The Donald and the damage done

In our third quarter outlook, we split the first half of the year into two distinct periods – before 8th April, when markets panicked that President Trump would drive the world economy off a cliff, and after 8th April when he backed down and markets assumed that everything would be fine. A quarter later, his policy making is as erratic as ever, and markets are still flying.

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

Source: MSCI. DataStream. Total returns measured in EUR as at 10th October 2025.

Now in our fourth quarter outlook, we assess how the United States and the world economy are doing and whether the stock market strength is justified. We also look again at the US dollar, whose depreciation has led to such divergent returns for international investors.

The Trump economy – Hot or not?

Depending on your choice of news source, the US economy is either in rude health or in terminal decline. The reality as usual is more complicated, as Figure 2 illustrates. The jobs data is trending downward, indicating a cooling economy, whereas the inflation data is trending upwards, indicating an economy that is running hot. Which is the truer picture?

Figure 2: Job growth and inflation in the United States

Source: Bloomberg, Bureau of Labor Statistics. Both inflation and job growth are 3 month rolling averages.

Awkwardly for the Federal Reserve (or ‘Fed’), which has to set interest rate policy on the strength of the economy, both of these can be true at the same time. Inflation can run above target while the economy struggles to create jobs, but we caution that this is a far cry from the ‘stagflation’¹ of the 1970s, which saw double-digit inflation and unemployment.

During the post-COVID-19 recovery, the job market was so tight that wage pressure pushed up services inflation. But now in the Trump economy, there is less demand for labour (as firms cut hiring) and less supply of labour (due to the crackdown on immigrant workers). At the same time, tariffs are pushing up the cost of foreign goods, causing inflation but not job growth.

For the past year, the Fed was focused more on inflation risks and resisted cutting rates. However, as inflation is now coming more from tariffs, which cause a once-off lift of goods prices, and not from wage pressure, they view the slump in jobs as the greater risk and are cutting rates again. This should help to support growth and financial markets.

Figure 3: Contributions to US growth – the consumer vs technology

Source: Bloomberg.

Given that personal consumption makes up roughly 70% of the US economy, how worried should we be about the slowdown in jobs? Spending growth did slow in the first half of the year, but revised figures showed continued strength. The big surprise is the surge in spending related to AI (artificial intelligence), which Figure 3 shows has added more to the US economy in 2025 than all the consumers combined.

The rest of the world economy

A natural question to ask is whether US growth, in this era of America First, is coming at the expense of other countries. Despite the trade war, other countries are doing better than expected in 2025 too.

Figure 4: 2025 global growth forecasts are turning up

Source: Bloomberg consensus forecasts. Gross Domestic Product (GDP) is the standard measure of economic activity.

Across the Eurozone, UK and China, growth forecasts for 2025 were dragged down by the tariff announcements on Liberation Day (2nd April), although by less than the US numbers. However, after Trump was forced to back down by the bond market, and countries lined up to strike trade deals, recession fears receded, and forecasts recovered.

As we enter the final quarter of the year, US economic data continues to improve – except for the labour market – and the Federal Reserve is cutting rates again. The momentum is positive too in the Eurozone and UK, and despite the negative sentiment, growth numbers are beating expectations again.

No balancing for government budgets

One reason that growth is holding up in the face of so much uncertainty is that governments continue to operate beyond their means, spending more into their economies than they raise from them in taxes. This was a concern at the start of the year, and to the disappointment of fiscal hawks, deficits are still too wide, as shown in Figure 5.

Figure 5: Government budget deficits from 2024 to 2026

Source: IMF. Gross Domestic Product (GDP) is the standard measure of economic activity.

To its credit, the UK government is at least trying, but stimulating growth while reducing the deficit will require more convincing efforts. Meanwhile, Trump’s One Big Beautiful Bill Act (OBBBA) will keep the US deficit close to recessionary levels, and Chinese efforts to revive their consumer and housing sectors is keeping their budget deep in the red.

Markets have tolerated these imbalances for some time, as the debt costs have remained affordable and the debt levels sustainable, just about. But several countries are now straying beyond reasonable levels, and we would not be surprised if the Bank of England (BOE), the Fed and the European Central Bank (ECB) were required to support UK, US and French debt again.

Who would be a central banker?

Mervyn King, the former governor of the Bank of England, remarked in 2000 that central banking should be boring. But crises since then have forced central bankers to extend their efforts from plain old monetary policy to controversial market intervention and bailing out governments.

It would be naïve to assume that modern governments never tried to influence their officially independent central banks. However, President Trump is taking interference to levels more typical in developing-world autocracies, from social media abuse to firing board members and installing his own favourites.

In the most recent Fed meeting, Trump’s new appointee, Stephen Miran², exhibited his loyalty by calling for large immediate rate cuts, but his previous appointees stuck to more modest reductions. With Fed chair Powell’s term expiring in the new year, the risk is increasing that the president bends monetary policy to support his fiscal agenda.

Figure 6: Market expectations for future interest rates

Source: Bloomberg, as of 30th September, 2025. Each interest rate is expressed in the local currency. Each dot represents a central bank meeting.

The market currently prices US rates to reach 3% by late next year, which may not be low enough to cure a job recession but is too low compared to inflation. Either way, we expect the Trump administration to continue trying to ‘run the economy hot’, while keeping a lid on borrowing costs, which may require more bond market gymnastics from the Fed.

The situation in the Eurozone is more straightforward. Consumer inflation is down close to the 2% target, and the European Central Bank (ECB) feels that 2% rates are about right, so we wouldn’t expect much more movement here unless the economic picture changes. As mentioned above, there may be more pressing issues for them in the bond market.

