The trade war is not a shock. It is a slow train.

The most important issue of the time is, of course, inflation.

British inflation’s pickup to 3.6% last week did not inspire particular fear. Stagflation (very low or no growth and higher prices) doesn’t tend to last very long. Either prices spiral (which requires strong demand) or growth subsides further. Usually it’s the latter, and with higher unemployment and sluggish growth, we’d be less worried about sticky prices going forward, and more anticipatory of lower interest rates once the data allows it.

But the pickup in US inflation is a different sort of beast altogether.  

The long-expected inflation rise last week to 2.7% was even cheered by some economists who were wondering why US prices didn’t rise earlier, despite more than half the firms passing tariffs on to consumers. It’s not just a slight rebound in oil prices, but also higher core services prices that drove up headline inflation.  

Despite the pickup, most of the US economic data remains robust. Growth at 1.5% this year isn’t great, but certainly it’s not a recession either. Consumption data from June was also good, suggesting that consumers aren’t shocked.  

Meanwhile, the US stock market is near all-time highs once again.

And even as the White House presses for Fed Chair Jerome Powell to be replaced (presumably with a Chair that will be willing to floor short term rates long enough for the US to refinance a very high amount of short-term debt rollover this year), long-term borrowing rates (where inflation lives) and the yield curve (the difference between long and short-term rates) haven’t really reflected rising inflation risks.  

Nor have market-implied inflation expectations.

In other words, the US economy is not collapsing, even as tariffs are 6x the previous long-term average and the highest they have been since the Second World War.  

Why is that? Why hasn’t inflation skyrocketed along with borrowing costs yet, and growth collapsed? And why are equity markets so unfazed?  

For one, supply chains are proving robust. Unlike China, whose pandemic-related economic convulsions shocked global supply chains, leading to shortages and spikes in demand, skyrocketing container costs and blocked ports, the US is at the end of the supply chain, not at the heart of it. The inflation spike of the time was a combination of supply-side disruptions (the pandemic, the war in Ukraine) and the wake of sharp US monetary expansion during the early stages of the pandemic. These conditions are not met today. Supply chains work, and, since the trade war hasn’t proliferated between third countries (yet), the main problem is one of erratic and possibly slower future demand. Inventories were built early, so that economic activity was brought forward.  

Second, some assumed that their own dismal forward-looking outlook would instantly translate into consumer and investor disappointment. But, as we know from previous examples, economic decisions are not the same as market/financial shocks, or event-driven shocks like the pandemic. They are decidedly slower-moving trains. Consumerism is specifically designed to induce consumption, over possible economic fears. While consumers may be worried about what they read in the news (and worried they are), paradoxically, they might as well vent those worries with a weekend spent shopping! (In case you ever wondered why three Economics Nobel Prizes have been given to behaviourists.) US core retail spending is slowing, but at 4% it is still at the post-pandemic average.  

Third, energy prices are persistently low. Whether by design (a deal) or not, oil prices are down 10% since the inauguration, and nearly double that in Euro or GBP terms. Saudis, like the Chinese, have pegged their currency to the Dollar. Because they are not big importers, they don’t suffer much from their own devaluation (China might eventually if commodity prices begin to spike as product-focused tariffs pick up). Now to be fair, this hasn’t quite translated at prices “at the pump” (average gasoline prices are at $3.63, nearly at the same level as they were in January, $3.59) mostly because of inventories and maintenance issues, seasonal issues, as well as increased export demand, but, considering the lower Dollar it’s still a boon that American consumers may enjoy.  

Now, equity markets are not really unfazed. In fact, they have wisely priced in the lower US Dollar. While US equities are at all-time highs, and trading at expensive multiples, they are, in fact, negative for Euro and GBP investors. Investors expect a healthy 5.3% year-on-year growth in US earnings, a bit lower than the 7.7% average but still well on track to deliver 10.7% by the end of the year.  

