One big beautiful bubble again?

To borrow a phrase from the football pundits, 2025 has been a game of two halves for the stock markets – before and after 8th April. In the first period, the United States almost fell into a bear market¹, and the tech sector fell right in. Then President Trump changed his mind on tariffs, or had it changed for him by the bond market, and an extraordinary rally followed.

Figure 1: Stock market returns before and after 8th April 2025

Source: Stock market returns before and after 8th April 2025

It’s not unusual for the stock market to hit new highs – it happens most years – but to occur less than three months after an almost-bear market is not normal. The tariff pause gave traders confidence that Trump will always back down when markets push back hard enough, and his One Big Beautiful Bill Act (OBBBA) will fuel the US economy with trillions of dollars of tax cuts.

As usual though, the picture is never as clear-cut as we would like. We have yet to see the impact of tariffs or the Trump stimulus, the US economic data is softening, and the dollar has dropped by 10%. In our outlook for Q3, we explore the strength of the global economy, the decline in the dollar and the dramatic surge in the stock market. First, we look at the economy.

Is the world economy Trump-proof?

Trump boosters got a shock in April when the GDP² report showed that the US economy shrank in the first quarter. The pre-tariff surge in imports was so enormous that net trade dragged the overall number into negative territory, but the domestic data did show that US consumers continued to spend. However, revisions since then have shown spending growth to be weaker, and retail sales dipped for two months in a row in Q2.

Despite the tariffs, US inflation has barely budged all year, with the Federal Reserve’s (the Fed) preferred measure steady around 2.7%, versus a target of 2%. The Fed does expect this to pick up later in the year, due to tariffs and the weaker dollar. The unemployment rate declined to 4.1%, but this is a little misleading. The ratio of job openings to unemployed has dropped from 2 down to 1, and business surveys point to slower hiring.

The Fed again declined to cut rates in June, drawing the ire of the president. Overall, we agree with Chair Powell’s view that at some point tariffs will show up in consumer prices and growth will slow. But this is not stagflation, nor a recession. The Fed is still likely to cut rates eventually, softening the tariff impact, and the OBBBA will selectively stimulate growth too.

Figure 2: Economic growth forecasts for 2025 have fallen

Source: Bloomberg. Growth figures are presented in local currency, except the world data is in US dollars.

In the Eurozone, hopes were high that Germany would loosen the purse-strings to boost their stagnating economy and lift the wider region. Chancellor Merz has started well, and Q1 growth was revised up to 1.5% for the bloc. The ECB (European Central Bank) has done its part by cutting rates to 2% but is not expected to go much further. The stronger euro will hurt growth, with or without more tariffs, although it will help to keep a lid on inflation.

The United Kingdom is in a tighter situation. Growth in Q1 was stronger than expected but then fell negative in April, frustrating government hopes for expansion. Inflation at 3.4% is holding back the BOE (Bank of England) but we expect this to moderate and for rate cuts later in the year. This should help the weakening employment figures and lower borrowing costs.

Further afield, Japan is holding up well, and China continues to add stimulus to grow out of its housing slump. Overall, the world economy has not been derailed by Trump’s tariffs, a better result than many feared, but it is still decelerating.

Deficits don’t matter apparently

A major concern at the start of the year was the sustainability of the debt that governments had piled on before, during, and after the COVID-19 period. With bond yields close to zero, as in Japan, there didn’t seem to be any practical limit on new borrowing, but now higher yields are beginning to constrain governments.

Figure 3: Government debt trajectories in the US, UK and Germany

Source: Bloomberg, International Monetary Fund (IMF), US Congressional Budget Office, UK Office for Budget Responsibility, Eurostat. GDP is gross domestic product, the standard measure of economic activity. As of June 2025.

In developed markets, this is most clear in the UK, where gilt yields have tracked the troubles of Chancellor Reeves in balancing an already strained budget. The path to stimulating growth will be a difficult one for the Labour government, and the BOE may be called in to support the gilt market if traders react badly to their policies.

Apart from forcing Trump to pause on tariffs in April, the constraints of the bond market have not been as obvious in the US. The OBBBA is a serious challenge to US debt sustainability. But from Trump’s frequent attacks on Fed chair Powell on interest rates, and Treasury Secretary Bessent’s comments, we know that borrowing costs are a key focus for them.

