Double Bubble, Trump and Trouble

Among the Wall Street book of proverbs is the old adage that ‘markets climb a wall of worry’. Well, these past two years have seen remarkable climbing against some considerable worries, yet now, as we face into 2025, the list of worries appears to have lengthened.

Inflation in the United States is still above target and interest rates are higher than we had expected. Governments continue to accumulate debt, undermining the credibility of their bond markets. Led by the tech sector, the stock market’s rise has been relentless, reaching valuations reminiscent of the 1990s bubble period. Alternative assets, from gold to crypto, continue to attract capital and reach their own record highs.

Moreover, we will soon have a more defiant and less constrained President Trump in the White House. In the Eurozone, Germany and France are in political turmoil, and further afield the Chinese government faces serious and difficult choices. Russian disruption continues and violence in the Middle East has spread. Without pretending we have any powers of prediction; how do we guide our clients and position our portfolios for 2025 and beyond?

Higher for longer – wages, inflation and interest rates

Before probing the negatives, it’s worth making two positive points. First, is that the world economy, led by the United States, outperformed growth expectations in 2024, shrugging off the highest interest rates in two decades. Second, it is forecast to grow at or above its trend rate again in 2025.

The core strength of the US economy i.e. the consumer, contrasts sharply with Europe and Asia. In the US, continued stimulus and wage growth have

powered consumption while other sectors struggled, whereas Germany and China have been too reliant on manufacturing and exports. Importantly, US and European unemployment is very low, and wages have been growing ahead of inflation for almost two years now, supporting consumers in both regions.

The downside of such wage growth is that it feeds into prices, especially in services, which make up most modern economies’ consumption. Looking at ‘supercore’ inflation, which strips out food, energy, and other elements to get a truer picture of price pressures, we see the problem facing central banks. Keeping rates above neutral still hasn’t brought inflation back to target (2%) yet¹.

While the weaker Eurozone economy has allowed the ECB (European Central Bank) to bring the euro rate down to 3%, higher wage growth is holding
back the Fed (US Federal Reserve) and BOE (Bank of England). The Fed has played a confusing hand so far in this cycle, holding off on cuts, then starting with a double cut, and now hinting at a pause. To be fair, the US jobs data did take a few turns last year,but weakening trends are emerging, which we will need to monitor carefully.

For example, the construction sector, a large employer and sensitive to interest rates, has seen a decline in headcount. More broadly, continuing claims show that laid-off workers are not finding new jobs as quickly as before. Employment in the Eurozone and UK is weakening too, but as in the US, the deterioration is from historically strong levels, not close to recessionary levels. If anything,this should give central banks a freer hand later in the year, perhaps more than markets now expect.

Enter Trump – The Great Disruptor

As if investors and central bankers didn’t have enough to deal with, we now face another four years of an unconventional and unpredictable government in the United States. President Trump is more determined to have his way this time but may suffer more from a lack of policy coherence and executive competence. However, it’s worth noting that since the election, sentiment in the US has improved and the consensus forecast for growth in 2025 has risen by 0.2%, given Trump’s pro-business agenda.

Trump’s main policy objectives have been clearly flagged – taxes, trade, and immigration. Reducing the labour supply and taxing imports may advantage American workers and companies, but they will likely slow US growth and certainly increase prices, fueling inflation. These policies can both be enacted on day one by executive order, whereas growth-positive tax cuts will take much longer to get through Congress, so we can expect the path to be bumpy.

The Trump effect may be felt more outside than inside the US. As we don’t know how much of his tariff threats will be implemented, nor how targets will react, estimates of the impact vary widely. Studying the 2018-19 trade war, analysts estimate that the direct hit to exports combined with the associated drag on business investment and sentiment could take 0.5% off Eurozone growth, and up to 1% off Chinese GDP2. The UK economy, with lower levels of international trade, would be less affected. 

Of course, tariffs won’t happen in isolation. Target countries will have to act to support their economies or to satisfy Trump’s demands. The new German government will likely loosen its debt brake and spend more, while the rest of the EU will need to make tough political decisions. China is already signaling its intent to further loosen fiscal policy. Trump’s “America First” agenda may be the disruptive tonic that stagnating Europe and China need to drive new stimulative policies.

Ultimately though, this is all guesswork. All we can say with reasonable confidence is that the range of economic outcomes for 2025-26 has widened. With some confidence we can say that inflation and government deficits will be higher, leading to higher interest rates and larger debts. The question then is what this means for the already-stretched finances of governments around the world.

Balancing the government books

Given that the root cause of the global financial crisis (GFC) was too much bad borrowing, it was a little ironic that the solution was more borrowing, but by governments, moving the private sector debt burden on to government balance sheets. Despite debt ceiling battles in the US, the global debt pile was never seriously tackled post the GFC and before COVID-19 arrived. The extreme government spending during and after 2020 has pushed the ratio of sovereign debt to GDP to levels unseen outside of wartime.

Late last year, as markets looked forward to another year of deficits in 2025, long-term global bond yields rose by almost 1%. Does this mean that investors finally care about fiscal rectitude? Not necessarily. Given that German yields did not rise as much as US and UK yields suggests that interest rate outlooks are still at least as important as deficits. Also worth noting is that bond yields in late 2024 were still below their highs of late 2023.

So, is there a practical limit to how much a government can borrow? Obviously, they need willing buyers for their bonds, beyond their own central bank. For this the world must need their currency, as it does the US dollar, or must believe their ability to finance the debt. Assuming enough willing buyers, the limit then becomes how much interest cost the government can carry, and this is where current debt levels are beginning to get interesting.

