Investors could be forgiven for feeling like the ball on a roulette wheel, going round and round with the various tariff announcements, not knowing where they will land.
Nonetheless, markets are becoming inured to the swings in US trade policy and reacting less sharply to each new announcement. There appears to be a growing realisation that many of the tariff moves are simply short-term negotiating tactics – hence the quick market reversals once President Trump feels the objective has been achieved.
Investors would do well to focus on the likely medium-term outcome of the ongoing negotiations. We remain of the view that the baseline 10% tariff on imports into the US will be permanent, with higher tariffs for certain strategic sectors, for example, steel and aluminium. The higher strategic tariffs might affect around 20% of US imports.
Offsetting the higher US tariffs could be lower levies for some US trading partners. Only time will tell to what degree this is achieved, but given the significant leverage the US has due to the size of its domestic market, we are cautiously optimistic the reductions will come.
The main caveats are twofold:
- Europe may yet decide to pursue a tougher negotiating stance, possibly retaliating against US services exports.
- Additionally, China may be unwilling to make significant concessions, meaning that US tariffs on Chinese goods could be higher than for other countries.
Either of these factors would lead to a greater drag on US growth in the short term.
The risk to growth is not trivial. Japan offers a cautionary tale. Like the US, Japan has a high debt-to-GDP ratio. In 2013, the government decided to hike its consumption tax to raise revenue. This occurred in two stages and in the quarters immediately following each increase, GDP growth dropped sharply. It rebounded, however, in the following quarter, so there was no recession (see Exhibit 1).
How likely it is that something similar happens in the US will depend on the ultimate level of its tariffs. Note that inflation initially rose in Japan after the tax boost, but then reverted to the trend level.
The risk to US growth is all the greater as the economy is already slowing. Recall the view most investors had before the US elections: expectations were that Kamala Harris would win and that a ‘soft landing’ was in store for 2025.
The narrative was that households’ excess savings would eventually run out, leading to a slowdown in consumer demand and hence slower GDP growth, allowing inflation to decelerate towards the US Federal Reserve’s 2% target and enabling it to cut policy rates further.
At least the first part of that story seems to be happening. In the first quarter, personal consumption expenditures (consumer demand) rose by just 0.3% at a seasonally adjusted annual rate (SAAR) – less than half the pace of the prior two years. We would likely have seen a slowdown regardless of who won the elections.
The second part of the ‘soft landing’ story, however, is not happening. Instead of cutting rates, the Fed has decided to wait and see what the impact of the tariffs will be on growth and inflation. Nonetheless, the market’s expectations for the level of the benchmark fed funds rate at the end of 2025 are more or less exactly where they were before the elections (between 3.5% and 3.75%).
For all the short-term risks to growth, one should not lose sight of the compensating positive factors which drove our initial move to overweight US equities after Trump’s victory:
- Deregulation
- More mergers and acquisitions
- Lower energy costs
- Fiscal stimulus
- Increased investment thanks to import tariffs.
These factors should still support US growth. It remains to be seen whether they will be large enough (and arrive soon enough) to offset the tariff shock and the resulting decline in consumer and business sentiment.
Another, perhaps overlooked, positive factor is business investment, particularly related to artificial intelligence (AI).
While consumer demand weakened in the first quarter, business investment surged. Non-residential fixed investment rose by 2.5% in the quarter (SAAR) compared to a 0.6% rate in 2024, when presumably investments linked to the Inflation Reduction Act (IRA) were increasing.
The recent growth has stemmed largely from information processing equipment and software, evidence of the impact of higher capital expenditure by companies seeking to develop and implement AI models (see Exhibit 2).
Equity market outlook
It is notable that, even as investors have accepted that global tariffs will be higher than before President Trump’s election, equity markets have gained by over 6% since his ‘Liberation Day’ announcement (in US dollar terms as at 4 June 2025).
Higher tariffs will clearly hit company profits in the short term and analysts have revised their expectations downward, but the estimated earnings growth rates are still positive for 2025. Valuations for most equity markets have remained reasonable, leaving rising earnings expectations as the likely main driver for stock prices.
The initial overweight investors we had to US equities has not been rewarded. The leaders so far this year have been European and emerging market (EM) equities (though it is worth noting that US equities had similarly underperformed global equities at this point in 2017).
We are more optimistic on the continued outperformance of emerging market equities than for Europe, and we also expect US growth stocks to recover.
