Geopolitics have been dominating the headlines, and driving market movements, to a particularly high degree recently. Should the conflict in the Middle East escalate, it could lead to a sharp rise in oil prices, with negative consequences for inflation, economic growth, and risk assets.
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At the time of writing (25 June), a fragile ceasefire appears to be in place, but investors will continue to monitor the news to determine whether the situation has truly stabilised.
Given the limited market reaction to the exchanges between Israel and Iran (for example, Brent oil prices rose by just $10 per barrel and prices have fallen back since), there has been little direct economic impact.
Recent data, then, gives us a reasonable picture of the current state of the global economy. The key release has been the flash purchasing managers’ indices for June. The PMIs are painting a picture of steady growth in the US, but ongoing struggles in Europe.
US tariffs still a worry for European industry
To start with the manufacturing sector, where worries about the impact of US import tariffs are concentrated, the three European economies reporting so far (France, Germany, UK) have shown continued contraction in the sector. The rate of contraction has accelerated in France but slowed in Germany and the UK (see Exhibit 1).
US ‘reciprocal’ tariffs have been suspended for now (they will be re-evaluated on 9 July), but baseline 10% tariffs remain in place, with higher rates on sectors such as steel and aluminium.
While these levies are a drag on manufacturing activity, the sector already had sub-50 (i.e., contractionary) PMI readings in Europe for months before they came into effect. This suggests to us that the region’s problems are more broad-based. Higher infrastructure and defence spending should eventually reaccelerate activity, but this is not likely to occur for many months.
Exhibit 1
Purchasing managers’ indices show impact of tariffs on Europe
Data as at 24 June 2024. *Institute for Supply Management. Sources: FactSet, BNP Paribas Asset Management.
In contrast to Europe, the US manufacturing PMI came in better than expected at 52.0. As the administration intended, tariffs are benefiting US manufacturers (as far as they do not depend on imports for inputs).
The Institute for Supply Management’s manufacturing activity indicator, however, had a sub-50 reading in May. We will learn next week whether it will continue to send a contradictory signal.
Activity in the services sector also retraced in France and Germany, though it was steady and expansionary in the UK (to some degree offsetting poor retail sales in May).
The impact of tariffs on services activity should be minor, which suggests slowing activity reflects broader problems. The data looks particularly worrying when one considers that the ECB has been lowering its main policy rate since September last year.
Again, in contrast, the US services sector continued to expand at a robust pace (53.1).
Market reaction mirrors diverging paths for Europe and the US
The divergence in economic activity on either side of the Atlantic has been mirrored in recent equity market performance. So far in June, the MSCI Europe index has fallen by 1% in local currency terms, while the S&P 500 has risen by 3%.
Ten-year US Treasury and Bund yields have remained near the low end of the range they have been in over the last several weeks, with market worries over the bulging US budget deficit and Donald Trump’s ‘Big Beautiful Bill’ evidently marginal – for now.
The US dollar has stabilised since the ‘Liberation Day’ tariff announcements, but the DXY index – which measure’s the dollar’s strength against a basket of six developed market currencies – is still 10% lower than it was at the beginning of the year.
One of the key factors in understanding this decline are portfolio flows: are foreign investors selling US assets (or are US investors buying foreign assets)?
Recently released data from the US Treasury shows what occurred in April. Typically, the US sees portfolio inflows, which are the mirror image of its current account deficit.
In April, however, the US recorded the fourth largest month of outflows since 1978 (see Exhibit 2). It could even be considered the second largest, as far as the two highest monthly outflows occurred during Covid, which was a unique situation.
These outflows show that there was a clear change in the perception of investors of the advantages of investing in US assets relative to non-US assets after the tariff news.
Given that being overweight US equities was such a consensus view after Donald Trump’s re-election, it is little surprise that the reaction to an event which challenged that position was so strong.
What’s next?
The question now is to what degree these outflows will persist (‘sell America’), and whether the dollar will continue to depreciate. Time will tell, but it is worth noting that since April, exchange-traded fund (ETF) flows show European investors returning to US assets.
If the dollar does fall further, one of the beneficiaries could be emerging market equities. During the last period of sustained dollar deprecation, from 2002 to 2011, emerging market equities consistently outperformed those of developed markets. By contrast, there was no correlation between the dollar and the performance of US equities compared to non-US equities.
