"Bending, not breaking": The global economy’s new normal

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Joyce Chang: Hello, welcome to ‘Research Recap’ on J.P. Morgan's Making Sense. I'm Joyce Chang, Chair of Global Research here at J.P. Morgan. Today I'm joined by Jahangir Aziz, head of Emerging Markets Research, and Jay Barry, head of Global Rate Strategy. And we are here to discuss the recent conference that we hosted around the annual IMF World Bank meetings. Well, over the course of two days, we had more than 50 sessions on the macro and emerging markets outlook with 100 speakers and 1,000 conference participants from 40 different countries. And we heard perspectives from policymakers, official creditors, think tank and academic and independent analysts on the state of the global economy and markets. Three themes really dominated the meetings, AI, easy financial conditions, and financial innovations. And one of the big surprises was that tech trumps tariffs. There was an overwhelming focus on AI as a game changer that shifted the narrative away from the global trade disruption. This shift is also transforming how markets perceive the time horizon and space to address longer-term fiscal challenges. So I'm delighted to have Jahangir and Jay with me to really look at the macro risk, how are we looking at where we're at with respect to the trade wars? How are we looking at the rise in fiscal debt and what this could mean for treasury markets? And what is the risk of higher inflation and term premium and stagflation risk at this juncture? We are finding that sentiment is less reliable during a period of regime change as a predictor, particularly as we have many offsets now, there are plentiful, AI, tariff revenues, private markets, digital assets and deregulation. All of this is disrupting traditional economic reactions. So Jahangir, let me start with you and let's just start with trade, because that has been front and center this year, although I do think that tech is at the point now where it's kind of overtaking in the headlines. So despite the tariffs, the geopolitical uncertainty, the global economy has proved largely resilient so far, there's been a disconnect between the pessimism in global sentiment surveys and strong hard data. So how has recession risk changed and what is the risk of stagflation?

Jahangir Aziz: Thanks, Joyce. We'll touch upon AI and tech even in this question, but let me start with tariffs. So clearly the transmission of tariffs both to supply chain disruptions and to inflation has been much more muted than we all feared back in April when the first round of tariffs came. And let me point out to about three or four reasons as to why that was the case. So first of all, even though the tariffs have increased on an average basis, there are several very sensitive sectors, like autos, pharma, energy, electronics, where there are extensive exemptions. There's also exemptions to goods through the USMCA trade channel from Mexico and Canada. Remember, Mexico and Canada are the two of the largest trade partners of the U.S. Let's add to that, the trade deals that, U.S. have signed with EU, Japan, Korea. Don't get me wrong, the average tariff rate is around 16-17%, it's significantly higher than the 2.5% at the end of last year. But I think the transmission to supply chains because of these have been limited. Similarly, the transmission to inflation also, also has been muted. And that's partly because firms so far have been absorbing much of the tariff increases on profit margins. And to some extent you've seen a very strong front loading before the tariffs actually kicked in. So April and May, there was a massive increase in U.S. imports. And lastly, I would say that transshipments, which is basically rerouting goods from high-tariff countries such as China, through low-tariff countries like Vietnam, Thailand is still ongoing. And I think as a combination of all of these things, we have seen much more muted impact on goods inflation than what we had feared. But the challenge is that there are limits. There are limits to how much a firm will absorb these tariff increases on prices. And our sense is that the first phase, which is absorbing things on their own margin, is probably coming to an end, and therefore we should see much bigger transmission onto inflation in the coming months. The third factor, and here comes AI, third factor has been something that no one saw it. Back in April when we were in Washington during the spring meetings, we had one session on AI. This time around almost in every session AI was brought in. And here too, AI plays a big role. So independent of the tariffs, independent of the position of the U.S. business cycle, there is a secular increase that is taking place in capital spending, both on construction of data centers, as well as on tech equipment. And that roughly about 30, 40% of U.S. growth in the first three quarters is being attributed just to that. And this is not just a U.S. phenomenon. We've seen this being spilled over in East Asia, which is obvious because that's where the semiconductor equipment come from, but surprisingly it's also in Euro area over the last two, three months. So this is a global phenomenon, and that's been one of the key factors holding up U.S. growth and the global economy. Again, the big question is, how long will it last? I hope you got some clarity from the meetings. But those are the factors, I think are keeping up the global economy, pass-through and inflation is coming. So even if we see that the global economy will be slowing down, it's not going to break. So the language that we have changed now is not about recession risks, but the economy bending but not breaking. Alongside, that inflation will likely remain very sticky. It's been sticky, it'll likely remain sticky. And we are talking about the U.S. over here. Part of the reason is that we are anticipating an impact coming from tariffs. But also if you look at wages, which is another key factor in core inflation, wages haven't really come down, even though employment has come down. And that is largely because immigration has been brought down very sharply. So unemployment rates haven't really spiked the way you would expect it. So the combination of all of these three things is where we think that the U.S. economy is going, which is, yes, we have avoided recession, but most likely we are in for a stacked inflationary kind of an environment in 2026.

