Trouble with a capital T

Every year brings its challenges, but we entered 2025 with more on our minds than usual. Our main concerns were the fiscal balances of the major governments and the valuations of the stock market, in particular the US tech sector. President Trump was an acknowledged wild card, but the strength of the US economy gave us comfort that he could only do so much damage.

Now as we enter the second quarter, and Liberation Day has come and gone, it is clear we underestimated just how much one president could do. So now we recast our outlook in the light of his trade war, and look again at the global economy, government balances, and of course the impact on financial markets and our investment strategy.

How strong is the economy?

Before the tariff shock, there was a widening divide between “hard” economic data and “soft” surveys in the United States. Unemployment was stable at just over 4%, net job creation continued at trend pace – despite the efforts of Elon Musk – and wage growth was strong at 4%. Inflation at close to 3% was keeping the Federal Reserve (the Fed) interest rate at 4.5%, but overall, we had a strong but gently cooling economy.

However, if you asked the average American how things were going, you’d get a completely different picture. Even before Liberation Day, consumer sentiment was at levels last seen during COVID-19 or the global financial crisis, and expectations for future inflation were several points higher than actual inflation. The concern was that perception would become reality, and consumers would slow their spending and businesses slow their investing.

Figure 1: University of Michigan consumer sentiment & future expectations

Source: University of Michigan, Bloomberg.

The Eurozone was moving in the opposite direction, after several years of weakness. Unemployment reached a record low of 6.1%, and with inflation coming down close to the 2% target, the European Central Bank (ECB) was on course to bring rates down to 2% later in the year. Lastly, while they’ll take some time to hit the real economy, the new spending plans of the European Commission and German government will add significant stimulus.

The United Kingdom is somewhere in between. Unemployment is low at 4%, but growth has been weak, and inflation has stayed above target, keeping Bank of England (BOE) rates at 4.5%, and frustrating the plans of the Labour government to turn the economy around.

Over in China, which has struggled for several years with a crumbling property sector and a cautious consumer, the government seems to be grasping the problem and targeting large stimulus at consumption and technology, rather than their industrial and export sectors.

Governing beyond our means?

A serious concern at the start of the year was the state of global government finances, and the apparent unwillingness, outside of the UK, to do anything about it. Has anything changed?

US government balances are very different now from when President Trump blew out the budget in his first term. Deficits and debt levels are higher, post the COVID-19 and Biden stimulus. Inflation is higher too, as are interest rates and bond yields. The annual interest cost of US government debt is now almost $1tn, close to the total military spend, so there is understandable pressure to reduce the deficit.

However, the Trump administration is working to extend his original tax cuts from 2017, due to expire this year, which will expand the deficit further. Of the annual spend of $7tn, only $2tn is discretionary, yet this has not stopped Elon Musk’s controversial DOGE (Dept. of Government Efficiency) in their ideological drive for efficiency. Unfortunately, the savings they have achieved have turned out to be a small fraction of what was advertised.

In Europe, Chancellor Merz has done the previously unthinkable – a German conservative has tampered with their debt brake to allow more spending – and the European Commission is moving towards mutualised debt to support the continent’s ambitions. We caution against too much optimism though. Germany has the fiscal space to expand, but the debt-laden French are on their third prime minister in a year and are yet to pass their 2024 budget.

Figure 2: Government debt / GDP ratios, current and forecasted¹

Source: Bloomberg, IMF, US Congressional Budget Office, UK Office for Budget Responsibility, Eurostat. GDP is gross domestic product, the standard measure of economic activity. As at April 2025.

In the UK, the Labour government has also done some previously unthinkable things – cut foreign aid and welfare benefits – to convince markets of their fiscal seriousness. Compared with the previous government, the effort is a welcome change, but unfortunately their chosen path is narrow and global winds have blown against them.

Thus spoke Trump – Liberation Day

The tariffs announced on April 2nd were 2-3 times more than we or the markets expected, hence the sharp sell-off. Expressed as a percentage of US imports, they would bring the US back above 1930s levels, when trade barriers helped turn a recession into the Great Depression.

Figure 3: Effective US import tariff levels (1880-2025)

Source: Yale Budget Lab

The initial proposals included a baseline tariff of 10% on everything, as well as a “reciprocal” tariff based on each country’s goods surplus with the US. At the time of writing (April 11th) the reciprocal layer had been paused for 90 days for everyone except China, and most countries had rescinded their retaliatory tariffs except for China. While the pause is welcome, we note that the remaining tariffs are still well above initial expectations.

Estimates of the economic impact vary widely, but the direction is clear – lower growth for everybody and higher inflation in the US. If the initial proposals are fully applied, research houses predict a high likelihood of recession for the US. They would also push US inflation above 4%, making it difficult for the Fed to soften the blow with interest rate cuts.

Figure 4: Estimated impact of Trump tariffs

Source: JPMorgan, UBS, Bank of America, Goldman Sachs

Inflation is lower in the Eurozone and China, and depending on their retaliation, the price impact of tariffs will be small, so they will have more room to cut rates. Both regions are readying fiscal stimulus too, so damage from tariffs will be less than in the US, although it would still hurt. With no US goods surplus, the UK is less impacted by tariffs, but with higher inflation the BOE has less room to cut rates, and the government has less leeway to apply stimulus.

