Trump 2.0 - capital markets as collateral damage?

The experience of the past few months clearly highlights that managing risk is essential for being successful in the long-term. Even well-informed agents can be caught off guard by economic or political shocks. And it is to be expected that not only the past few years but also the years ahead will be characterized by unforeseen events. The reason is that political uncertainty is at an all-time high. Trump has a big share in this. His exceptionally erratic approach to diplomacy has clearly intensified compared to his first term in office. Trade policy is the obvious example. Trade policy uncertainty rose to unprecedented levels in post-WWII history.

Looking at trade policy it is astonishing to see how Trump is rewriting the global order. The debate on negative economic repercussions from the trade war has quite rapidly focused on the US, rather than its trading partners. Fears of the US economy being pushed into a recession started to become a dominant market topic, much more so than in Europe. It is, however, important to keep the starting position in mind. On financial markets price changes need to be viewed relative to previously held expectations. And here the US economy is looking back at a very successful year 2024. The US economy was performing solidly. In Europe, however, economic growth underperformed as the hoped for economic recovery failed to materialize. Looking ahead, the negative growth effects from the tariff shock, thus, have a larger potential to rewrite the economic outlook for the US rather than for Europe. Simply due to the fact that expectations towards the US economy were much more favourable to start with.

While a shift towards US-protectionism has always been seen as negative for Europe’s economic outlook and as ambiguous for Europe’s inflation outlook, it is seen as pro-inflationary for US consumers. For US monetary policy this implies that the Fed has to balance upside risks to its inflation mandate with downside risks to its labour market mandate. Not an easy task, particularly when considering that the last inflation shock is not long ago. The Fed might thus be more cautious with ‘looking through’ rising inflation. This does not necessarily mean rate hikes are imminent but rather a more cautious approach towards rate cuts. In anticipation of a challenging inflation environment the Fed has not decreased key interest rates so far in 2025 and we expect this to remain the case for most of the year. On financial markets rate cuts started to be priced for the second half of the year as the focus shifted towards discussing a US recession. For the Fed, 2025 will be a balancing act. If the economy only slows but does not fall into recession and inflationary pressures at the same time re-appear, the rates market might currently be positioned too optimistically on rate cuts. For equity markets, which have corrected on the back of tariff induced recession talks, this implies that the Fed put might this time not be pulled. On the one hand, the long-term outlook on US equities remains constructive as long as the US economy avoids recession. But, on the other hand, interest rates might be a head- not a tailwind for equity markets over the coming months.

In Europe, Trump is not only about tariffs. Particularly in the first weeks of Trump’s second term, Europe has been fully occupied by Trump’s push for a peace deal between Ukraine and Russia. The US’s approach towards Ukraine under Trump can be described as a U-turn compared to Biden’s approach. European leaders were shocked and started to question the US’s security guarantees within NATO. On financial markets prospects of a peace deal, and the at least partial suspension of sanctions, lifted sentiment in European markets. European equity markets rallied, energy prices embarked on a downward trend and the euro appreciated. Given the current positioning on markets, the question arises whether a quick, yet long-lasting solution, is possible. US pressure alone won’t do the trick and so there is a risk that markets will be disappointed on the geopolitical front.

What US pressure, however, achieved is a change of thinking about European security policy and military spending. Germany is the prime example. Under chancellor Merz, Germany has softened the debt brake by basically allowing unlimited spending on military plus a sizeable budget allowance on infrastructure. It’s Germany’s ‘whatever it takes’ moment, so Merz. Combined with Brussel’s flexibility on deficit / public debt rules for the EU as a whole, Europe’s push to take security seriously triggered a repricing on sovereign bond markets and an appreciation of the euro. On the one hand, debt financed government expenditures increases the expected supply of bonds on the market. On the other hand, it is also a fiscal stimulus for economic growth and with that for inflation. The repricing on bond markets came with higher sovereign yields, particularly for longer maturity bonds. The yield curve steepened markedly.

While fiscal policy and a wall of public debt issuances has been a crucial topic on European bond markets, it is interesting to see that this is not a key market topic in the US. The US has been on an unsustainable public debt trajectory for years and neither Democrats nor Republicans seem to worry about it. Yet, even for Trump the actual fiscal space is small, and key initiatives might at first be limited to prolonging tax cuts from his first term. Whether tariff policy will provide him the revenues he wishes for remains to be seen. Unsound public finances speak for short-term volatility with yields spiking on the Treasury market, particular in times when the global reserve currency status of the US dollar is questioned. In an adverse scenario the trust in the US financial system could be undermined and weaken the US dollar even further.

Summing up, the first three months of Trump in office show that things turned out quite different than commonly expected. In times of elevated political uncertainty and more frequent shocks even to advanced economies, an open approach towards risk scenarios is incremental. So far, financial markets are struggling with ‘known unknowns’. Managing those well will be important to obtain the flexibility in dealing with ‘unknown unknowns’.

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