Joyce Chang: No, thank you so much, Jahangir, because as we look at the challenges that are coming up, I think we see focus on the, not just like the fiscal, the macro outlook, we're also seeing just a lot of questions on the use of executive power and the use of emergency powers. And what we have coming up in the next couple of weeks is a Supreme Court decision that's pending on the legality of the use of emergency powers for imposing tariffs. There's a lot of concern that the deficit hasn't come down, but this tariff revenue may not materialize depending on what the Supreme Court rules about the legality of using the Emergency Economics Power Act for reciprocal U.S. tariffs. So let's talk about this a bit. How would this impact the fiscal dynamics? And this really will lead us into going to the rate side for the discussion. And how easy is it to substitute tariff collection through other mechanisms?

Jahangir Aziz: So if you look at the actual amount of tariff collected on an annualized basis, last month it was running around $350-billion. Of that, we estimate that about $200-billion. So the, most of the $350-billion is attributed to what are these IEPA tariffs. These are the emergency power tariffs, these are the reciprocal tariffs, the fentanyl-based tariffs. These are not the sector-specific tariffs. Those are not the ones on auto, steel, aluminum, et cetera, or the 301 tariffs that were imposed on China. But if you leave those out, all of the tariffs are essentially IEPA tariffs. So if 200-billion goes away, if the Supreme Court actually sides with the lower courts and says, "Look, IEPA is not legal," then we do have a problem, at least Jay has a problem, because the market is basically looking at $350-billion as additional revenue that was not in the CBO estimates when the One Big Beautiful Bill was being discussed. So both for FY25 and FY26s, people are looking at, at least half a percentage of GDP will come from these tariff revenues. So instead of a 6.5% of fiscal deficit in 2025, you're looking at 6% roughly. Instead of a 7% fiscal deficit, you're looking at about 6.5% for next year. This along with the anticipated Fed rate cuts are key anchors to long-term yields. So if this goes away, there will be a period of uncertainty when the market and analysts will be trying to look for, "Okay, what are the alternative means by which we can get back tariffs?" There are alternative means. There are several other means by which the U.S. can reimpose tariffs. These are under various sections of the various trade acts of 1974 and 1962. And they can be used to reimpose tariffs, and most likely they will be used. The problem is that all of the other sections, are much more cumbersome, they're limited in scope, and they're very resource intensive to implement. This is the reason as to why the Trump administration did use IEPA in the first place. So there will be a period of time when people will start questioning how much more tariffs can the new tariff regime bring about. And in that period of time, my guess is that people are going to look at much higher fiscal deficits. And that would clearly have an impact on, at least on the long end of the yield curve, if not on the short end of the yield curve.

Joyce Chang: So it sounds to me that the trade war is not gonna go away anytime soon, we're gonna have to keep our eyes on the tariff rates. But the other thing that has heated up along with the Supreme Court decision and what happens with tariffs is we had thought that perhaps we might see some fragile stability between the U.S. and China, but we see that tensions are back again. And I wanted to just ask you how you're seeing the U.S.-China relationship developing, and also what impact this is having on China's growth prospects, and what their policy response is, and the market implications.

