The US elections are done and dusted, boosting US equities (at least for now), but Treasury bond yields less so. In contrast, Europe is struggling amid political upheaval and gloomy growth prospects. We kept our overweight in euro investment-grade credit, increased our exposure to US equities and retained our conviction on precious metals.
Many pre-election assumptions had to be revised after the surprisingly convincing victory by the Republican party in the US elections. While markets had predicted a Trump win, a Republican clean sweep of the presidency, House and Senate was largely unexpected and will likely allow incoming President Donald Trump to implement more of his policies.
The initial reaction of equity markets was as expected. US indices have made strong gains premised on fiscal stimulus, deregulation and increased mergers and acquisitions.
Non-US markets have either risen less – or fallen – on worries over possible import tariffs and relatively weaker growth.
Though there are risks ahead, our view is that this equity index outperformance, in particular in the US, will continue for the time being.
The main threats many investors see to this outlook are higher tariffs, lower taxes and a tougher stance on immigration. While much was said during the campaign, we will have to wait until there is more detail on what the Trump administration actually wants and is able to implement before being able to assess the potential impact.
Muted fixed-income reaction
This uncertainty perhaps explains why the reaction of fixed-income markets has so far been rather muted. US 10-year Treasury yields initially rose by just 15 basis points (bp) after the election and have fallen back below the 4 November 2024 (pre-election) level since.
Near-term inflation expectations for 2025 have settled about 25bp higher, but for years further out, they are largely unchanged. Initially, markets priced out one of the cuts in the fed funds rate foreseen for 2025, but that has since been reversed.
From soft landing to no landing
The US macroeconomic narrative has moved somewhat away from one of a likely ‘soft landing’ – where slowing growth and inflation allow the US Federal Reserve (Fed) to cut the policy rate several times next year – towards one of ‘no landing’, where growth and inflation remain high and there are fewer cuts in the fed funds rate.
Core personal consumption expenditures (PCE) inflation is currently 2.8%. Third-quarter US GDP growth was 2.8% (at a seasonally adjusted annual rate) and the GDPNow forecast from the Atlanta Fed for fourth-quarter growth is 3.3%.
One of the few things investors can be certain about is that this combination of growth and inflation is unsustainable; both will have to fall. The question is how and when this happens.
Risk of inflation being driven higher
One scenario is that Trump succeeds too well in his desire to spur growth in the US economy. Tax cuts would drive domestic household and business demand, while tariffs would further reorient that demand to domestic producers. The worry is that with growth already above potential, the increase in economic activity would simply drive inflation higher.
The US unemployment rate is now fairly low at 4.2% and restrictions on immigration and an increase in deportations would dampen labour supply, putting upward pressure on wages.
Were inflation to rise, the Fed could increase policy rates – as happened after the first Trump tax cuts in 2017 – to put the brakes on growth and return inflation to target.
By at least one measure, though, there may be scope for US activity to remain at current levels without pushing up inflation: capacity utilisation in the economy is currently below average (see Exhibit 1).
An alternative scenario is that the response of US trading partners to higher tariffs leads to a global trade war. Higher prices for imported goods would limit consumption, while US exports would face retaliatory tariffs from other countries. A slowdown in economic growth could happen quickly in this scenario.
US equities benefiting from expected higher earnings
We will have to wait for Trump’s inauguration on 20 January to be able to better assess which path the economy is likely to follow. For now, at least, US equities are benefiting from the anticipated increase in nominal earnings stemming from economic growth and higher inflation, with little evidence of worries about any drag from tariffs.
These earnings expectations had already been rising for the tech-heavy NADAQ 100 and have now started to turn around for US small-cap stocks (see Exhibit 2).
The fact that Treasury yields are lower now than they were before the election has also boosted equity markets.
However, the modest sell-off we saw in equities when Treasury yields rose in November is a reminder of the risks ahead if growth accelerates and yields rise again. Both the NASDAQ and Russell 2000 indices fell sharply after yields rose (as one would expect given their sensitivity to interest rates, for NASDAQ stocks due to the ‘long duration’ of earnings, and for small-cap companies due to higher debt levels).
A return to higher yields — bear in mind that the 10-year US Treasury was at 5% in October 2023 — would likely drag on US equity returns. Once the adjustment had taken place, however, the positive earnings outlook should reassert itself and lead to a renewed positive trend.
Europe – Already gloomy before US election
Before the US election, the outlook for the eurozone was already fairly gloomy. Purchasing managers’ indices (PMIs) were either low (for the services sector) or below 50 (for the manufacturing sector).
Germany was anticipating a new election, making major policy decisions unlikely before next year. A bit more than a month on from the US elections, it is now France facing political turmoil.
Economic data points to a further deceleration in eurozone growth. November flash PMIs for both manufacturing and services were lower in every eurozone country, and in France and Italy, they dropped from expansion to contraction territory.
The consequence of these developments has been positive for government bonds (see Exhibit 3), while eurozone equities have lagged those in the US by six percentage points (MSCI USA vs. MSCI Europe).
The main near-term threat to eurozone growth is US tariffs. Recent news, however, suggests that this may not happen, or at least not in its most extreme form. The discussions that President-elect Trump has had with Mexico and Canada suggest that he sees the threat of tariffs as a means to achieving other aims. If Europe can negotiate effectively with Trump, the negative impact of tariffs may be avoided, while the region’s exporters would benefit from stronger US growth and a weaker euro.
Asset allocation highlights
- The Republican clean sweep in the US elections came as a surprise, leading us to increase our exposure to US equities. They should be supported in the short to medium term by the positive impact of fiscal stimulus packages and deregulation on US growth. That said, questions are likely to emerge about the inflationary impact of these policies and their implications for the Fed’s monetary policy. As valuations remain a concern, we chose to broaden our positions via additional exposure to the S&P 500 Equal Weight Index, which offers a more balanced exposure to US large caps.
- Our position is neutral on euro sovereign bonds, ECB rate cuts now being fully priced into government bond yields. We remain overweight euro investment-grade credit, however, after a European earnings season that confirmed companies’ solid fundamentals. The search for yield should continue to support the asset class.
- In a context of increased interest-rate volatility and a surging US dollar, we took partial profits on precious metals after the strong performance year-to-date. Our conviction on this segment remains intact given its medium-term outlook.