Our bigger concern is the bond market. The market has not priced in a meaningful shift in the inflation regime, which means that investors are quite relaxed about a change of paradigm at the central bank. They also don’t see risks rising from profligate fiscal spending in the US and across the globe. This creates upside risks, especially for longer-dated bonds, where inflation lives. Conversely, it could create opportunities for short-term bonds if the Fed somehow capitulates and embarks on a rate-cutting binge.  

The larger picture is one of summer lull, some would argue complacency, where investors, tired from the noise, don’t extrapolate economic and financial risks into the future until something actually happens, be it an inflation or growth surprise, an escalation (or de-escalation) of trade wars or any other such similar event. In other words, if we assume that the slow-moving economic consequences of the trade wars will eventually materialise (unless it is scaled back), by reducing their appetite for forecasts, investors may be under-pricing economic downside or upside risks. This is why it is best to remain neutral in terms of risk, despite the recent equity rally, vigilant and diversified.  

George Lagarias – Chief Economist 

Market update 

Global stocks rose by 0.9% last week as investors focused on strong earnings and resilient consumer data. US stocks rose by 1.3% in GBP terms, helped by a stronger dollar as the earnings season kicked off with large banks reporting better than expected results. Technology stocks also rose as the lifting of export restrictions on certain semiconductor exports to China was announced. US stocks fell after inflation data, which reported figures broadly close to consensus, but made up this loss later in the week after strong retail sales figures. UK stocks made a small gain of 0.6% over the week, while European stocks fell slightly by -0.1% as tariff concerns weighed on sentiment. EM stocks returned 2.2%, helped by Chinese stocks which rose as China reported strong GDP figures.  

There was some midweek volatility as speculation swirled around the possible firing of Federal Reserve Chair Jerome Powell. Stocks initially fell after the news, while the trade-weighted dollar fell by around -1%. Short-term US yields, which are more sensitive to expectations for Federal Reserve policy, fell on the news, while longer-term yields, which tend to be more tied to inflation and real growth expectations, initially rose. These moves were quickly reversed, however, as President Donald Trump stated that it was unlikely that he would fire the Fed chair. Bond yields ultimately ended the week not much changed – the US 10-year treasury yield ended the week exactly where it started at 4.42% while the 2-year yield fell slightly by 0.03%. UK bond yields advanced by 5 basis points, while German bund yields edged up by one basis point.  

Gold initially spiked by over 1% on the expectation that the Fed chair would be fired, but reversed this gain to end up lower in USD terms by the end of the week. In GBP terms, gold returned +0.5%, but this was primarily due to an appreciation of the US dollar by 0.7% over the British pound.  

Macro news 

Heightened stagflation risk in the UK. Recent economic data indicate a notable increase in the risk of stagflation in the UK. June's headline inflation rate climbed to 3.6%, marking its highest level since January 2024. This acceleration was predominantly attributed to rising food prices (4.6% YoY) and energy prices (7.5%). Core inflation similarly advanced to 3.7%, with services inflation holding at 4.7%. Simultaneously, UK GDP experienced an unexpected decline of 0.1% MoM in May, extending a 0.2% contraction recorded in April. These developments put the Bank of England in a tough position, having to decide where to prioritise inflation or growth. During the last week, BoE Governor Andrew Bailey suggested that a slowing jobs market could prompt an interest rate cut. 

Concerns about US Federal Reserve independence. Speculation has swirled about President Trump potentially firing Federal Reserve Chair Jerome Powell, driven by disagreements over interest rate policies. Administration officials have also criticised Powell, citing cost overruns on a Fed renovation project as a possible pretext for dismissal, though no action has been confirmed. Markets dipped and the US dollar weakened in response. The debate about the independence of the US central bank coincides with a context of rising inflationary pressures. In June, US inflation climbed to 2.7%, from 2.4%, with the first clear signs that the new tariffs are hitting prices.