The annual interest cost of US government debt is now over US$800bn, approaching the size of the defense budget. We expect that Scott Bessent, the incoming US Treasury Secretary, will bring relative stability and credibility to the treasury department, while Elon Musk, co-head of the new US Department of Government Efficiency, may have too many conflicts of interest and personality to make a meaningful difference to the US budget. However, we note that other countries, such as Germany and China, have much more fiscal space to expand and stimulate growth.

A more realistic constraint on US government finances may well be the stock market. President Trump is known to take great pride in measuring his success by the performance of the US equity index. A budget debacle or a bond crisis that caused stocks to sell off would likely influence his course of action. However, positive behaviour adjustment may be tougher to come by than before, as the US equity market has almost tripled since his first election in November 2016.

The stock market delivers again

For two years in a row now the US stock market has returned over 20%3. This is more common than investors might think, happening twelve times in the past one hundred years, although four of these were in the 1990s. What matters more is how it happened – was it driven more by corporate profits or by eager buyers chasing hot stocks? The answer varies by market.

Looking back to the start of the decade, we find that US and European equities have been fueled by above-average earnings growth, partly driven by inflation and partly by the boom in technology. But here the similarities end. US returns were boosted significantly by an increase in price-earnings ratios, while Europe suffered the opposite, with a decline in valuations. Returns to US stocks were also helped by the appreciation of the US dollar, unlike Japan where the falling yen hurt foreign investors. 

The natural question is whether US valuations are too high now, as long-term charts suggest. We are sympathetic to the idea that the profitability of the stock market may have changed now that it is dominated by capital-light tech businesses. But if we restrict our attention to the past 30 years, we see that the US index is very expensive by its own high standards4. Unlike the 1990s though, this is not the case for the average US stock, and less so for stocks outside the US.

Can earnings growth justify the price?

Paying a higher valuation for a stock can make sense if you believe that the earnings will grow at a faster rate. One way to assess this is the PEG ratio, which is the price-earnings multiple (PE) divided by the earnings growth (G). Of course, this approach is sensitive to the growth  assumption, but it does shine an interesting light on today’s market

The first thing we notice is that the US market does have high expectations for earnings growth over the next two years, especially for tech stocks. As we know that equity analysts tend to overestimate growth, we average the forward-looking rate with the historical rate. Comparing this G with the forward PE we find that US tech valuations are not out of line with other sectors – if their earnings come close to the ambitious forecasts.

Looking at historical growth runs, it certainly wouldn’t be unheard of for US earnings to continue at this expected pace from 2024 through 2026. But it would be a strong three-year run, at roughly the 75th percentile for the US index or 80th percentile for US tech5, and quite a stretch considering that we’re not rebounding out of a recession and profit margins are already close to all-time highs.

We’re not brave or foolish enough to try to predict how AI (artificial intelligence) plays out, but there are serious questions about the profitability of the enormous investments that the largest US tech companies are making. What we can say is that an awful lot has to go right to justify their current valuations. The bar is lower for the average US stock, and much lower outside the US.

Investment conclusions

His words and actions may be counter-productive, but President Trump wants to “run the economy hot”. We don’t see him dragging the US into recession this year, although we will be watching the labour market for emerging weaknesses. The most likely consequences are higher inflation and interest rates than were previously expected. Internationally, Trump’s policy impact may be more negative, depending on how countries react, but again not enough to cause recession.

Central banks will continue to trade off growth and inflation, with the Fed and BOE running tighter policy than the ECB. We note that this gives them room to respond should their economies cool more than expected. Bond yields have already adjusted upwards to reflect higher rates, and if they continue to rise, we will consider adding to our bond duration. We prefer government bonds as corporate credit spreads are too low currently.

Expectations for interest rates and trade wars brought further dollar strength in 2024, particularly against the euro, and it’s expected to remain strong in 2025. If it returns close to late 2022 levels, we will look to reinstate dollar hedges in our equity allocations. Relative US strength and local problems are causing pain in some emerging markets, which may create opportunities there too.

Despite the heady valuations, we are highly resistant to under-weighting equities, especially when the US economy is doing so well. We are conscious that valuations and earnings expectations are unusually high for the US market, but we reiterate that this is driven by the mega-tech companies and is not as pronounced elsewhere in the US or outside the US. This is why our equity allocation is tilted in these directions, and we are inclined to buy more if markets do fall.

We are aware that our clients have heard this diversification story before and watched the same few tech stocks dominate markets for two years now. However, we stick to our principles for two main reasons. First, if the bulls are correct and animal spirits are emboldened by Trump 2.0, we expect market gains to broaden into areas that are not already priced for perfection.

Second, if we’re wrong, the bear market of 2022 and the correction of July-August 2024 showed us that when the growth narrative stumbles, the most excited assets suffer the most. Returning to our earlier conclusion, all we can say with any confidence for 2025 is that the range of potential outcomes has widened, and we believe our portfolios’ diversification should reflect that.

¹ Neutral interest rates are considered to be in the range of 2.5 to 3% in the US, between 1.5% to 2% in the Eurozone, and close to 3% in the UK.

² GDP is gross domestic product, the standard measure of economic activity.

³ The S&P 500 index of large US stocks returned 25.0% in 2024 and 26.3% in 2023, both in USD terms. In EUR, this translated to 33.7% and 22.3%, and in GBP it was 27.5% and 19.7%.

⁴ We use MSCI indices for this analysis, but other indices show the same extreme valuation.

⁵ These growth rate percentiles are calculated using DataStream sector indices back to 1973.