Are Equity and Bond Markets Both Wrong?

Summary

• Equity and bond market pricing of the US economic outlook could only be consistent under the ‘Goldilocks’ economic conditions prevailing during 2022-24’s immigration surge.
• But immigration has collapsed, which is likely to cause ‘stagflation-lite’ economic conditions.
• Soft private sector demand due to weak confidence will dampen inflationary pressures in 2025. The fiscal stimulus Congress is about to deliver could offset this in 2026.
• Expectations of an earnings recovery and of multiple Fed cuts in 2026 are unlikely to be realised.

Market Implications

• I still expect two-three Fed cuts in 2025 starting in September in line with market expectations. I expect only one 2026 cut against markets pricing 2.5.

Immigration Surge Enabled Goldilocks

Equity and bond markets are pricing inconsistent macro-outlooks. Equity analysts expect earnings growth to rebound next year while rates markets have been pricing a falling terminal Fed Funds rate. Viresh argues both could be right only under an extreme Goldilocks scenario.

Here, I argue both markets are likely wrong mainly due to the immigration collapse translating into lower growth and higher inflation (i.e., stagflation-lite, full-fledged stagflation would involve recession and inflation far above target). Also, inflation pressures are likely to be contained in 2025 due to weak demand but could resurge in 2026 as Congress delivers a fiscal stimulus.

The current growth slowdown started in Q4 2024 and therefore cannot entirely be explained by the Trump administration’s policies (Charts 1 and 2). Rather, it partly reflects the collapse of immigration following the 2021-24 surge (Chart 3). In 2018-20, undocumented migrants averaged about 750,000 a year. By contrast, in 2021-24 they averaged over 2.5mn a year. These are only estimates as there is no reliable official data. Census Bureau population estimates undercount migrants and so do household survey estimates that are based on the Census Bureau’s population.

By raising labour supply and consumption, the immigration surge allowed growth to accelerate despite Fed tightening, as I highlighted a year ago. Without immigration, the US economy would have experienced recession in 2022 as households digested the hangover from 2021’s surge in durables purchases. Consumption per capita fell in 2022 and recession was only avoided through population increase (Chart 4, due to the aforementioned data issues, I use payroll data as a proxy for population).

The immigration surge also supported disinflation by suppressing wage growth, especially for low-skill workers who were in more direct competition with migrants. Real wage growth turned negative in 2021 and by Q1 2025 real wages (measured by the Employment Cost Index, the Fed’s preferred measure) were still 1% below pre-pandemic levels (Chart 5). This markedly contrasts with, for instance, the recovery from the GFC.

This Goldilocks macro-backdrop explains why equities have been scaling new highs with only a limited increase in long-term yields (Chart 6).

However, the immigration surge is over. In 2024, facing a political backlash, the Biden administration tightened border controls. The Trump administration tightened these further. While no recent data is available, undocumented immigration flows have likely fallen below 2018-20’s lows. This suggests lower growth and higher inflation.

Chart 1: Growth Is Slowing	Chart 2: Growth Slowdown Started in Q4 2024
Chart 3: Immigration Surge Has Ended	Chart 4: Migrants Surge Kept Growth Going
Chart 5: Immigration Restrained Wages	Chart 6: Immigration Enabled Goldilocks

From Goldilocks to Stagflation-Lite?

The Congressional Budget Office (CBO) January 2020 pre-pandemic macro projections suggest monthly NFP could fall to about 50k this year, a risk I highlighted in November. These projections ignore the immigration boom and rather reflect US population aging. 2022-24 were going to be years of massive baby boomer retirements. As a result, participation and employment growth were expected to fall markedly (Charts 7 and 8).

The pandemic and the immigration surge obscured these changes. With the latter over, domestic demographic trends are reasserting themselves. The decline in participation over the past year or the decline in NFP shows this.