As for the BOE, with UK inflation still stubbornly above target, close to 4% now, the economic data will need to get worse before we can expect much movement on pound rates. They have already slowed their bond sales to avoid stressing the gilt market, and they may have to use their balance sheet again if markets lose patience with the government’s efforts.

No dollars please

While stock markets have shaken off the tariff shock and risen to new heights, the US dollar is still down almost 10% on the year. Although most of the damage was done in March and April, markets are still wary of the Trump administration’s plans to undermine their own currency.

Figure 7: Net foreign purchases of US assets in 2025

Source: US Treasury Department.

The anti-dollar narrative is strong, but we caution against taking it too far. Treasury Secretary Bessent removed Section 899 from the OBBBA, the section that introduced extra taxes for foreign investors in US assets. When we examine investor flows, Figure 7 shows that apart from the month of April, foreigners have remained net buyers of US assets.

So why has the dollar not recovered? Market data shows most of the dollar selling happened in Asian and European hours, as investors in these regions increased their currency hedges (effectively selling dollars). Flows into currency-hedged funds have increased too. So, the reaction to President Trump has not been ‘sell America’, it’s been ‘hedge dollars’.

We note that the largest tactical position in Davy portfolios this year has been to underweight or hedge US dollars.

Is the US stock market all just hot air

The investing world may have fallen out of love with the US dollar, but not it appears with US stocks. For the third year in a row, the US index is on track to post double-digit returns, and it has doubled already this decade, despite two bear markets³ along the way.

The surprisingly strong recovery since 8th April has led to two opposite concerns. Some observers are seeing a ‘melt-up⁴’ in the US, as the AI (artificial intelligence) narrative and the momentum in corporate earnings push the index higher. While others point to the extended valuations and the sheer scale of the deals and expectations in the AI space.

Figure 8: Returns and earnings growth in major markets

Source: MSCI, DataStream, Davy. Total returns measured in euro from end Dec-19 to end Sep-25.

To put things in perspective, as our accompanying equity outlook does, valuations in the broad US market, approaching 23 times forward earnings, are very high. This measure reached almost 25 times in the tech bubble of the late 1990s. But as Figure 8 shows, although valuation increases have driven roughly 20% of returns since 2020, earnings growth has driven over 70% of returns. This is very different from the late 1990s, when valuation expansion was the dominant driver.

Either way, the US market is very expensive, and it would be optimistic to expect profits to keep growing at their current pace, especially if technology companies keep diverting their cash-flow into AI at the current extraordinary pace. Therefore, we choose to be underweight the US market and the technology sector.

Figure 9: Speculative nature of the recent stock market rally

Source: MSCI, Goldman Sachs, UBS, Bloomberg. Price returns in euro as at 10th October 2025.

We also note with concern the re-emergence of speculative behaviour among some investors. We don’t doubt the transformative potential of AI as a technology, but we question the investment case for many AI-related stocks, as well as the so-called ‘meme’ stocks⁵. These areas have almost doubled since their April troughs (see Figure 9), having previously fallen 30-40% in two months, and they are particularly vulnerable to any changes in sentiment.

Investment conclusions

Despite all the noise and negativity, the world economy appears to be re-accelerating. The US labour market is a concern, but if we were market timers – which we are not – the current environment of positive macro momentum and falling interest rates would not lead us to dial down risk now.

Our main concern is that some parts of the stock market are too expensive and some investors are chasing stories. We choose to steer away from those sectors, and we can live with the short-term under-performance that this may cause. Fortunately this year there have been plenty of other profitable opportunities to pursue, such as Europe and emerging markets.

The US dollar was a serious concern in the first half of the year, and it stabilized into a range in the third quarter. Given the depreciation to date, we have reduced the size of our hedge, but further downside would not be a surprise in this political environment, so we maintain an underweight to the currency.

Lastly, as regular readers will know, our strategy is not to try to predict the unpredictable. It is to hold a diversified portfolio to get through the volatility, and if markets do fall, to be ready to take advantage of opportunities that emerge.

Figure 10: 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.

Tactical portfolio changes in Q3 2025

1. Reduce US dollar hedge. Earlier in the year, we hedged dollar exposure by swapping global equity index products for currency-hedged versions⁶. After depreciation of more than 10%, we believe there is less dollar downside to come now, or less upside from hedging dollar exposure. So we reduced the size of our hedge by swapping some of the index products back.

2. Buy more Latin American equities. After Trump’s tariff attack on Brazil, we re-assessed our position in Latin American equities. We found that the fundamentals and investor flows had both improved and we decided to increase our position.

3. Renew Japanese yen position. In 2023 we established a structured product position in the yen, as it had declined to multi-decade lows due to the difference in Japanese and global yields. Although this yield gap has since partially closed, the yen has yet to recover and so we re-established another position when the original one expired.

Strategic portfolio changes in Q3 2025

As highlighted in the previous Davy Wealth View, changes in the behaviour of bond yields since the re-emergence of inflation risk have made bonds less effective at dampening equity risk in multi-asset portfolios. Therefore, we adjusted the strategic, or long-term, equity-bond mix in low to middle risk portfolios.

¹ Stagflation means a stagnant or contracting economy accompanied by high inflation.

² Miran is the author of the controversial 2024 paper “A User’s Guide to Restructuring the Global Trading System” which, among other things, advocates penalising foreigners for trading with the US and for investing in the US.

³ A bear market is a price decline of 20% or more.

⁴ A melt-up is a rapid price increase in the market, which tends to be driven by investor optimism or a fear of missing out, rather than economic or corporate fundamentals.

⁵ A meme stock is one that experiences a sudden surge in popularity and price, driven by a spike in social media attention.

⁶ This position was only applied in portfolios or funds which hold global equity index products.