The whirlwind of policy announcements on all fronts since US President Donald Trump’s inauguration has left investors grappling with the implications for financial markets. What will be the impact of the new policies on business decision-making? Could US exceptionalism have peaked? To what extent is regime change under way in international affairs? These are just some of the questions facing investors after the new US administration’s first month in office.
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One month in, things are moving fast across many policy areas with numerous objectives. At the outset of Trump 2.0, investors may have reckoned that his administration’s main objective would be to shy away from policy measures that could endanger the US economy because of an underlying commitment to a robust US business sector.
There may now be some doubts about the validity of this assumption.
Tariffs – Keep calm and carry on
There has been no let-up in policy announcements about prospective new tariffs. So far, however, financial markets have shaken off concerns as to the potential consequences, judging the credibility of the threats to be questionable after previous measures were postponed and/or became the subject of negotiations.
On 14 February, President Trump declared he would levy reciprocal tariffs on all trading partners – that any tariffs other countries imposed on the US would be matched. However, there were no definite dates, no details, and the president did not sign the usual executive order, instead signing a memo for others to work on it. Markets responded with relief, suggesting they saw this announcement primarily as a negotiating tactic.
The key for financial markets is that the US president (so far) keeps threatening tariffs, but quickly claims victory and backs off. Even if this pattern continues, the problem for financial markets is that all this cacophony and confusion may weigh on business sentiment.
Recent comments highlight the risk that bombastic rhetoric has damaged sentiment among multinational CEOs and policymakers about the investment environment and America’s reliability as a trading partner.
Currently, US business sentiment is still rising. It will take time before any deterioration feeds through into the data, but at the very least, the risk of negative outcomes appears to have risen.
Our fixed-income team perceives US policies as potentially constituting a supply shock, slowing the pace of both US growth and disinflation. Clamping down on immigration into the US and increasing deportations is another policy area that could jeopardise supply chains if seasonal labour becomes harder to find.
In this environment, we favour US real yields, which we see as trading at attractive levels. We view it as less likely that the US Federal Reserve will ease policy rates in a stagflationary scenario. The yield curve could flatten between 2 and 10-years as short-dated bonds reprice accordingly.
Meanwhile, in Europe…
Uncertainty about the direction of travel in the US, some cautionary reallocating of assets for diversification purposes by investors, and the prospect of a resolution to the Ukraine-Russia war has bolstered sentiment towards other markets.
This includes European equities/’peripheral’ Europe (Poland, Hungary, etc.).
Some of the thinking may be that the rebuilding of Ukraine, an increased focus on defence spending, and an improvement in trading conditions will be beneficial for businesses in Europe.
US Defence Secretary Pete Hegseth has ruled out the deployment of US troops in Ukraine should the war with Russia end, saying “any security guarantee should be backed by capable European and non-European troops.” He added that troops deployed to Ukraine should not be part of any Nato mission, nor be covered under the alliance’s Article 5 mutual defence clause.
Shares in European defence companies rallied strongly in the week of 17 February as investors expect European governments to have to shoulder more of the burden for the continent’s security by increasing military spending.
Since the start of his new mandate in January, Trump has ratcheted up the pressure on European allies to boost their defence spending beyond a Nato target of 2% of GDP, suggesting 5% as a new bogey — which at present only Poland is close to reaching. A speech by US Vice-President JD Vance on 14 February in Munich further raised the pressure on European governments.
In response, the European Commission has proposed exempting defence from EU limits on government spending. The head of the EU executive, Ursula von der Leyen, said the lifting of restrictions on defence spending would follow the same logic as the removal of borrowing limits during the COVID-19 pandemic.
One consequence of increased defence spending in Europe may be a rise in sovereign bond issuance to finance it. However, an increase in financing will not come immediately. Legislation requiring a political consensus will be needed.
Our multi-asset investment team continues to favour allocations to eurozone sovereign debt.
What to look out for in the German federal election
Following the collapse of the ruling coalition in November, voters go to the polls in Germany on 23 February. An important outcome of this election will be the share of the populist protest parties in the German parliament. Winning one third of the seats would enable them to potentially block any significant change to the country’s fiscal straitjacket, imperilling major supply-side reforms and initiatives to raise defence spending.
Germany’s balanced budget amendment, or ‘debt brake’, is a fiscal rule enacted in 2009. The law is designed to restrict structural budget deficits at the federal level and constrain the issuance of government debt. The rule limits annual structural deficits to 0.35% of GDP.
