Where is the drama?

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There is more bearishness around but not a lot of asset (re)allocation. Having lived through the fall of the Berlin Wall, the 1991 Soviet coup, the Mexican peso ‘tequila’ crisis, the Asian financial crisis, September 11 and the subprime mortgage debacle, it would not surprise me if market volatility really got going. President Donald Trump has been quiet this week, but we are still heading towards a trade war and a dissolution of US-European relations (or am I being too dramatic?). Covering markets feels a bit like watching the latest series of the HBO show, White Lotus – there’s a lot of tension but not much drama so far, even though we know something bad is coming!

Bonds outperforming equities in the US, and equities outperforming bonds in Europe is the winning box trade that most investors would not have expected (or had as a strategy) at the beginning of the year. However, the belief that Trump’s policies would be good for US growth, and therefore equities, has been ‘trumped’ by concerns that the impending trade war will be bad for growth – in the rest of the world and in the US. The Citi Economic Surprise Index turned negative for the US in February and the perception is that the flow of monthly data has turned a bit stagflationary. Measures of consumer confidence have fallen; employment growth has eased, and the Federal Reserve (Fed) has cut its 2025 growth forecast (though it left rates unchanged on 19 March). At the time of writing, the S&P 500 index was 7.8% below its February peak and 10-year Treasury yields were nearly 60 basis points below the mid-January high point.

Unclear outlook

It is still not clear what level of tariffs will be imposed and when, with most of the proposed actions on Canada and Mexico delayed until early April. But it’s the not knowing that hurts. There is growing anecdotal evidence that businesses are becoming more concerned about the outlook. How will they cope with higher input prices? Will they be able to pass them on to consumers? How could that impact their own output and supply chains? And will company revenue streams be hit? None of this bodes well for hiring and investment. On the consumer side, people don’t believe the Washington mantra that foreign companies will be the ones paying the tariff (taxes). The University of Michigan’s consumer sentiment survey, published on 14 March, showed one-year US inflation expectations jumping to 4.9%, the highest since the middle of the pandemic inflation surge. Expectations of inflation over five-to-10 years rose to 3.9%, the highest since 1991.

Bit of pain

One of the reasons the Democrats lost the 2024 election was the higher level of inflation through the second half of Joe Biden’s presidency. Higher inflation will not be good for Trump’s approval ratings if it does transpire and persist over the next couple of years (hence his insistence that the price of eggs is coming down, thanks to him of course). Another driver of sentiment and potential voting intentions (it’s only 20 months until the mid-term elections) is the stock market. Trump recently said he does not look at the stock market, as part of a broader attempt to deflect away from what he and people like Treasury Secretary Scott Bessent say will be some short-term pain due to the administration’s “make America great again” policy. But equity prices matter - I am sure Trump would be taking credit if the indices were continuing to reach new all-time highs.

Wealth losses

We tend to focus on equity indices’ price levels. What is also important from a macroeconomic point of view is the wealth impact that changes in equity valuations have. At its 13 March low, the S&P 500’s market value was down around 10% (equivalent to around $5.2trn) from its recent highs. According to the Fed’s Flow of Funds data, the US personal sector holdings of corporate equities and mutual funds stood at around $49.6trn. Financial holdings make up a considerable portion of total household wealth. If portfolio values keep going down, it will become a big problem for consumers. As you would expect, there is a very tight correlation between the market value of the S&P 500 and individuals’ personal wealth.

Big drawdowns in household financial wealth (driven by the stock market) happened in the early 1990s following the dot.com bust. It occurred again during the 2008-2009 global financial crisis and in 2022-2023 when the Fed was tightening monetary policy (there was a brief large drawdown during the lockdown period, but the policy puts responded quickly). The most recent wealth drawdown was caused by the Fed; the previous examples resulted in the Fed easing aggressively as the hit to financial wealth was both the result and the cause of recession.

Big drawdowns will trigger the Fed

So far, the stock market wobble is manageable for the household sector. The six-month change in wealth is still positive. However, bearish arguments on US equities are well rehearsed (high valuations, slowing earnings growth, concentration, debt stability concerns and so on). Further growth and valuation adjustments could, under some circumstances, create a bear market in US equities leading to a large mark-to-market loss in household wealth. That would be a recessionary situation and would lead to the Fed easing more than is currently suggested. What the reaction from Washington would be to a prolonged move lower in share prices is anyone’s guess, but more pressure on the Fed to ease might be one of them (banning short-selling and taxing foreign investment flows anyone?)

There’s always a circular relationship between stocks and the real economy. Initial equity market falls are provoked by a change in the economic outlook and downward revisions to earnings growth expectations. As stock prices move lower, the behaviour of households that own equity and businesses changes. Spending and investment get cut, exacerbating the economic downturn. It’s a similar relationship between the central banks and the stock market. Sometimes monetary tightening causes markets to fall. If markets fall too much, central banks ease. In 2022-2023, the Fed increased rates, raising fears of a recession and changing the relative valuations between stocks and bonds. Markets subsequently fell. But there was no recession. The domestic economy was cushioned from the stock market correction by the high level of savings that had been built up during the pandemic. A market decline hitting household wealth today might result in a different outcome.

Foreign owners (ripe for taxing?)

I wrote recently about the role that foreign buying of US equities had played in financing the current account deficit. Again, using the Flow of Funds data, foreigners owned roughly 18% by value of US corporate equities at the end of 2024 and a further 7% of US mutual funds. Under the current economic and political environment, reduced foreign ownership of US equities is a risk (the relative performance of US markets versus European equities this year suggests rotation has already got under way). The bear scenario for US equities and the US economy is that foreign ownership is further reduced, confidence in earnings growth continues to fade as the economic data weakens, and lower equity prices hit household wealth even more. Any suggestion that foreign investors would face some tax penalty from trading US equities would accelerate the rotation out of the US.

Trump put (he practices every weekend)

Pessimism may be overdone. Trump may not follow through with all the tariffs, business and consumer confidence could stabilise, and the Fed might be able to ease policy more than twice this year if there is no tariff-generated rise in inflation. The ‘Trump put’, if you like. But nothing can be taken for granted and the rhetoric we hear directed towards Canada, China and the European Union does not suggest a major shift in the direction of travel is on the cards. It should not be surprising if there are more large market moves in the months ahead, even if investors appear to be mostly sitting on their hands. The upcoming S&P 500 reporting season will be very interesting. Company guidance will need to incorporate the uncertainties associated with the Trump agenda and, in the wake of DeepSeek, what makes a more competitive environment for generative artificial intelligence developers. The current 12-month consensus forecast for S&P 500 earnings growth is 12.3% - but it was 14.2% in December, and the gap between the up-down revisions ratio between Europe and the US is getting wider.

Bad things happen

Investors should think about the worst case because we have profound changes taking place in the world. I would think about a lower dollar, a higher level for credit-default swap indices, further gains in gold prices and further strengthening in the Swiss franc and even the Japanese yen (Japanese investors may be very wary of investing abroad now, especially on the bond side where dollar hedging costs are punitive). The Swiss National Bank cut its policy rate again this week, to 0.25%, reflecting almost no inflation in Switzerland and a strong currency that has surely been driven to some extent by global safe-haven flows (historically, periods of negative drawdown for US equities have seen the Swiss franc rise on a trade-weighted basis). What is it about politically neutral, ideology-free, low tax Switzerland that makes it such a destination for global capital?

Rivals

I am not inclined to write about football much these days. But I will suggest that a re-invigorated Manchester United might end up winning the same number - or one more trophy than Manchester City this season. I have not been able to say that for a while!

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 20 March 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.