Calm but not comfortable

Posted 13 June 2025

This week’s political events did not disturb markets until Israel’s military action on Iran on Friday morning. Even then, the reactions were relatively muted. In the days prior, Brent crude oil rose from $66 per barrel to $70 but other markets showed no discernible price reaction. Investors seem to be waiting for the actual event before deciding to move, as many past rumours have been nothing more, while much else can happen while one waits.

Even when historic geopolitical events do happen, the market reaction is often mild. Friday morning’s moves followed that pattern, with the dollar broadly about 0.5% higher from the close of UK trading on Thursday, gold up 1% and global stocks futures down about 1%. Europe’s equities are slightly worse off, given their heightened sensitivity to energy prices. Bond yields fell initially but have risen back to Thursday’s levels.

Oil has shown the sharpest reaction, with Brent crude up another $6 to $76 per barrel. That might be why bond yields rebounded – with higher energy costs pushing up inflation expectations. If oil prices move higher for longer and supply chains are disrupted, making tariff negotiations more difficult, input price would rise despite compressed economic activity.

However, geopolitical mayhem has been rising since the pandemic, and investors have become a little desensitised. The pessimistic explanation of this is that people have stopped trying to predict the outcomes of complex and fast-moving situations, becoming more used to shocks and discounting the chances of after-effects. The more optimistic explanation is that the political world has become better at containing situations.

In any case, this weekend will be tense and markets could well move after we finish writing. We have warned for a while that stock markets might be too positive – particularly on the US. Positivity is not unreasonable, but we discuss some market factors (rather than geopolitical concerns) that could undermine it below.

UK markets react positively, but Britain’s equity markets have a liquidity problem.

For all the spending promises, it was notable that Chancellor Reeves’ spending review did not change the treasury’s fiscal rules. Many had expected some tweaks – the IMF even argued for them – but Reeves reiterated her commitment to fiscal discipline and bringing down interest rates.

UK government bond yields fell in response, sterling strengthened and the FTSE 100 hit an all-time high on Thursday. A chancellor of any political persuasion would probably look at that as a budget well received by markets.

Less encouraging was Britain’s unexpectedly large 0.3% GDP contraction in April. But we should not overinterpret the monthly data, which was stronger-than-expected in March and has seemingly reverted to trend. More positive was Nvidia chief Jensen Huang calling the UK a “Goldilocks” environment for AI, as Kier Starmer promised £1bn in AI funding on the same stage.

With capital flowing out the US this year, and Europe lacking the financial architecture to take it all in, we should not underrate the UK’s investment opportunities. Unfortunately, there is no guarantee these opportunities will benefit Britain’s stock market. The UK has an increasing problem with trading liquidity, partly due to transaction costs. The FCA seemingly acknowledged these problems with the announcement of PISCES (the Private Intermittent Securities and Capital Exchange System) but the system does not seem to address the more fundamental liquidity problem. We plan to write in more depth on this soon.

US growth slows, but that might not be a bad thing for stocks.

Before Israel’s strike, US stocks edged upwards, despite company earnings projections levelling off. Lower earnings growth matches up with weaker employment data (in everything except the much-watched non-farm payrolls) and it supports the thesis that US profit exceptionalism is fading.

Likewise, inflation came in lower than expected – 2.4% year-on-year in May. Donald Trump will take that as vindication that his tariffs are not lifting prices, but the inevitable conclusion is that they are weighing on demand. This is a sign that US consumers – the country’s economic engine – will spend less if prices rise.

Businesses will therefore struggle to pass on higher costs, eating into their profit margins and hurting earnings further. This backs up the Federal Reserve’s hunch that tariffs could be deflationary by curtailing growth. That is for the current ‘manageable’ tariff levels, at least. It may be a different story if the “reciprocal” tariffs come in on 9 July – as the president claims but markets doubt.

Stock prices can still rise in a low growth environment – much as they did in the decade before the pandemic. As long as the economy avoids recession and interest rates drop to allow for credit expansion, US equities could keep grinding higher. We just should not expect the stellar returns of the last few years, in that case.

Bond dynamics could stretch stock valuations to breaking point.

Of course, if stocks grind higher and profit growth slows, that means price-to-earnings valuations go up. But many already consider US valuations too expensive, especially compared to bond yields. They are now at historic levels, on our model, after yield rises over the past two months.

US valuations have been high for a long time, though, and there are reasons to doubt that higher bond yields will feed through to stock markets. Bonds and equities play different roles in a portfolio, which cannot be easily substituted. This is especially true for retail investors, who typically prefer buying stocks and are less influenced by relative valuations.

As we discuss in a separate article, the overall amount of global government bonds has risen dramatically over the last decade, while equity issuance is in a prolonged lull. If asset markets overall have more bonds and fewer stocks, it makes sense that investors would start valuing stocks higher relative to bonds.

Nevertheless, this makes equities more vulnerable. When companies do need to raise capital by issuing shares, stock prices can fall sharply, hurting the existing holders. We saw this recently with Eutelsat: the European satellite operator’s shares soared when it became clear that Europe would need to invest in its own satellites, but those shares have fallen back down as Eutelsat has raised the capital needed to actually meet that demand.

The other risk is that sharply higher bond yields scare investors out of stocks altogether. We have seen flashes of that panic this year, and we have speculated that US fiscal deterioration could be another flashpoint. But, so far, investors have held their equity positions. Rises in bond yields do not make the asset class attractive enough unless those rates remain high while other things conspire to start a recession. It might happen but it has not happened yet.