Are exuberant markets ignoring risks?

Yet risks remain: growth data is soft, core inflation is edging up, and the Fed's stance is still cautious. Currency exposure is erasing returns for non-US investors, making FX a key risk factor. Businesses should avoid overreacting to short-term noise, downplay near-term US debt fears, and not overprice rate cuts. Instead, they should focus on fundamentals and currency dynamics.

Asset managers can look at the political negotiation with some amusement, but they can take very little from it. Would one invest in European steelmakers if one weren’t certain that European governments don’t plan to honour their defence spending pledge? Should we “bet” on a quick and dirty (according to Politico) deal between the US and the EU (“quick and dirty” being the only thing one can get in such a short space of time – real trade deals take years), or should we position on a protracted trade war? What will the world look like by the 9^th of July, the end date of the (first) postponement of American reciprocal tariffs? We don’t know. And with such low visibility, the safest way is:

1. To go with the market flow
2. Focus on fundamentals
3. React to high-confidence outcomes

And that is exactly what we should be doing right now. Instead of making assumptions about how the trade war will play out, we should focus on a different set of variables altogether.

Let’s start with the equity markets. Investors want to know three things:

1. Why are markets rallying?
2. Will money stay cheap?
3. Will the Dollar stay weak?

Let’s start with the first.  Markets are rallying because the war in the Middle East didn’t materialise. Oil prices are down, equities are back up and yields are pushed down.

Gold corrected and volatility levels have subsided significantly. It’s the perfect risk-on market. We could put some of the blame on the low dollar, which inflates US equities, but this doesn’t account for the lower borrowing costs. So why are markets so happy?

After all, debt levels continue to climb, the US mega-bill may be delayed and not deliver the spending cuts it promised, the truce in the Middle East is as tentative as ever, and the 9^th of July is just next week.

The answer? For one, the Fed has turned more dovish. While some more dovish members suggest a July cut, markets are now fully pricing a September rate cut.

Because of pressures from the President (and rumours of a dovish “shadow Fed President” installed months before Powell’s tenure ends) and partly because of persistently benign economic data, we are now seeing the most dovish Fed since mid-2021. 

This is a liquid market and is projected to be even more liquid. Add the Dollar inflating profits reported in USD and the Mega-bill that will likely offset some of the tariff impact on growth nearing passage, catalysed with good news from the Middle East, and we can somewhat explain why we are now seeing US large caps at their all-time highs.

Is this sustainable?

To consider this, we need to look at inflation and growth. Last week wasn’t particularly good for either. Despite a small rebound in US consumer sentiment, personal income and spending were disappointing as some social security-related benefits ended.

The Chicago Fed National Activity Index, a relatively reliable economic “Nowcast” (a forecast of what the economy is doing “now”), contracted for the second straight month.

Despite economic weakness, core PCE expenditure, the Fed’s preferred gauge of inflation, unexpectedly climbed higher. Tariff inflationary pressures are partly offset by a weak housing market and Chinese deflation, but these are big forces and the data could tilt either way.  So we would best heed Jerome Powell’s warning that “Tariffs will impact inflation” and recall his reminder that the Fed’s projections and comments don’t come from a very high level of certainty.

Right now, the equity market is pricing in some very good outcomes. So, while there’s optimism that the Fed will cut rates, it is probably more prudent for investors to focus on the Fed’s real message, which is “wait and see after the summer”.

And then there is the Dollar. US portfolios are having a good year, but nearly every other international investor with exposure to global stocks (more than 50%  dollar assets) is actually negative since the beginning of the year.

So the second concern is currency exposure, which has erased profits for most non-US investors. This is not unlikely to continue as the US government has been positive about the benefits of a weaker Dollar.

As for the bond market, which seems to have forgotten all about the impending US debt Armageddon? Experience suggests that debt crises are not linear events. Risks are low until one day, they begin to rise exponentially. Until such a day manifestly dawns on the biggest economy in the world with the deepest market and the world’s reserve currency, we would be less worried about the bond market mispricing risk.