The US government is actively seeking ways to bring bond yields down, by changing their bond issuance strategy, and finding new buyers for the bonds. Despite widespread concern, demand for treasury bonds has yet to decline, and by changing bank capital rules and encouraging the proliferation of stablecoins (that must be backed by treasuries) they are trying to create more demand. Of course, in a crisis the Fed can always backstop the bond market, as it has before.

One country where adding debt should not be a problem is Germany, and the fact that they have finally begun to borrow and spend more is a huge positive for Europe. But Germany is only a quarter of the Eurozone, and other country budgets are in much worse shape. To face up to its challenges, the European Union will eventually have to move to mutualised debt, something Germany still resists.

Overall, there seems little appetite to balance the national books, even in the UK where the government is at least trying. At the margin this means higher borrowing costs than we’ve been used to in recent decades, and potentially higher inflation too, and continued pressure on central banks to step in when needed.

Back to the future for bonds

While fiscal indiscipline and inflation risk are a headache for central banks, they have also changed the game for investors. They have reversed a two decade trend in asset allocation, where government bonds were a highly effective portfolio stabiliser and diversifier against stock market risk.

Figure 4: Bond index volatility and correlation to the stock market

Source: Bloomberg, MSCI. Rolling 5-year volatility and correlation based on monthly price returns in US dollars.

This is not a new phenomenon. It pre-dates Trump 2.0, although his policies have made things worse. Since 2022, when the surge in inflation hammered the bond market, the volatility of bonds, and their correlation with equities, have increased to levels not seen in over 30 years. Bonds have thus become riskier investments and portfolios with large bond allocations have become riskier portfolios.

We have been watching this trend for some time, and now that markets have calmed post the Liberation Day volatility, we have decided to take action. In the coming weeks, we intend to adjust down the risk in our cautious and moderate growth portfolios. We note that this is not a tactical call on the current market. It is a strategic, or long-term, shift to reflect the new environment for bonds in the 2020s. Please see the supporting article for more details here on changes to our strategic asset allocation (SAA).

Is the dollar done?

For European investors, the most significant development this year has been the drop in the dollar. It is remarkable how, in a few short months, the global consensus has swung from a strong dollar view, based on a higher growth/higher inflation/higher rate tariff-bound Trump economy, to a ‘dollar doom’ scenario, where the only foreseeable path is downwards.

Figure 5: US dollar-euro exchange rate and forecasted rate

Source: Bloomberg. Forecasts are consensus compiled across industry.

We share the market’s concern that US policies are a threat to dollar stability, but the US is not the only country pushing fiscal boundaries, just the largest. Despite US policies and the recent performance of US versus non-US assets, capital flows out of the US have been very small so far. But the relative sizes of international markets mean that it doesn’t take much movement, or hedging, to push up European or Asian currencies.

It is also true that Trump and his advisers prefer a weaker dollar, to make US firms more competitive globally, but at some point, there will be resistance. A weaker dollar will push up prices in the US just when tariffs may be doing the same. Also, foreign central banks may push back if the exchange rate interferes with their mandates. For example, the ECB has identified 1.20 as a threshold for concern for the euro-dollar exchange rate.

As a result, we can see dollar weakness continuing, but we believe that most of the big move has probably happened. Exchange rate forecasts are notoriously unreliable, so we refrain from making them, but on the current trajectory we would not be surprised to see the euro-dollar rate in the low 1.20s and pound-dollar in the low 1.40s by the end of the year. In other words, a further decline of 2-5%, which is not enough to change our portfolio strategy.

We also caution that this is not a one-way bet. The brief military scare in June, when Israel and the US bombed Iran, showed that in times of crisis the dollar still benefits from a flight-to-safety. If Trump and his MAGA fans do manage to fracture the global financial system they so frequently disparage, the US system and the dollar will be the strongest bloc standing.

The stock market strikes back

The double-digit decline of the dollar masked another remarkable market event – the 20% rally in the US index and the 33% rally in the global tech sector (both measured in dollars) in just two months following Trump’s tariff pause. At the time of writing, both rallies continue, and global indices have hit new all-time highs (in dollars). Does this make any sense?

Corporate earnings have held up well so far, especially in the US and technology, with trade troubles yet to dent profit growth. Lower bond yields, a weaker dollar, and the prospect of Fed rate cuts are all positives for equities, again more in the US. The realisation that the president’s bark is worse than his bite, at least as far as markets go, and the support of corporate interests in the OBBBA all point to a better environment for equities.

