Rewind: The Inevitable Divergences of 2025

Here are the important macro trends that will shape not just this calendar year but also the entire decade

By V Thiagarajan

“There is an inevitable divergence,” J William Fulbright noted at the height of the Cold War, between the world as it is, and the world as man perceives it. For a long time, the consensus at least agreed on the trajectory of travel with respect to most of the asset markets. But in recent times, there has been hardly any agreement.

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Such lack of consensus might be the consequence of the continued higher imbalance between perception and reality leading to exuberant expectations of prosperity at the beginning of a calendar year followed by a trough of disillusionment towards the end of the year. This year would follow this script as well.

At this time of the year, investment houses publish their yearly forecasts. Unlike in previous years, the direction of all the asset classes this year majorly depends on the trajectory of policymaking in Washington. Most research reports see a 10% rise in stock indices on the presumption that markets would muddle through the fog on some middle ground that’s less than half the annual gains of the past two years. The hype cyclers — in keeping with their broad business interests — have been pushing the idea of a lower US dollar and softer rates accompanied by higher equities. Interestingly, they tend to go with that narrative every year. It is quite possible that these forecasts would fail to endure beyond the first few months of the year.

The story of Latin American revival implies that the continent could see a strong spell of growth whereas Asian economies led by China would continue to stay sluggish in 2025

Hence, it would be an easier option for anyone to say that the investors should brace for a year that might feel deceptively calm on the surface but could still be fraught with pitfalls, without committing to any imminent direction. The tougher task is to walk the extra mile and build a macro view by assessing the structural trends without getting distracted by the cyclical aberrations.

A few important macro trends that would be relevant not only in this new calendar year but over the course of the decade are:

Trend 1: Fiscal dominance to stay

Fiscal dominance is an economic condition that arises when debts and deficits are so high that monetary policy tends to lose traction. After years of dormancy, fiscal policy has emerged as the major driver of the economy over the last five years as the fiscal impulse (‘push’ or ‘pull’ from the government to the economy) has been quite large with enormous impact. For context, the global economy was about 15% larger at the end of 2024 compared to the start of 2020, while the incremental global fiscal impulse 13.9% of the collective GDP for 2020.

Understanding monetary or fiscal dominance begins by appreciating that at the most fundamental level, monetary and fiscal policies must achieve the prime directive: determine and control the aggregate price level — and its rate of change, inflation — and stabilise the level of government indebtedness to ensure those policies are sustainable. If one policy is dominant or “active” — then the other policy must stay supportive, or “passive.” Two dominant policies cannot coexist indefinitely and one policy should relinquish dominance eventually to become passive.

We may be living through five Sputnik moments at the same time across semiconductors, artificial intelligence, quantum computing, climate technologies and biotechnologies

The intellectual appeal from the above matrix is clear — the current dynamics of fiscal dominance explain why there had been no recession, why inflation remains sticky, why long yields are still high despite the Fed’s easing, and why stocks don’t care about the yields. It is now expected that the realised debt-to-GDP ratios five years ahead can be 10 percentage points of GDP higher than projected on average. So fiscal dominance is set to stay as a key factor going forward.

IMPLICATIONS

• As fiscal dominance rises, the economy faces a greater risk of prolonged inflationary periods as validated by Nobel laureate Tom Sargent’s assertion that ‘sustained high inflation is always and everywhere a fiscal phenomenon, in which the central bank is a monetary accomplice’. As a result, interest rates could continue to stay elevated. Experience shows that high debt and lack of credible fiscal plans might trigger adverse market reactions, constraining room to manoeuvre in the face of turbulence.

• Levy-Kalecki’s identity holds that bigger government deficits would always translate into higher corporate profits if there are no major changes in investment, private savings or dividends. So in this regime of fiscal dominance, corporate earnings would be higher, supporting higher stock prices.

• Higher government debt always results in lower corporate investment. Standard models of crowding out confirm an increase in government spending puts upward pressure on interest rates which, in turn, leads to lower private investment.

• Rising deficits driven by interest expense are less stimulative and hence growth creating capacity for the incremental debt is always limited. So the markets expecting growth impetus from higher fiscal deficits might be disappointed.

• The thumb rule is that the price of gold reflects the inverse of trust in the central banks. Higher gold price is a manifestation of the collective wisdom that central banks have been pushed to the brink of losing their independence.

• It is pertinent to note that Trump’s previous presidency had been in an era of monetary dominance and the upcoming tenure would be in fiscal dominance regime. Hence the economic impact of his second presidency might not evolve on the lines of his first.

