Global economic update: resilient markets, critical uncertainties, and transatlantic gaps

Can we relax again now?

Judging by the recovery in equity markets from the April slump (Figure 1), which was triggered by the US government’s heavy-handed, erratic, and still uncertain trade policies, the answer seems to be yes. 

Still, I would not fully count on it—just yet. Before stating my case to remain cautious, let me try to defend the rebound on the basis of three observations:

  • During past episodes of unusual uncertainty, the collective wisdom of market participants has occasionally provided a better guide to the economic outlook than analysts and economists. For instance, during the 2020 COVID-19 recession, when economists (myself included) were warning that it could take five years to recover from the pandemic recession, the sharp rally in global stocks to all-time highs in 2H20 signalled the largely V-shaped recovery that unfolded in 2021.
  • For all his sabre-rattling, US President Donald Trump has rolled back—albeit only temporarily—his sky-high ‘Liberation Day’ tariffs in response to the sudden correction in US stocks, Treasuries, and the dollar in April. Investors may have worked out that the worst of the shock and awe is over, and, in the end, when push comes to shove, financial markets will act as a check and balance on his unconventional approach to policymaking.
  • With the partial rolling back of China tariffs—although to still-damaging rates—the deal with the UK, and a continued emphasis by Washington on the host of ongoing talks with other trading partners, markets may have concluded that the resilient and dynamic US economy will manage to muddle through with OK growth, even as the anti-growth tariffs depress household real incomes and raise the cost of doing business.

 

Figure 1: US, European and Japanese equities

1 January = 100. Daily data. Source: Bloomberg

 

Mind the risks

Against these arguments in favour of a market rebound stand a series of critical uncertainties and risks.

  • Consensus expectations for US growth continue to decline, while projections for inflation tick higher. As Figure 2 shows, 2025-26 cumulative growth expectations have declined from a peak of 4.3% at the end of February to 2.8%, while cumulative inflation expectations have risen from 5% to 6.1% since the start of the year. Less growth and more inflation is typically not a ‘risk-on’ combination for equities.
  • The Fed remains caught between conflicting pressures. Upside risks to inflation and downside risks to growth leave the US Federal Reserve (Fed) in a bind as it tries to balance the trade-offs associated with its maximum employment and 2% average inflation dual mandate. Typically, the Fed reacts more quickly and more aggressively to downside risks to employment than to upside risks to inflation. But Fed Chair Jerome Powell has repeatedly emphasised that the Fed remains steadfast in focusing on the inflation side of the mandate. Money markets expect just two full cuts before year-end—totalling 50bp (Figure 3). That would take the Funds Rate corridor to 4.00-3.75%—well above Fed members’ assessment of the longer-run neutral Funds Rate of 3.0%.
  • Fiscal vulnerabilities are growing. The elevated federal deficit (around 7% of GDP) leaves the US bond market prone to bouts of panic selling if downside surprises to economic activity amplify debt-sustainability worries. Never in the US’s post-WW2 history has there been such a large gap between government borrowing and unemployment. But recessionary levels of borrowing at full employment—having helped to pump up domestic economic activity and fuel the stock bubble in 2023 and 2024—now pose a serious vulnerability. The Trump administration risks a tariff-induced recession while attempting to pass a budget that involves further borrowing to finance additional tax cuts and make permanent the temporary cuts set out in the 2017 Tax Cuts and Jobs Act (Trump’s major fiscal legislation in his first term).
  • Soft data remain weak, and hard data may follow. Although the still-firm hard data coming out of the US economy give some comfort that underlying activity remains resilient, soft data on activity and expectations remain depressed. It could be that soft data are overreacting to the immediate confidence and uncertainty shock and hence will snap back soon. But that logic is hard to follow, given the impact Trump’s eye-watering tariffs are likely to have on near-term spending and investment plans, supply chains, and prices. The risk that hard data follow soft data lower—with a lag—potentially sets equity markets up for another pullback. It is noteworthy that, while equity markets have recovered, the performance of other asset classes looks much less benign. The dollar has fallen by almost 10% since the start of the year—with only a very minor rebound over the past couple of weeks, even as stocks snapped back (Figure 4).
  • Too many unknowns remain. Chief among them: what will be the eventual outcome of US trade negotiations with China and other trading partners? Merchandise imports are worth around 11% of US GDP, and the US-UK deal—the only one Trump has agreed to so far—covers just 2.5% of US merchandise imports (or a trivial 0.24% of US GDP). While the average tariff will fall from the 22% peak following Liberation Day and the China tariff peak of 145%, it may remain in the high single digits even in a positive scenario, given Trump is signalling that a 10% tariff could be the baseline for most countries, excluding certain categories. But what if negotiations with China and the EU—the two ‘big’ deals—fail?

