Can markets keep up with the pace of change?

The three things investors should know this week – and which risk markets seem to ignore, for now:

1. Europe has a big decision to make in the next few months: will it pull together, address its inefficiencies and make a productivity push, or will it become less relevant in a fast-changing world?
2. American inflation is pulling up, even before any trade disruptions are included in the data.
3. The US has taken another step towards imposing global tariffs. Markets may have cheered on the temporary reprieve, but the US and the world are inexorably moving towards remaking the global trade map.

Summary

As US inflation rose to 3% and the US administration announced another milestone towards imposing global reciprocal tariffs, while at the same time ignoring Europeans in Ukraine peace negotiations, risk markets remained unperturbed. Meanwhile, UK growth rebounded unexpectedly, but forward-looking data suggests that the Bank of England should remain on a rate-cutting path.

Week ahead

The most important piece of news will be Germany’s election on Sunday, which will likely lead to a new government coalition. UK inflation numbers on Wednesday are expected to show that British prices rose by 2.8% for the year to January, accelerating from 2.5% in December. On Wednesday, also, minutes from the FOMC, the Fed’s rate-setting body, will reveal more about the US central bank’s intentions on interest rates. Finally, on Friday, preliminary (Flash) PMI data should show whether global services continue to slow down.

The four things we didn’t know last week are:

1. Baseline inflation ahead of tariff implementation is already 1% north of the Fed’s target. This is not very helpful for risk assets which may not be ready for an inflation wave.
2. Tariffs will come, but later than originally expected. Some investors feel vindicated ignoring the subject altogether. As a result, however, markets may be under-pricing an event that has a high probability of happening – significant tariffs towards Europe, and potentially a pushback from EU allies.
3.  Europe is being quickly brought to a fork in the road. Very quickly, possibly after Germany’s election, European leaders will have to decide: will they pull together, which means adopting Draghi’s memo on how to improve growth, i.e. mutualising debt, reducing regulation, increasing defence spending, or will they rather deal with the US individually? The former choice could unlock a lot of value from unloved European risk assets.
4. UK growth slowing down may be a less straightforward business than we might have thought.

“What an hour brings, a year may not”, an old Greek saying goes. Some weeks go uneventful, and some do not. The foundation of the post-WWII Euro-Atlantic partnership, America exchanging growth for influence is now under review, as the Trump foreign policy doctrine takes hold. Whether it is dead, on hiatus or just under review is a question for a future historian. But for all intents and purposes, this world is different, and it feels like systemic risks are piling up as geoeconomic fragmentation momentum accelerates.

Last week wasn’t all about statesmanship, however a lot was about a negative inflation printout of the US, where prices rose for the fourth consecutive month, by 3% for the year to December.

Geoeconomic fragmentation, which is accelerating, could accentuate inflation pressures going forward. And equity and bond markets may have been relieved that the US President’s reciprocal tariffs will not be imposed at least until April, this is somewhat of a short-term view, as inflation risks are to the upside. 

And as action unequivocally begets reaction, Ursula Von Dee Layen, the German CDU politician serving as President of the European Commission, suggested that defence expenditures be excluded from the stability pact, which requires a deficit of 3% or less from EU countries. Coupled with Friedrich Merz’s (the presumed next Chancellor of Germany) openness to removing the debt brake in Germany, we could see a meaningful increase in EU spending in the near future, which could help push growth upwards. The Eurozone alone would have to increase spending by about 210bn Euros to match the US’s military spending. The number is big, so common borrowing, like during the pandemic, might be required. Apart from the obvious benefits to growth, the move could bring European nations together. Pete Hegseth warning that American troops can’t stay in Europe forever, may also help the union move closer militarily.

Meanwhile, the UK unexpectedly returned to growth in December (+0.4% for December, +0.1% for the three months to December). However, we wouldn’t pop the champagne bottle just yet. Growth significantly surprising on the upside may be good news, however, the spectre of stagflation is very much alive.

Upside came mainly from the service sector, and in particular professional services. However, the more forward-looking January PMI data on British services suggest that orders remain soft, corporate risk aversion is high and employment conditions are deteriorating. While we can’t totally dismiss a good growth number, we don’t think that it alone will move the needle for the Bank of England which is on a dovish path.

For those who remember the elation after the Fall of the Berlin Wall, under the “Wind of Change” by the Scorpions, last week seems like somewhat the opposite. It does feel like the weight of history is crashing down on us.

But is it so?

“Alliances win wars”, the Duke of Wellington would argue. Without Prussia, Waterloo would have been a loss and Napoleon could have become Emperor of Europe. “Shattering alliances may win the peace” Pericles (495-429 BCE) would counter. After all, his move to turn the Delian League (a confederacy of 150-330 city-states) into the Athenian Hegemony, by stealing the alliance’s common Treasury and bringing it to Athens, built the Parthenon, brought money to Athens and, at the peak of the first “Golden Age”, established the foundation of Western civilisation. The same could be said about the positive effects of the Bubonic plague (1353) and the fall of Constantinople (1453), both horrible, end-of-times events, without which the Renaissance might not have happened.

The point is that, irrespective of how it feels, history’s judgment is reserved for an era beyond ours. As such, it is good to be reminded that we are but fund managers, with the humble task of navigating client assets through good or tumultuous times. A broad study of history suggests that, when chips are in the air, no one knows where they will land, so high-confidence forecasts are off the table. The one thing we know for sure is that taking the present status quo and projecting it into the future in perpetuity will almost certainly lead us to wrong conclusions.

George Lagarias – Chief Economist

Market update

Last week, the European equity market rose by +1.8%. Comments by the European Central Bank on maintaining supportive monetary policies played a role in lifting market sentiment.

The pound rallied, supported by stronger UK economic data, including better-than-expected GDP growth and employment figures. The stronger pound meant that returns in overseas markets were diminished in GBP terms. The GBP was particularly strong versus the Japanese Yen – GBP/JPY appreciated by 2.1%, which led to Japanese stocks falling by -1.2% in GBP terms despite rising 0.9% in local terms.

Following a hotter than expected CPI report on Wednesday, the US 10-year treasury yield spiked, but saw a decrease throughout the rest of the week, so even though the overall weekly increase was only that of 1 basis point, it was a volatile week for the US treasuries. (Bond prices and yields move in opposite directions.)

Macro news

The UK economy unexpectedly grew by 0.1% in Q4 2024, after flatlining in the previous three-month period. Official figures from the Office for National Statistics came in slightly above economists’ forecasts of a decline of 0.1% of GDP in the three months to December. The figures mean that annual growth across the calendar year hit 0.9%, following a 0.3% expansion in 2023.

The ONS said monthly output in December grew by 0.4%, higher than the 0.1% expected by economists, but a measure of GDP per head, adjusted for a rising population, declined by 0.1%.

Across the quarter as a whole, the UK’s dominant services sector expanded by 0.2% and the construction industry recorded a 0.5% rise in output. Production, which includes manufacturing, contracted by 0.8% at the end of 2024.

US inflation unexpectedly increased to 3% in January, bolstering the case for the Federal Reserve to proceed slowly with interest rate cuts and hitting stocks and government bonds. The CPI increased 0.5% month over month in January after rising 0.4% in December. Core CPI also rose 0.4% after an increase of 0.2% in December. Economists expected consumer prices to rise 0.3% on a monthly basis in January, and for the annual inflation rate to rise to 2.9%. The S&P 500 and Dow Jones industrial average were each down by about 1% after New York opened for trading. The 10-year US treasury yield – a key barometer for US economic expectations – rose to about 4.6%.