How should businesses and investors deal with such an environment?

1. Avoid too much speculation and projection of present events forward. We are at a negotiation phase of a new version of the global economic system, and this can get noisy.
2. Avoid pricing in a US debt collapse. The debt buildup is a big problem, to be sure, but it could be years before that particular risk begins to play out.
3. Avoid too much exuberance on rate cuts from the Fed, as central banks tend to err on the side of caution. If the US central bank cuts into an inflation rebound, it could risk losing its credibility and any control over the long end of the yield curve (where mortgages live), without even having its independence compromised.
4. Focus on the currency. While they are nearly impossible to predict, this year, and possibly forward, they could be the most important determinant of returns and even business decisions.

George Lagarias – Chief Economist

Market update

Global equity markets experienced broad-based gains of +1.4% over the week, driven by easing geopolitical tensions, dovish central bank commentary, and potential for improving trade relations. In the US, equities surged to record highs, rising +1.5% in GBP terms (+3.5% in USD within the week - GBP strengthened against USD by+2.0% over the week), buoyed by easing tensions in the Middle East, a US-China trade truce, and signals of further trade deals in progress. In Europe, equities rose +1.3%, supported by German stimulus prospects and NATO’s increased defence spending. UK equities saw only a small rise of +0.3%, as concerns about the UK economy, including signs of a weakening job market, persist. Bank of England Governor Andrew Bailey said interest rates are likely to come down, but very slowly and carefully. Japanese equities climbed +1.7%, fuelled by strong tech performance and reduced trade war fears. EM equities also saw an increase of +1.5%, partly attributed to Chinese equities rallying, following confirmation of a trade framework with the US.

US 10-year Treasury yields declined by -11 basis points over the week, lifting bond prices (bond prices and yields move in opposite directions), as softer-than-expected economic data and dovish remarks from Federal Reserve officials increased expectations of potentially soon rate cuts. Business activity showed modest growth, and durable goods orders rebounded strongly. In the UK, Bank of England Governor Andrew Bailey signalled a cautious approach to rate cuts, citing domestic economic slack and a softening labour market - last week's change in the 10-year gilt yield was -4 basis points, whereas Germany's 10-year bund yields saw a rise of +9 bps.

Easing geopolitical tensions removed a major source of risk premium that had previously driven oil prices higher, leading to a reversal of the earlier rally, a significant drop of -13.6%. Gold prices also decreased by -4.7%, partly due to the reduced demand for the safe-haven asset as Middle Eastern geopolitical tensions eased, but also as the precious metal struggled to maintain its all-time highs and strong momentum in the first quarter of the year.

Macro news

NATO members commit to 5% of GDP spending target. NATO leaders agreed to increase defence spending to 5% of GDP and renewed their "ironclad commitment" to mutual security in response to an increasingly belligerent Russia. The new spending target breaks down into 3.5% for core defence spending and an additional 1.5% for related investment, including infrastructure and cybersecurity. The new spending target could transform Europe's militaries and security architecture, with Germany promising to build Europe's most powerful conventional military. With little fiscal space, many European economies, including the UK, may struggle to meet this target without cutting social spending or raising taxes.

British activity has improved in June.  The PMI survey, a key coincident indicator, revealed a sustained recovery in the private sector output after a brief dip seen in April. New orders grew for the first time this year, although the upturn was largely confined to the service economy. Meanwhile, manufacturing posted another export-led decline in order books. The survey also showed a cooling of inflation pressures, notably in services, which has been a major concern of the Bank of England.

In the US, the PMI survey showed stable manufacturing (52.0, above the key 50 threshold that signals expansion or contraction) and slowing services (53.1) growth, with rising prices adding to inflation concerns. Additionally, the durable goods survey, which tracks private investment dynamics, showed that durable goods orders rose by 16.4% month-on-month in May, surpassing the expected 8.5%. Orders to Boeing were an important driver of the surge. Excluding transportation, orders increased by 0.5%.