some inflation problem that is driving it? We had inflation driven rises in yields in 22, 23. Those were more damaging. But most of the reason we've pushed yields up is because the economy has continued to perform significantly better than people have expected.

So it's a side effect in general of a big growth upgrade that the markets made and that's sort of more manageable. As long as that stays the kind of driving and motivating force, that's probably manageable. The second thing is, in the end, do you think the Fed is ready to cut rates if there's a real growth problem? Are they constrained in any way? I think for equities, in some ways, you need that more than you need yields to be at a particular level. If you know that the Fed is ready conditionally to support you, that is a source of comfort, that put, if you like.

exists. I think there are worries about it every time inflation picks up a little, but the basic answer to that still is yes. And the third, which reflects those two things, is when I think of longer dated bonds, is are they getting more protective of equity portfolios? People are going to want to hold those against an equity portfolio, which comes down a bit to what's driving again. But the more we think that the inflation environment is still gently cooling, even if it's still above target, and that

There are these potential downside risks to growth in which bonds might be protective. The case for having bonds in a portfolio is also something that helps anchor demand for that in a broader sense. So I would say those things could be challenged. There are definitely policy outcomes and macro outcomes that could challenge them. But at the moment, I feel like with those questions giving you more generous answers still, I think it's not an unmanageable situation.

Yann, I want to end with a broader question, which is also policy related, but in a slightly different way, which is, I think you said something to the effect recently that policy changes are making the data murkier. And you said this in the context of

payrolls, I think, because we are seeing big changes in the population, which could be influencing them. We're also at the same time seeing federal agencies being shrunk and consolidated. So when we think about the data that's available to us to understand what's going on in markets,

Ultimately, are you concerned that the information isn't going to be there or it's not going to be as reliable as in the past? Yeah, I think the payroll numbers have been a bit less meaningful in the last couple of years. That continues. It might get a little bit better again, but it has been less meaningful because prior to the pandemic, we always had a very clear sense of what the break-even rate of payrolls was. And it was

call it 70,000 a month. So you knew that anything materially above that was a strong report that meant reducing labor market slack and something below that was a weak report. There's been a lot of uncertainty about the break-even rate of payrolls, in part because measuring immigration, especially unauthorized immigration in real time, is very complicated. We think that the break-even rate is about 150,000

but coming down probably fairly steeply. And the range of uncertainty is several tens of thousands at any point in time. So that's been less reliable. I think if we get to a more stable, very low net immigration environment, we'll go back to something in the 50 to 100,000 range for break-evens so we can put a bit more weight on payrolls again. I think in the recent past, I would...

say, you should put more weight on the unemployment rate, you should put more weight on employment to population, on USECs, on some of these household survey ratios, and that might shift back a little bit. In terms of federal agencies being consolidated and perhaps shrunk and programs being shrunk, that's certainly something to keep an eye on. So far, we haven't seen any data sets disappear that are essential. You know, it's a little bit TBD-y,

I think in general, I would always recommend looking at a broad range of indicators that aim to measure similar things and then averaging them. And in many cases, that gives you a more robust answer because...

Even under normal circumstances, there's a lot of noise in each individual series and you want to try to wash out that noise as much as possible. But it sounds like your job and our jobs could get a little bit more challenging, maybe. There are always new challenges. Jan, Dom, thanks so much for joining us today and continuing the conversation. I look forward to continuing the conversation in the future. Thanks so much. Thank you. This episode was recorded on Thursday, February 13th, 2025. I'm Alison Nathan. Thanks for listening.

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