Monday Digest

Posted 19 May 2025

A rally that requires belief
US large cap stocks have erased all of the year’s losses in dollar terms. Investors are split between ‘buy the dip’ bulls and still-sceptical bears. The former see lower volatility and rapid trade deals, and think profits will get back on track. The latter see roadblocks in US-China and US-EU negotiations, plateauing profits and consequently stretched stock valuations. Some paint the bulls as Trump-loving retail investors and the bears as measured professional investors – but that’s too kind to the latter. Many retail investors have done very well recently, after all. 

Still, nerves are showing in bond markets (partly due to budget fears discussed below) and higher yields have stretched relative stock valuations on our model. This is hurting corporate lending, which a recent loan officers survey shows is already tight. 

The increase in US yields once again spiked UK yields – but that doesn’t match the government’s tight fiscal policy and the Bank of England’s relatively dovish outlook. It could be about stronger than expected Q1 growth, but that strength came from retail sales which are already dropping off. Stock markets expect the UK to weaken in the second half of 2025 and they are probably right – but if economic data keep beating expectations it will boost UK equity. 

As long-term investors focussed on risk and reward, we’re cautious on US stocks. US tariffs are still significantly higher than expected a few months ago, and price rises are year to be felt. They will hit prices later in the year, and in the meantime the US will have to deal with delayed business investment and tightening credit. The Trump show has had some feel-good episodes lately, but the fundamental picture hasn’t changed.

This doesn’t mean the rally can’t continue in the short-term. Our caution isn’t a near-term directional call but an assessment of higher risks without higher rewards.  

European hope or hype?
European stocks have significantly outperformed the US in 2025 – the reverse of what many expected coming into the year. This is partly tariffs weighing on the US economy, but investors are also excited about Germany’s defence and infrastructure spending. Fiscal stimulus in Europe’s largest economy would go a long way to correcting Europe’s historic underinvestment, of which Germany’s old government debt rules were emblematic. It’s not just short-term spending markets are excited about, either. Investors hope that defence coordination will force Europe to integrate further and overcome competing national interests.

Capital Economics think Europe’s spending spree might be overstated, however. Germany can’t be the only fiscal source, but other nations – like debt-ridden Italy and France – don’t have the same spending capacity. Capital Economics estimate the Eurozone’s total budget deficit will be 3% after Germany’s increase, and growth will return to 1% annual growth beyond 2028. There’s also no guarantee that defence spending will boost productivity, as European nations typically spend just a fraction of their defence budgets on research and development. 

The difference in spending capabilities could also reignite old tensions – especially after the US apparently softened its stance on tariffs and Ukraine. The EU still has significant non-tariff barriers between nations, especially in the services sector. There’s still no single capital markets regulator, for example, and very few pan-European banks. 

Removing those structural barriers would be the real long-term prize for Europe. New German Chancellor Merz will know all about these from his time at BlackRock, and he has talked up the need for unity since entering office. But the rise of nationalism over the last two decades has pushed European leaders away from integration – so revitalising the European project will take more than the occasional show of unity. If leaders can pull it off, they could unlock the continent’s true potential. 

Trump’s Big Beautiful Bill
Republicans in US Congress have drafted a tax cutting plan that President Trump calls his “Big Beautiful Bill”. It mostly extends time-limited measures from the Tax Cuts and Jobs Act (TCJA) Trump signed in 2017, but includes some new cuts: tax-free bank accounts for children under eight, and tax-free tips, overtime and car loan interest until 2028. Contrary to market expectations, the bill has no additional corporate tax cuts beyond TCJA extensions. But markets still hope for corporate giveaways as the bill makes its way through Republican-controlled congress.

Cuts will reportedly drain $3.7tn of federal funding over 10 years, and the costing proposals are controversial: Republicans want to strip $625bn from Medicaid insurance and $300bn from Biden-era green policies – many of which benefit Republican constituencies. 

Trump suggested last week that Americans making over $2.5mn could face a higher tax bracket, but traditional low-tax Republicans shot down the idea, and they are emboldened by the party’s razor-thin majority. Many think tariffs could fund tax cuts, but Trump’s tariffs change too often to provide stable revenues. 

The $3.7tn cuts would therefore worsen the already high debt and deficit, which fiscally conservative Republicans warn could become unmanageable. Trump fought off this group in 2017, but Republicans had a stronger hold on congress and markets cheered on the cuts. We expect markets to be less receptive this time, given the rise in US bond yields. Our preferred measure of government credit risk shows fears are already rising.

Trump needs to deliver growth benefits to regain markets’ confidence, but that’s a tall order for a bill which mostly just extends the TCJA. True, many US investors still buy into the sugar rush of tax cuts, but they are increasingly outweighed by budget hawks warning about a fiscal comedown. Whichever way the narrative tips, it will significantly impact global markets.