Much of the return on European equities has come from financial stocks, boosted by the relatively looser monetary policy in the eurozone and the steepening of the yield curve. The question is how much further this can go.
The second biggest contributor has been aerospace & defence, reflecting investor expectations of significantly increased spending in the EU in the coming years. Profit forecasts for 2026 have already risen, however, with earnings-per-share (EPS) estimates rising by 2% this year when EPS for the broader European equity index has dropped by 6% (in euro terms).
We see more sustainable earnings gains in emerging markets. Earnings expectations have moved up, but one must be careful to take the impact of the US dollar into account. While investors generally receive their returns from EM investments in hard currency, when there are significant declines in the dollar, it can be the currency providing the gains rather than underlying profits.
The trend of forward EPS looks much better for the MSCI Emerging Markets index in US dollar terms, but less so in local currency terms (see Exhibit 3). We believe earnings in local currency terms have sustainable momentum, with returns potentially boosted by a continued depreciation of the dollar.
Fixed income and the US dollar
Alongside concerns about the impact on US growth from tariffs, rising interest rates have been another headwind (partly offset in the US by the weaker dollar). Increasing the worries is the Trump administration’s proposal to extend the tax cuts from the first term. This could lead a significant increase in debt. The latest projections from the Congressional Budget Office (CBO) — which has forecast a large US budget deficit for years — now see it rising even further.
While financing the US deficit is a worry, the increase in long-dated US Treasury yields has actually been smaller this year than the gains in long rates in other major bond markets.
The yield on the 30-year Treasury is just 10bp higher than it was at the beginning of the year, compared to a 65bp gain in Japan (see Exhibit 4). One reason the reaction has perhaps not been as bad as the debt projections would suggest is that focusing solely on the impact of the proposed legislation does not consider the offset from tariff revenues.
That said, estimating how much will be raised from the import tariffs is difficult given the ongoing negotiations and legal challenges.
Another reason is that the projections do not attempt to assess the impact of the tax cuts, deregulation and other measures on GDP growth. Stronger growth would mean the economy could support a higher level of debt.
This is exactly what occurred during the first Trump administration. While the budget deficit rose after the passage of the tax cuts from 2.1% to 4.6% as a percentage of GDP (it is at 6.7% today), the debt-to-GDP ratio actually fell.
The outlook for US Treasury yields, however, is uncertain. The increase in the term premium that has contributed to the rise in bond yields this year could easily go further, depending on how the tax cut legislation evolves in the US Senate. Conversely, a bigger slowdown in growth could result in falling yields as the market factors in lower policy rates from the Fed.
The picture is clearer in the eurozone: weaker growth and falling inflation thanks to the US tariffs, and a central bank inclined to cut rates further, suggest bond yields should remain contained.
The shock absorber for many of the market stresses has been the dollar: contrary to expectations, it has weakened this year. The view after the US elections was that the dollar would strengthen (as it had done during the first Trump administration), supported by relatively higher US growth and interest rates. Those differentials have been a support for the dollar, but they have been offset by fund flows as foreign investors reallocated out of US assets.
On a real, trade-weighted basis, the dollar is currently 13% above its long-run average. This level is higher than the previous peak in 2002, though below that reached before the Plaza Accord in 1985. A sustained, structural shift away from the dollar could see the dollar index fall towards the mean.
Asset allocation
• While uncertainties remain high, concerns over a recession in the US have receded amid the recent news about trade negotiations. Still positive hard macroeconomic data, a good Q1 earnings season and improved technical indicators support our cautiously positive position on equities.
• Diversification is key in the current context. It has led us to shift part of our overweight from global developed markets to emerging markets. De-escalation in the trade war could trigger support for EM assets together with attractive valuation (especially in China), accommodative monetary policies and low investor positioning. Recent currency moves look favourable for this asset class which has historically tended to outperform when the US dollar weakens.
• As investor concerns over fiscal deficits grew in the US (and to a lesser extent in the eurozone), we neutralised our global positioning on duration. Our conviction on Europe and the US decoupling in terms monetary policy is intact and we are maintaining our long positions in European yields combined with short positions in US T-notes.
• We have tactically returned to a neutral stance on gold. Prices could consolidate in an easing tariff war. The extreme optimism of investors is a further signal of caution. However, we are positive on the long-term outlook for gold.