Trend 2: Technological Supremacy of US

Science and technology have emerged as the ‘new currency’ of global power and the US continues to be far ahead.

The turn of the millennium heralded a transformative technological era that profoundly reshaped the US economy and was marked by the rise of the internet as a ubiquitous platform, a surge in mobile connectivity, and the birth of the social media culture. The technology giants in the US created enormous wealth as the rest of the world continued consuming their goods and services. The market capitalisation of Mag 7 rose from $244 billion in year 2000 to $16 trillion in 2024 and even to this date, they don’t have any competition from the rest of the world.

The technology giants in the US created enormous wealth as the rest of the world continued consuming their goods and services. Even to this date, they don’t have any competition from the rest of the world

As if these giants are not enough, the US will add more powerhouses in the next decade. US Secretary of Commerce Gina Raimondo compared the contemporary chips race to the space race of the 1960s: a new Sputnik moment. Indeed, we may be living through five Sputnik moments at the same time across semiconductors, artificial intelligence, quantum computing, climate technologies and biotechnologies. Ultimately, the most critical long-term path for the US is to out-innovate China across advanced technologies.

The technological supremacy of the US is set to sustain over a long period and would be the first pillar of US exceptionalism.

Trend 3: Productivity boom in US continues

Productivity is the bedrock of growth — in the long run, creating more with the same amount of labour is the only way to durably increase wages, consumption and overall prosperity. The US economic output per hour worked has risen 8.9% over the last five years — faster than the five years’ prior or any point in the 2010s — in spite of the pandemic. This productivity boom has delivered significant gains in real wages throughout the pay distribution, which in turn has enabled higher household consumption.

It’s also worth noting how little of this productivity boom can be ascribed purely to technological innovation — other high-income countries have the same access to the teleworking tools and artificial intelligence programmes that the US has, but none of them have productivity booms on the scale of the US. It’s the combination of technological innovation and macroeconomic incentives for its rapid deployment which, when combined, brought American productivity growth back up.

This productivity boom is one of the reasons for economic resilience and this productivity differential with the rest of the world is the second pillar of US exceptionalism.

Trend 4: Latin America is New China

Opportunities are never static and capital is always dynamic. There appears to be a subtle shift of importance as well as capital from East to West on the back of expectations about Latin America’s economic revival. The second half of this decade of the 20s could be the key road to Damascus for Latin America resembling China’s WTO moment of 2001.

The standout story of the Argentina economy in 2024 has created this rethink. Because of the intrigue surrounding the administration, the specific economic views and economic policies of the new President of Argentina Javier Milei have become one of the more popular topics in contemporary economic and political discussions.

Market capitalisation of Mag 7 (Magnificent Seven Stocks: Alphabet, Apple, Amazon, Meta, Microsoft, Nvidia and Tesla) rose from $244 billion in 2000 to $16 trillion in 2024  

After taking office in December 2023 and inheriting an economy with hyperinflation of 211%, Milei was mainly associated with words like ‘chainsaw’ and ‘anarcho-capitalist.’ In his first year of presidency, Milei’s commitment to fiscal adjustment is changing Argentina and he is now associated with cutting back bureaucracy, falling house prices, a current account in the black for the first time in decades, much lower government bond yields and a stock market (in USD terms) that has almost doubled and an economy emerging out of a deep recession into the solid growth path.

The Milei template has been rapidly gaining political ground in the rest of the continent and the belief that this Argentine model would get wider and swift acceptance in their respective countries. In such a case, there would be an economic revival in Latin America in the next few years dwarfing what had happened in Asia in the last three decades potentially leading to a wave of prosperity in Latin America, even if not everywhere at the same pace. The region has abundant natural resources and hence investment would follow the economic revival — it is not inconceivable to think that Latin America could emerge as the new China in the remaining 20s.

In Sum

Broadly, rates across the world might stay elevated on account of the continuing dynamics of fiscal dominance. The rest of the world would anchor their monetary policy with the US — a systematically important nation for the rest of the world — and they cannot adopt incremental monetary policy easing, whatever the divergences in the business cycle are. Exchange rate depreciation is the only choice and the dollar is likely to continue gaining strength.

Technological supremacy and incredible productivity boom are the two resilient pillars of US exceptionalism — the story of divergence with the rest of the world is set to extend further.

The story of the Latin American revival implies that the continent could see a strong spell of growth whereas Asian economies led by China would continue to stay sluggish in 2025 — Another Divergence might emerge. These are Inevitable Divergences.

(The author is Chairman of SYFX Treasury Foundation. Views are personal and not to be construed as recommendations)