Are markets complacent?

Correctly pricing risk is what allocators try to do for a living. It is easier when central banks underwrite some of that risk. But the probability of over- or under-pricing risk becomes exponentially higher when the policy keeps shifting.

The One Big Beautiful Bill Act is the law. It will likely add around $3.4tn to the deficit in the next decade out of the way, without improving growth too much, as it mainly constitutes an extension of previous tax cuts. High tariffs on Brazil, the EU and Mexico may materialise. And then again, they may not.

In this environment, equities have chosen to believe that trade will resume as normal. Excluding the Dollar effect, which drags down all returns for non-US investors, global equities are up 10% since the beginning of the year.

And global bond markets have somehow shrugged off previous concerns about mounting US debt, or even the threat of loss of the central bank’s independence, which they previously fretted.

We are still very much in the phase of negotiating, where tariff threats don’t necessarily reflect end outcomes and where deadlines are not set in stone. Financial markets have begun to assume that they can finally analyse and predict the psychology of the Oval Office. They are essentially forecasting that stock market losses or economic malaise will be enough to deter the White House and that a few UK-style business deals will suffice for the trade wars to be over.

It may well be so. But then again, it may not. From an investment and business planning perspective, basing an investment strategy on assuming the actions of one single individual one has not met is wrong. Of course, markets can take bets either way. But it is one thing to assume that it will all resolve itself quietly, and quite another to fully price in this best-case scenario. The latter may be a sign of investment complacency.

The truth is, we don’t know how it will play out. US trade and economic policy is the result of two equal forces:

1. The US consumer’s demand for more fiscal outlays, affordable houses, better jobs and assertion of primacy over other consumers, especially those in China.
2. The White House’s constantly evolving view of the world.

The first force demands action, the second force provides just that, even if it does so in an unpredictable way. As long as they both remain in play, businesses and investors should have no clear expectations as to what the immediate future may bring. The only expectation should be one of persistent volatility. When things are looking very bad, experienced managers look for opportunities. And when markets are very expensive and optimistic about the future, it is their job to ask, “How much potential bad news is priced in?”.

While expected earnings growth in the US is higher than its post-2010 average, these valuations are still much higher than average.

Because of the wide range of outcomes, portfolios need to remain diversified, and managers need to remember that currency is a significant contributor to portfolio returns, especially at a time when the US seeks to monetise some of its debt. Similarly, businesses should seek to take advantage of trade war deferrals, build more robust supply chains and consider where they need to invest more in inventory.

George Lagarias – Chief Economist