Jahangir Aziz: So if we look at the data right up to the first three quarters, China has done remarkably well given the amount of tariffs they had to face, right? I'm not talking just about the 145 threatened tariff, but even the current rate of tariffs, which is around 40% average tariff rate, these are significant tariffs. And China has essentially managed to get around it by, A, finding out new markets, and by using other countries, low-tariff countries in Asia through, of transshipping its own exports. So just to give you some sense, so China right now, only about 10% of China's exports go to the U.S. It was 18% back in 2017. So there's a huge decline in U.S. market share. And again, you know, one, the market share in European Union has gone up, market share in other emerging markets have gone up, but it's becoming more and more difficult to do that. And so if you get a new tariff regime, so one hopes that the summit between President Trump and Xi Jinping will end up in some sort of a compromise. But if that doesn't happen, and we end up with a higher tariff regime, then clearly China is going to face serious headwinds next year. And add to that, domestic demand, whether you're looking at consumption, whether you're looking at investment, remains very weak. So if you add these three things together, headwinds on exports continue to slow down in consumption and investment, then you really require fiscal policy again for the third consecutive years to be the big support for spending. In fact, we do have fiscal deficit going back to 4% at the central-government level, at the overall government level, going back to about, close to 13% again next year. And that should more or less be able to give you a 4% growth rate, which is likely to be lower than what the government's target of 4.5% we think will be. And so it will be a struggle. And again, China requires structural reforms, China requires a way in which it redirects its fiscal policy away from just pushing things to be produced to things to be consumed. And as long as China doesn't do that, they will continue to face this problem.

Joyce Chang: No, thank you so much for that Jahangir. There's just a lot of risk on the horizon. And I really want to turn now and talk about debt markets, the structural shifts that we're seeing in the fiscal deficits and the debt levels, because they've ballooned not just in the U.S., but across the G4 with more market volatility. But despite all of this, over the last few months, we've seen the term premium has stabilized. I am wondering if this is going to be sustainable. And so I'm just so pleased to have Jay Barry here to talk about the rates markets. Well, Jay, we're seeing inflation stuck in the 3% zone. A lot of the speakers we heard from last week argued convincingly for patience before embarking on an extensive Fed easing cycle despite the pronouncements that we need lower interest rates. How are you seeing the conditions for the treasury market right now, and how do you expect the Fed to act? And where do you think that the Fed funds rate can go by the end of 2026?

Jay Barry: Sure, Joyce, and thanks so much for this. And I think just to build off of what Jahangir has already talked about, which is a U.S. economy which bends but does not break, that sets the stage for kind of considering our Fed forecast. But if we had all sat here six to nine months ago and talked about a Fed that had already eased 25 basis points with core inflation running 3% and markets pricing in an additional 125 basis points with core inflation where it is, I think we would've been shaking our heads. But I think we can attribute that to the Fed's asymmetric dovish bias. And much like we saw last fall, it has once again elevated its labor market mandate over its inflation mandate. So this risk management approach that the Fed has talked about, it understands that what we've seen here in the labor markets in the U.S., some of it is the reduced immigration that Jahangir has talked about, but some of it is a reduced demand for labor, which has pushed the unemployment rate higher. And the bigger risk to the U.S. economy from here is a labor market which really significantly loosens, and that's opened up the door for cuts. Our approach to this against the backdrop of an economy that again, bends but does not break, is a Fed that delivers sequential 25 basis points cuts in October, in December, and again in January. So another 75 basis points of easing. And I think with considering where the markets are priced right now, that would take the Fed funds rate to 3 1/4 to 3.5% zone by the end of next year. And again, markets are pricing in a considerably easier path than that. But I think it's because the market participants know when there's an asymmetric reaction function from the Fed, there's also an asymmetric distribution to the economic outcomes over the next year. The bigger risk is a bigger downdraft in the economy. But second, and Jahangir has spoken about this, because the impact of increased tariffs on consumer price inflation has been limited so far, markets are taking this in stride. Unlike where we were back in the spring after the supposed Liberation Day announcement. Market-based inflation expectations both at the short end and at the long end do not indicate inflation, which is likely to be since considerably higher. So I think some of this is not just downside risks to the labor market which is being priced, but also somewhat of an immaculate disinflationary sort of environment. So if we're right though, and the economy holds on and delivers a period of subtrend growth before firming up into next year, but inflation, as has been talked about, actually firms up from here as well, as you said, it's probably difficult for the Fed to embark on a full series of rate cuts. And if the Fed does not deliver them, it's probably tough for treasury yields to continue to decline from here. So if I look at our targets into next year, we have front-end treasury yields in the two-year sector very close to where they are right now. And in fact, we actually have 10-year yields a good 20 basis points higher against that backdrop as well.