In the MAGA mind, the tariff strategy will both rebalance trade in favour of the US and earn hundreds of billions of dollars for the government budget. Of course, slower growth will mean lower tax revenues, and higher inflation will likely bring higher bond yields and borrowing costs. To address this, some in the Trump camp have bigger and bolder plans.

The dollar goes down in Mar-a-Lago

Among other weaknesses, the first Trump administration suffered from a lack of vision or clarity of purpose. This time the president’s camp includes more ideological advisers with ambitions and plans to redesign the state and the global financial and security architecture.

To ease US fiscal imbalances, Treasury Secretary Bessent came into office with an ambitious “3-3-3” target – to raise growth to 3%, cut the deficit to 3% and increase oil production by three million barrels per day. To achieve this, he wanted to lower bond yields and weaken the dollar, lowering costs for US borrowers, including the government, and making US firms more competitive internationally.

But the plans run deeper. Last year, economist Stephen Miran2, now chair of Trump’s council of economic advisers, outlined a scheme by which foreigners would be made to pay for access to the US economy, capital markets and military security. For example, by accepting lower or zero yields on US government bonds. In a nod to the 1985 Plaza Accord, when Europe and Japan agreed to help weaken the US dollar, this new idea is known as the “Mar-a-Lago Accord”.

Figure 5: US dollar exchange rate history

Source: JPMorgan, Bloomberg. Dollar indices are measured against a basket of trading partner currencies. "Real" means adjusted for inflation.

While turning the tables on your lenders is a move that Trump would be familiar with from his developer days, we’re not convinced that foreign creditors will accept such terms, especially those under tariff attack. However, it does make the weakening of the dollar, which in inflation-adjusted terms is expensive by historical standards, a potentially acceptable compromise.

Safe havens no more?

Ironically, the bond market may have turned the tables on Trump’s plans. With roughly $10tn of debt issuance this year, bond yields are a crucial cost variable for the US budget, a fact not lost on foreign trade partners who own $7tn, or 30%, of the treasury market. Falling demand for US debt pushed up yields, which sparked a crisis among highly-levered bond traders, pushing yields up further, which was enough to convince the Trump camp to pause on tariffs.

It is a relief to see that there are practical constraints on MAGA Mar-a-Lago plans, but we are also concerned for what this means for two pillars of the global financial system – the reserve currency (the dollar) and the reserve asset (US treasury bonds).

First treasury bonds, up to now the deepest and most stable pool of capital in the world. There is simply nowhere else that China, Japan et al can park trillions of dollars of reserves, but continued US borrowing and bullying may well exceed their appetite or comfort levels. As they gradually diversify their reserves, this will put upward pressure on US yields, downward pressure on bond prices, and lead to more volatility. All of which weakens the bond case for investors.

As for the dollar, its role may be changing too. In recent decades, it had become a safe haven in times of market stress, even when, as in the global financial crisis, the stress came from the US itself. We caution though that it was not always as reliable a safety play as remembered, but we agree with dollar critics that it is less likely to play this role under current US leadership.

Figure 6: US dollar behaviour during equity sell-offs

Source: DataStream, Davy calculations. Corrections are 10% price declines. Dates from Yardeni Research. S&P 500 returns are in USD. The dollar index is vs major trading partners.

This all brings to mind the words of John Connally, treasury secretary under Nixon, who told European finance ministers that the dollar is “our currency, but your problem”. We note that it is possible to hedge against movements in exchange rates, which we already do in our bond allocation, and which we have occasionally done on a tactical basis in our equity allocation. In early April, we re-introduced some currency hedging in our global equity holdings.

Here comes the bear?

Which brings us to equities. We came into 2025 at our strategic levels of equities for each portfolio, but underneath the surface we were underweight US and tech stocks, and overweight Europe and China. Not because we foresaw current events, but because the elevated valuations and earnings expectations in US tech left so little room for disappointment there.

Now that the global index has fallen by over 15%, and the tech sector by over 20% (a “bear market”), the natural question is whether we should reduce our exposure or buy more. We note that 15% drops are usually buy signals, as they tend to precede above-average returns. Figure 7 shows that this can be true in recessions too, depending on their severity.

Figure 7: US stock market returns post 15% drops

Source: Bloomberg, Davy calculations. Price return of S&P 500 index in USD. Shaded areas represent recessions. Median includes selloffs back to 1973.

Of course it could get worse. A 15% drop could be a step on the way to a much deeper decline, but these are almost always associated with severe recessions or burst bubbles. As outlined earlier, the underlying economy was doing fine before the trade war, and outside of US tech, stock market valuations were not extreme. Therefore, we are more inclined to buy than sell at these levels.

But what should we buy, and in particular has US tech corrected enough to become attractive? Price-earnings multiples have fallen from 22x to 19x for the overall US market, and from 29x to 24x for the US tech sector, both of which are still around the 80% percentile vs their 20-year history. In other words, they are certainly still expensive.