The danger is that equities are currently riding high on a big dose of ‘hopium’ that may wear off suddenly when the realities of US protectionism start to reveal themselves in economic data. My colleague Douglas Jack put it well last week when he said, “fundamentals are being swept aside in a torrent of short-term news”.

Figure 2: Bloomberg consensus US cumulative expectations for growth and inflation

In %. Weekly data. Source: Bloomberg

 

Figure 3: In %. Weekly data. Source: Bloomberg

In %. Daily data. Based on overnight index swaps markets. Source: Bloomberg

 

Figure 4: Trade-weighted dollar index

2 January = 100. Daily data. Source: Bloomberg

 

Goodbye Boomtown US

Back in March, I wrote a note titled You're leaving Boomtown USA, drive carefully, in which I outlined the cyclical and structural downside risks to the US economic outlook—and why these would present a new set of challenges for financial markets. But that was before Trump’s tariff announcements. Since then, the situation and outlook for the US economy has deteriorated. While recession remains a risk—with a 35% probability, in our view—rather than a base case, US equities now look less attractive on a risk-adjusted basis.

Last Friday, the credit rating agency Moody's downgraded the US’s rating by one notch to AA1. All of the big three agencies have now downgraded the US from a triple-A rating. Even if the technical change in credit status has limited practical implications for banking sector capital requirements and the like, US assets across the board have appreciated enormously relative to the rest of the world in the post-GFC era on the basis that the US is genuinely an exceptional market—defined, roughly speaking, as the only one offering consistently abnormally high returns at abnormally low risk. Given the administration’s anti-growth policy choices and their unfolding economic impacts, US exceptionalism looks—for now—to be over. Moments like this matter, as they symbolise a structural break in the narrative. Put simply: the US is no longer the only game in town.

But where to next for global risk markets? That is harder to say. In a more risk-averse world, where global trade looks ever more unstable, trade-dependent emerging markets are a mixed bag. How individual emerging market economies fare will depend upon the net impact of weaker US demand growth and the potential for supply chains to re-route in their favour as companies pivot away from China.

As for China itself, its fate will depend on how well it can stimulate household consumption to support the transition toward more domestically-driven growth. But consumers are chronically pessimistic in the wake of the housing market crash and Beijing’s mismanagement of the COVID-19 pandemic. The unresolved US-China trade war adds a fresh layer of uncertainty.

 

Hello Stabletown Europe?

The title above almost certainly exaggerates the situation. Still—dare I even say it—things may be starting to look a little better on this side of the Atlantic. After several years of uneasy economic performance in the wake of severe shocks (see below), which amplified Eurozone and, notably, German de-industrialisation and extended the long period of outflows from the UK equity market, the outlook is looking tentatively positive, both in absolute terms and relative to the US, for three reasons:

  • The two major shocks are fading. The twin shocks of a gas shortage and the sharp tightening of global financial conditions as central banks slammed on the brakes in 2022 and 2023 are now fading. Although recent gains have come in fits and starts, economic momentum has improved since early 2024, even after two years of virtually no growth. Since 1Q24, Eurozone growth has averaged 1.2% annualised, while UK growth has been a respectable 1.8%.
  • Policy flexibility is greater in Europe. The policy calculus looks much more straightforward for the Bank of England (BoE) and the European Central Bank (ECB) than for the Fed, should downside growth surprises materialise. Money markets expect around two more cuts each from the BoE and ECB this year—similar to Fed expectations. However, low energy prices, strengthening currencies, and a likely diversion of Chinese goods into the European market mean that the overall impact of US tariffs will likely depress UK and Eurozone inflationary pressures rather than add to them. This creates space for the BoE and ECB to cut more aggressively to bolster demand – if necessary – without worrying too much about restoking inflation.
  • Politics are unusually calm. While European politics are rarely quiet, and have repeatedly been a source of risk over the past fifteen years, they currently look largely stable in the big four economies of Germany, the UK, France, and Italy. While future elections in France and Italy could shake things up, they are not due until 2027. For now, there is no obvious domestic political issue in Europe that could spill over and significantly impair economic performance.

All being well, if these trends continue to play out, UK and European equity markets can start to close the still-abnormally wide valuation gap versus the US (Figure 5). Given present uncertainties, this may be more of a hope than an unfolding reality for now. Still, anecdotally, I hear more and more positive signs that global investors are turning constructive on the UK and the rest of Europe as they look for opportunities outside the US.

Figure 5: 12-month forward PE ratios: US versus Europe

12-month forward price-to-earnings ratio. Monthly data. Source: Bloomberg