Joyce Chang: Jay, that is a great segue really into talking about the supply and demand conditions for U.S. treasuries in light of what Jahangir told us about the fiscal deficit, and some of the concerns that this tariff revenue just may not materialize or will be materially delayed as far as the collection. So can you just go through what your estimates are for the U.S. treasury funding gaps and also how demand is going to be met? Because we are seeing more questions about stablecoin, is that going to affect U.S. treasury bond demand? And how are foreign investors looking at this whole situation as well, as we have seen, just the rising level of debt as more of a global phenomenon, not just a U.S. phenomenon?

Jay Barry: I think the first thing I'll say, just to clarify, Jahangir, if we don't have tariff revenue, it's not just my problem, it's $30-trillion in bondholders' problems.

Jahangir Aziz: But, but, but it's going to be your problem first.

Jay Barry: (laughs)

Jahangir Aziz: (laughs)

Jay Barry: All right, fair. But I think, Joyce, back to your question on this, as we look ahead, we think that treasury is able to keep its long-term suite of auctions unchanged through the spring of next year. And there's a couple of reasons behind that. First, and I think we heard this from policymakers in DC last week, there's some comfort that tariff revenue is offsetting the loss of revenue coming from the tax cuts that were passed earlier this year. So that equal offsetting of 350-billion is just pushing out any need for the Treasury Department to make any changes to its suite of longer-term auction products. And in fact, for about a year and a half now, the Treasury Department has given us Fed-style forward guidance telling us that it does not anticipate making changes to its longer-term suite of coupon-bearing product for at least the next several quarters. So that's done an effective job at anchoring long-term rates using monetary policy-style guidance to anchor long-term yields right there. And I think that's a pretty strong story. We heard that from policymakers as well from the Treasury Department who did make that comment last week. If we're wrong, and the tariffs are not upheld in the courts, there is certainly a risk to that, because I think there's been a good degree of complacency in the markets that we don't need to worry about the expansion of the deficit and what it means for term premium. I also think there's a good degree of comfort there because there is some commonalities here going on globally. We've seen a similar story, central bank QT across the developed markets and reduce demand for long-duration assets, which is producing higher term premium and steeper yield curves, it's not just the U.S. But some of our biggest fears are not necessarily at the forefront right now. Yes, Takaichi becoming prime minister in Japan could point to easier monetary policy and more fiscal expansion, but it doesn't seem to be right now, and long-term JGB yields are not rising. Secondly, it seems like the markets are braced for a more disappointing outcome in the UK fall budget this fall too. So while there's been pressure at various points globally on treasury yields this year, it's just not there right now. And as I look ahead, we expect once again issuance to remain unchanged at the long end of the curve through the spring of next year. And we expect the Treasury Department to lean on the T-bill market, where the T-bill share of debt right now is about 22%, the administration has made overtures that the growth of stable coins could ultimately create 2-trillion in demand for treasuries over the next few years. When I look at our own estimates, they come up anywhere between five or 600-billion on the low end, up to 1.4-trillion on the high end. That would certainly allow for greater reliance on the T-bill market. However, I noted that there's 30-trillion in debt outstanding, and T-bills already represent 6.2-trillion of that. So there's going to be a limit at some point. And if we're right, there's about a $4-trillion funding gap that begins to emerge in fiscal '26, which has just begun. And it's going to mean at some point they're going to need to increase issuance, but it's just not until next year, which means that this is probably going to mean the scope for yields to move considerably higher coming from the fiscal perspective is pretty unlikely. And instead it may only come if the Fed delivers fewer cuts than as expected, as we talked about before.