However, the hard economic data is slowing, and the tariff impact is yet to be realised. Despite the OBBBA boost, higher prices and softer growth will eventually drag on corporate earnings. Despite exceeding expectations, Q1 earnings reports were less confident looking forward. The Q2 reporting season is about to begin and we will be watching for weakness or resilience.

Figure 6: Equity market valuations and earnings expectations

Source: MSCI, DataStream, Davy calculations. As of 4th July 2025 and end December 2024. Percentiles are measured over the past 20 years. Each index is in local currency, including Emerging Markets.

A concern for investors is that the rally has pushed valuations back to uncomfortably high levels, especially for US and tech indices. Although thanks to their impressive out-performance year-to-date, Europe and emerging markets are now expensive too, by their own more modest standards. At least earnings growth expectations for 2025-26 have moderated since the start of the year, except for technology where they have increased.

Another concern is investor behaviour in certain corners of the market. The ARK Innovation ETF³ and the Goldman Sachs Non-Profitable Tech index have rallied by 75% and 53% respectively from their April troughs. While sharp rebounds are normal after 30-40% drops, such strong performance in such speculative stocks can be a sign of over-exuberance.

Figure 7: Speculative behaviour in speculative stocks

Source: Bloomberg, Standard & Poors, ARK, Goldman Sachs. Showing price returns in US dollars.

Mar-a-Lago no more?

In our Q2 outlook, we described the Mar-a-Lago Accord – a proposal floated by Trump’s more ideological economic advisers⁴ to strike a new deal between the US and its international partners. The main idea is that foreigners should have to pay for access to the US economy, US capital markets, and US military security.

The imposition of tariffs is the cost to access the US economy for trade, and the demand for higher spending by NATO members is the cost to stand with the US military. The original version of the OBBBA contained a Section 899 which gave the US Treasury the ability to levy extra taxes on foreign investors on their US assets. Secretary Bessent wisely had this section removed but the idea itself was enough to sow more doubts in the minds of international investors.

However, until there is a realistic alternative to the dollar, it will remain the global reserve currency. This doesn’t mean it is immune from depreciation, just that it has far more natural buyers than other currencies.

Investment conclusions

In summary, the economic fall-out from President Trump’s trade war has been much milder than was expected back in April, as tariffs have been paused or have yet to make an impact. While the uncertainty has dragged on US consumer confidence, retail sales, and job openings, the OBBBA should be a net positive for the economy in 2025-26 before spending cuts start to hurt in 2027-28. The Eurozone and China are doing better than forecast, but the UK is in a tight spot.

Unfortunately, the better-than-expected news is mostly factored into equity valuations already, which have recovered rapidly to multi-year highs, led by the US and the tech sector. We note that high valuations are not enough to move markets on their own, but they do make a market more vulnerable to correction if the economic picture changes. For this reason, we maintain our bias away from the US and towards Europe and emerging markets.

As for the US dollar, we expect the current weakness to continue, but we would push back on the more extreme predictions of its decline. Our largest current tactical position is to be underweight dollars, but as we believe that most of the big move has already happened, we are not minded to increase our position.

Lastly, these past six months have been another reminder of the importance of diversification. We are investing through a period of unusually high uncertainty, and all sorts of assets have played a role already this year, from less-favoured equities to alternative strategies to gold, both by adding to returns and by cushioning declines. Given the incumbent in the White House, we intend to stay diversified.

Figure 8: 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 3% underweight to US dollars. We note that this is much more portfolio activity than we would normally expect in a quarter, but this is a reflection of the unusual market environment during the period.

Portfolio Changes in Q2 2025

1. 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.
2. 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.
3. 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.
4. Remove equity overweight - After the unexpectedly fast market recovery, we decided to take profits, close out the overweight position and return the capital into bonds. We kept the currency-hedged index and sold non-hedged index exposure.
5. Buy Latin American equities - Given our concerns with the valuation of US assets and exposure to the US dollar, we initiated a small position in Latin American equities. This region is much less affected by the trade war and much cheaper than US, European or Asian markets.

¹ A bear market is a drop in the index price of 20% or more. By early April, the US market had fallen by 19% from its high point in February (measured in US dollars).

² GDP is gross domestic product, the standard measure of economic activity or the size of an economy.

³ The ARK Innovation fund specialises in disruptive innovation, and is delivered in an ETF, or an exchange-traded fund, meaning that the entire fund trades on the stock market like an individual stock.

⁴ A User’s Guide to Restructuring the Global Trading System, Stephen Miran, Hudson Bay Capital, November 2024. Miran is now the chair of the Council of Economic Advisers in the US.