by Tim Sharp
The uncertainty surrounding the Trump administration’s policies continues to weigh on sentiment with global equities dragged lower in February by the US where a significant risk-off sector rotation seems to be underway. The Deep Seek announcement seems to have contributed to the push higher in Chinese technology stocks while the narrowing of the valuation gap between Europe and the US seen since the beginning of the year continues with renewed tailwinds of a potential Russia-Ukraine cease fire and commitments to increased defence spending by many countries but particularly Germany. Most of the main European equity markets were in positive territory in February, including the UK, but this was seemingly not enough to prevent a negative print for global equities due mainly to the weight of the US in most indices.
The so-called “Trump trades” that ran after the elections have been largely neutralised with the “Magnificent 7” and the Russell 2000 small and mid-cap index down significantly as growth underperformed value. Cyclicals underperformed defensives with the best returns from Staples, Telecoms and Insurance while Autos bore the brunt of Mexican tariff uncertainty, with Technology affected by its largest components, and Retail affected by negative consumer sentiment.
Global fixed income was also stronger in February led by US Treasuries following a flat January and negative December when curves steepened significantly. We see signs that the positive correlation between equities and bonds is returning as credit spreads including EMBI generally widened as the dollar fell against both developed and emerging market currencies. The fate of the dollar adds a further tailwind to gold, with increased volatility due to the uncertain environment, which saw gold rally 5% mid-month before paring gains into month-end.
The US economy would seem to have lost some momentum with US Surprise Indicators turning negative[i]. Services PMIs fell sharply into contraction territory at 49.7 while manufacturing is still slowly expanding with M-PMI at 51.6. European Manufacturing PMI is also seen recovering while services fell to 50.7 despite falling inflation and a 0.25% cut from the ECB last week. Meanwhile, the UK services PMIs were better at 51.1 but manufacturing contracted further as CPI inflation came in hotter than expected at 3% with core at 3.7%. The December print for GDP growth also came in above expectations at 0.4%. Finally, for the first time in about 40 years Japanese inflation is higher than the US with CPI a surprising 4% print due to rising food and energy costs which is having a negative effect on Japanese financial markets.
The Trump administration looks to have started a trade war with China, Mexico, Canada, and Europe with threats of reciprocal action, however, the outlook seems to be uncertain with US policy changing daily. Absolute Strategy Research (ASR) sees the positioning as having a bigger impact at company level than at a country level due to pressures on cross border supply chains with oil and gas, autos, and electrical equipment manufacturers the most at riski. At a country level, should tariffs stay in place as outlined then it may be enough to tip Canada and Mexico into recession while the likely impact on the US, ASR predict, would be to take 0.5% off GDP and add 0.5% to inflationi. US core CPI rose by 0.4% in January, the largest monthly increase since April 2023 as core goods prices were higher suggesting inflation remains sticky and perhaps inflation expectations are being impacted by aggressive tariff negotiations. This will also help to fuel talk again about recession and we see three US rate cuts currently priced into markets.
It is possible that a tariff-led trade war could create headwinds for global equities if it delivers lower growth and higher inflation. As ASR calculate 40% of S&P 500 sales come from outside the US, a tariff-led slowdown abroad could be a drag on US corporate profits. In Europe 20% of revenues come from the US particularly linked to autos, staples, and industrials while in Asia a 10% US revenue exposure would be felt in autos, technology, and consumer products. At the moment the US dollar is weaker, but a strong dollar would also be a headwind for non-US equitiesi.
The ECB cut rates last week 0.25% to take headline rates to 2.5% with many believing that the neutral rate is close or may have been met. Many forecasters now believe that the Eurozone growth outlook may not be as negative as suggested, not helped by the talk of being on the Trump radar for the introduction of further tariffs. However, capital expenditure seems to be generally picking up which could benefit manufacturing while construction activity is also recovering. The removal of political uncertainty, and the likelihood of looser fiscal policy in Germany and France may also underpin increasingly supportive monetary conditions, not to mention a possible ceasefire between Russia-Ukraine.
China has been stuck in a deflationary environment for seven quarters, and this has probably been a source of global disinflation. However, there are signs of activity as the output gap narrows due to strengthening demand away from consumption, however, the need for further stimulus may be necessary. Solutions to the housing market, a recapitalisation of banks to allow for more losses in firms and increased fiscal stimulus could all assist China escape its deflationary environment, assuming a deflationary mindset has not become entrenched.
In conclusion, we started the year believing that the environment best supported global equities and – despite the challenges of higher bond yields, inconsistent US tariff policy, a change in sentiment towards AI brought about by Deep Seek, and concerns regarding growth – fundamentals still offer support. A broadening out in earnings with several sectors now seeing double-digit earnings growth has now been complemented by a broadening out in returns. Therefore, currently, we remain in favour of risk assets but are mindful of the possibility that erratic US policies may lead investors to undergo an element of de-risking. A period of macro uncertainty could also concern markets, and as returns have become earnings-led any downgrades to 2025 forecasts may challenge valuations. Markets seem to be now pricing in 3 rate cuts for the US in 2025 which is similar to the ECB and the BOE outlooks suggesting that recession concerns are growing in the US. Furthermore, we see the outlook for US and European economies returning to a more normal setting implying that much of the US exceptionalism is perhaps being priced-out.
[i] Zara Ward-Murphy _ ASR Investment Committee Briefing _ March 3, 2025
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