Joyce Chang: Jay, you make a great point, that time is the ultimate judge, because I can hear Jahangir here say, "Well, there could be a gap." It's 350-billion on, that they're collecting in tariff revenue. But on the other side you're saying, "Well, the treasury demand, even though it's for bills, could rise 500-billion or even more." So I'm not sure that the market is necessarily going to push the panic button that easily when they look at the funding needs. But you mentioned some of the global conditions, worries about the UK, and that some of the volatility in France and Japan has subsided. But one thing that I think has just been very striking is that when I get questions about U.S. treasuries, a lot of them have actually been about the spillover risk to U.S. rates from things like the Japanese super-long-end fluctuations that we've been seeing. So how are you looking at the global backdrop and how much scope there is for rates to fall given some of the volatility we've seen? And outside of the U.S., how aggressive can the rate cuts be?

Jay Barry: So I think on the first, again, to kind of go back to what I mentioned briefly before, I think there are some common features to government bond markets across the developed markets right now. And one is that debt management offices who would lean more heavily on long-term issuance coming out of the great financial crisis, have found that the demand for those longer-duration assets has been fading. And it's most acute in Japan where it seems like new money is going to the banks and not to lifers. So the demand for the super long end of the curve in Japan has faded at the same time that the Bank of Japan is running QT at a faster rate relative to the size of its economy than any other developed market central bank. And that's introducing more volatility into the long end of the Japanese curve, but I think that's well understood right now. And there was the brief introduction of further volatility a couple of weeks ago when Takaichi unexpectedly won the LDP leadership. And I think there is, alongside her newly-minted premiership, the risk that it could result in easier fiscal policy and easier monetary policy over time. And certainly markets are pushing back on the notion that the BOJ can raise rates later this month. And that's the medium-term concern that makes us think that the volatility at the long end of JGB curve will remain elevated over time. But to the extent that these are not near-term developments, we think a lot of this is already in the long end of the curve price and unlikely to result in significantly higher JGB yields near-term, more of just medium-term volatility. Elsewhere, I think we've seen the same thing in the Euro area as well, where the anticipation of Dutch pension fund reform and the move from defined benefit to defined contribution should mean reduced pension demand for the long end of the European curve as well. But markets have been talking about this for nine months in position four, it seems like it's very much in the price as well. And further from that, those, there was an increase in supply in Germany coming from its fiscal expansion. The magnitudes of those increases are pretty limited, and against the backdrop of this dollar-diversification story you've talked about, we think are going to be easily absorbed. And then finally, there's the UK, which I think was the poster boy for fiscal largesse in the way the bond market treated it in 2022. But right now it seems like markets are prepped for a disappointment when the fall budget's released, and long-term gilt yields remain elevated. So I think there is certainly a risk that if any of those markets become more volatile once again, it could reduce, introduce uncertainty into the long end of the treasury curve, but it doesn't seem like it's right now. But I do think medium-term, this common backdrop means that term premium, which is reversed higher, is here to stay. The abnormal feature of term premium being low was a function of central bank QE and low interest rates for the last 15 years. And this is a normalization. So absent a recession, it means that long-term interest rates are going to be really challenged to fall further from where they are right now.

Joyce Chang: No, I completely agree with you that the long-term interest rates, when you look at just the demographics as well, which we didn't even have a chance to talk about, the dissavings that will occur, along with the fiscal debt mean that we should be prepared for a period for term premium not to come down around the globe. Well, we've talked about so much. We know that the trade war is not going away anytime soon and could become more complicated to watch as we await the Supreme Court ruling. We also see that U.S.-China tensions are going to be a source, uh, also of ongoing volatility, with economic consequences for both the U.S. and the Chinese economy. And turning to the fiscal debt, the inflation outlook, those really are the more medium-term challenges, which even if we see the very strong investment from AI, these problems are not going away anytime soon as far as the long-term secular trends. So time is the ultimate judge here, but over the near-term, it seems like this investment into tech and AI, the fiscal dominance, the deregulation, which we didn't talk about, could mean that these macro risks do not become more elevated for the next couple of months, but could be the key things we're gonna watch in 2026. So thank you so much, Jahangir and Jay. Stay tuned for more episodes of ‘Research Recap’ on the Making Sense channel, where we explore the key macro and market trends impacting financial markets. Thank you to all of our listeners for joining today.

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