Figure 8: Equity valuations and earnings growth expectations

Source: MSCI, IBES, Davy calculations. All in local currency, except Emerging Markets in USD. Percentiles are calculated over the past 20 years.

Furthermore, although earnings expectations have come down, they are still high by historical standards, even before we factor in a trade war. So, while we are becoming more interested in equities as prices decline, we would still be wary of the largest US stocks, and the tech sector in particular. We maintain our preference for Europe and China over the US and technology.

Portfolio positioning

Obviously, we can’t predict where Trump will settle and how much damage will be done, so our portfolio strategy needs to take into account an abnormally wide range of paths from here. We don’t want to bet too much on one single outcome (like a recession or a dollar crisis).

In an era of stretched government finances and inflation risk, it’s natural to think that bonds are a less useful asset. But in a growth shock or a recession, yields tend to fall and high-quality bonds protect portfolios. Alongside gold, US government bonds were the best performing asset during the 1930s. We are wary now though that Trump policies have undermined US treasuries, making bond markets more volatile and requiring more defensive portfolio construction.

Equities are the main source of pain and gain for most investors, and we expect no different in the Trump presidency. In the short term, recession risk is real, which normally means a price decline of 25-30%. With a peak-to-trough decline of 19% so far, the US market has implied a 60-75% likelihood of recession, which is more pessimistic than economists estimate.

In the medium to longer term, lower prices mean higher expected returns. Stocks are forward-looking assets, and markets tend to recover 2-3 quarters before the real economy does. So, waiting for the all-clear is not a realistic investment strategy, and we have already increased our equity allocation.

Gold has long been the asset of choice for those who are worried about inflation or a financial collapse. While its actual track record is varied, and it currently trades close to twice its marginal production cost, we believe that there will be enough fiscal and monetary uncertainty in the next few years that gold is still a useful holding. Also, alternative strategies which do not depend on economic growth or interest rates are a welcome addition to help smooth returns.

With the behaviour of the US government and the threat of a Mar-a-Lago Accord, it’s natural to be worried about US dollar exposure. We are sympathetic with the devaluation argument, and we have actively reduced our exposure. But if Trump does fracture the global financial system, the US will still have the strongest economy and capital markets, and for this reason we still keep dollars in our portfolios.

Conclusions

In summary, the world economy was stable before the tariff shock on April 2nd, with the US decelerating from an above-average pace, and Europe and China inflecting upwards after periods of weakness. While the tariffs could push the US and Europe into recession, we note that this is a man-made crisis, not an economic one, and therefore it can easily be averted.

We’re not brave enough to try to predict the evolution of the trade war, and rather than base our investment strategy on one path, good or bad, we prepare our portfolios for a wide range of outcomes. Put simply, we expect more policy twists and market turns, and so we maintain a broadly diversified portfolio.

But based on the balance of risks and valuations, we do have some tactical biases. First, since the 15+% decline, we are overweight equities, funded from bonds. Yes, they could easily decline further, but on a 12-month horizon, valuation is more reasonable now and stocks should benefit from an eventual resolution of the trade war. However, we are still underweight the US and technology as expectations here mean they are still the most vulnerable sectors.

Our other significant bias is to be underweight the US dollar. We don’t believe that Trump has destroyed the currency’s reserve status yet, but he clearly wants a weaker dollar, and global investors are waking up to their over-reliance on it. The exchange rate is still over-valued, and unless the global system breaks down completely, the international capital flows that have long supported the dollar will likely work against it.

Lastly, we fully acknowledge that this is an unusually unsettling time for investors, and so we finish with a particularly relevant quote from Morgan Housel, a well-known US investment writer. “All past declines look like an opportunity, all future declines look like a risk.”

Figure 9: Current positioning of EUR Moderate Growth portfolio

Note that each box represents 0.5% of the overall portfolio. The blue circle indicates the tactical under-/over-weight at the overall asset class level. * The tactical equity allocation means that there is a further 2% underweight to US dollars.

Portfolio Changes in 2025

1. Buy European equities. In January we increased our equity tilt towards Europe, funded by selling global equities, effectively making us more underweight US and more overweight Europe. This was due to more reasonable European valuations and earnings expectations, and the narrowing of the relative growth gap to the US.

2. Rebalance equities. After the sharp drop in equities following Liberation Day, in the 2nd week of April we rebalanced our portfolios back to neutral by buying equities and selling bonds.

3. Overweight equities. On top of this, with the market down over 15% from its peak, we increased our allocation to global equities, funded from bonds. To avoid adding more dollar exposure, we bought the currency-hedged version of the index.

4. Hedge US dollars. At the same time, given the growing concerns around US government policies and their desire to weaken their currency, as well as its above-average valuation, we swapped some of our existing global equity index holdings for currency-hedged index holdings, effectively reducing our US dollar exposure.

¹ GDP is gross domestic product, the standard measure of economic activity or in this case the size of an economy.

² “A User’s Guide to Restructuring the Global Trading System”, Stephen Miran, Hudson Bay Capital, November 2024.