I expect demographics could bring NFP to about 50k by yearend, aligning with the CBO’s long-term projections. This would translate into average 2025 NFP growth of 1.1%, barely below 2021-24’s 1.3%. In 2026 and long-term though it would translate into NFP growth of about 0.4%, well below recent years.

If productivity (measured by GDP per worker) was to grow at the 1970-2025 median of 1.2%, trend growth would slow to about 1.5% (Table 1, Chart 9). Productivity growth could accelerate above the median, though historically slower employment growth has tended to offset productivity accelerations (Chart 10).

I think equity markets are overlooking these demographic trends that alone would make for stagflation-lite. However, equity markets could also be overlooking demand weaknesses that will dampen inflation in 2025. By contrast, in 2026 inflation pressures could resurge due to the fiscal expansion Congress is about to deliver.

Table 1: Without Immigration, Population Aging Will Lower Growth

Chart 7: Participation to Fall Further	Chart 8: NFP Growth to Slow Further
Chart 9: Sustained Fast Productivity Unusual	Chart 10: Trend Growth to Slow

Trade Deals Will Not Quickly Restore Private Confidence

A key reason for equity market optimism is the expectation that come 9 July (expiration of the pause in reciprocal tariffs), the administration will not return to the 25% average effective tariffs announced on ’Liberation Day’. Trade deals have already been announced with China, the UK and Vietnam with others in progress.

I agree a return to a 25% tariff is unlikely, but I do not think this will be enough to restore private sector spending. The administration’s economic policies have caused a surge in uncertainty and a loss of business and consumer confidence (Chart 11 and 12). In turn, this has led to private agents suspending planned expenditures, as the marked slowdown in Q2 growth estimates show (Chart 13).

Uncertainty will remain high even if the reciprocal tariffs are not restored. Trade agreement implementation is uncertain. For instance, China is still rationing rare metals. The administration could be planning more tariff increases, based on the Commerce Department’s Section 232 investigations. More broadly, the administration’s tariff policy discretion remains unconstrained.

Lastly, policy surprises beyond tariffs could also be a concern. For instance, the administration’s barrage of Fed criticism could create perceptions of financial and economic risks.

For these reasons, I expect growth to remain below trend in 2025, which will restrain business pricing power and limit the inflationary impact of slower growth in labour supply and of tariffs. For instance, a limited recovery in consumption to 1.2% SAAR in Q2-Q4 from 0.5% QoQ SAAR in Q1 would still see GDP growth below 1% YoY and below 0.5% QoQ SAAR (Chart 14).

By contrast, in 2026 growth will benefit from a fiscal stimulus representing about 1ppt of GDP while the slowdown in labour supply will be much more pronounced than in 2025. These are likely to place a floor under inflation.

Chart 11: Policy Uncertainty to Remain High	Chart 12: Private Confidence Remains Low
Chart 13: Growth Is Slowing	Chart 14: Growth to Fall Further

Market Consequences

Data is unlikely to validate equity markets expectations of an earnings recovery. Growth is slowing and economy-wide corporate profits as well as SPX constituents’ total earnings are near the post-WWII high relative to GDP (Chart 15). This suggests limited scope for further margin increases to offset slower sales and a continued earnings slowdown will be difficult to avoid.

However, ‘economic time’ is slower than market time. Even if my economic predictions are correct, it will take time for the real economy to generate the signal to change equity market expectations. So, the rally could continue, possibly over summer, with the reality check coming in autumn with continued labour market and demand weaknesses.

Also, data could falsify rates market expectations of 2.5 cuts in 2026. In 2026, the impact of the immigration collapse will be more noticeable, including through faster wage growth. Meanwhile, fiscal expansion will boost demand. Lastly, the past year trend increase in goods prices could put a floor under inflation, a topic I will address in future research (Chart 16). As a result, I believe fixed income markets could be overoptimistic with expectations of 2.5 cuts in 2026.

I still expect two-three cuts in line with market expectations in 2025.

Chart 15: Limited Room to Increase Margins	Chart 16: Goods Inflation Predates Recent Tariffs

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