The first quarter of 2025 has been marked by significant shifts in both financial markets and political rhetoric across the globe. These dramatic changes reflect a significant adjustment to sentiment regarding the outlook for the US, European, and Chinese economies.
Initially, President Trump focused on immigration, but he has since pivoted to tariffs and global trade, catching the market off guard. This has reprised the risk of both a US recession and a return to inflation in the second half of the year. US stocks have fallen, bonds have declined, and the dollar has weakened. While the weaker dollar is welcome, the market has become much more aware of the risk of a significant slowdown in the US economy due to potentially higher prices and lower economic activity. Although Trump and his officials argue these are temporary disturbances, they mark a significant shift from the end of last year.
This shifting sentiment is counterbalanced by a potentially seismic change in Germany's attitude towards government spending, with significant increases in defence and infrastructure spending now expected to be financed through borrowing. This shift can be seen as a response to US policy, not just on tariffs but also towards Ukraine. European markets have started to price in some of this change, resulting in better performance in European assets in the quarter relative to the US. Similarly, China is signalling a more determined policy response, including fiscal expansion and structural reforms to counter economic stagnation. The Chinese authorities remain focused on boosting domestic demand and stabilising the economy amid external pressures. This has been reflected in better returns from the Chinese market.
The UK market has held up well despite the deterioration in sentiment in the US, boosted by strong returns from the financial and defence sectors. However, significant pressure remains given assumptions made in the Budget last October regarding borrowing costs and GDP growth, which have proven to be too optimistic in both cases. There was plenty of interest around the Chancellor’s Spring Statement, as Reeves sought to reassure markets that Office of Budgetary Responsibility’s fiscal rules are continuing to be observed, though the fiscal calculations leave little headroom in the figures. The UK government now needs to close the funding gap to meet their own fiscal rules. Recent economic data revealed a minor contraction in GDP in January and the spectre of stagnation still hangs over the UK. The irony of this poor data is that it affords the government leeway to make spending cuts in areas previously deemed too difficult to achieve. Any progress here will be a welcome boost for UK economic prospects which otherwise remain underwhelming. The UK stock market however should continue to benefit from its defensive characteristics and resources exposure.
An optimistic view might suggest that the global economy can see favourable convergence, with improving outlooks for European and Chinese markets closing the gap on the US. Unintended consequences of US trade policy actions could also result in countries looking towards China as an alternative. Europe, Canada and others, in a ‘coalition of the willing’, could also seek to club together to take a stand against Trump. However, caution remains that inflation is likely to rise in the second half of the year, exacerbated by US trade policy. Arguably the most interesting element of the Trump presidency is the effort to cut government spending and inefficiency. Any success here will be closely watched by other governments that need to address long-term structural deficits and avoid a debt spiral – the probability is that the impact is limited and may slow economic activity at the same time.
Significant defence spending increases are expected globally, outside the US. This should boost industrial production in Europe but also increase risk premiums. While Trump may see Russia as a favourable ally against China, history suggests agreements with Vladimir Putin carry little weight. Efforts to stop the wars in the Middle East and Ukraine are welcome news for markets, and the oil price has softened slightly during the quarter, reflecting progress towards peace. How long this lasts is of course debatable - it will not stop the shift towards higher defence spending, and exposure to the sector is important. It is a similar case with precious metals. This environment has supported the gold price, which hit another record during the quarter. Gold remains an essential holding in an environment of political instability, structurally higher rates of inflation and constrained government finances that weaken the real value of major currencies over time.
Given the impact of the events of this quarter, some caution is certainly still warranted. We have reflected this in portfolios with additions to short-dated treasury holdings, defensive equities and precious metals exposure. This does not mean that progress cannot be made and with the dollar weakening, European and emerging markets are performing better. There is certainly plenty of room for them to catch up. The question is whether the gap closes because of growth outside of the US or a contraction from within.
The value of securities and their income can fall as well as rise. Past performance should not be seen as an indication of future results. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.
