Europe First?

Posted 14 February 2025

Another dramatic week in global politics had rare and fascinating effects on capital markets. The Trump administration’s apparent plan to negotiate a Ukraine peace deal without European input, but leave European nations to foot the bill and bear the political consequences, is considered a nightmare scenario by many politicians on the continent. And yet, European stocks rallied while the US faltered. For the first time in a while, global investors seem more positive about equities outside the world’s largest economy – including booming Chinese tech stocks – than in it.

We also saw a decline in the value of the dollar; not large, but notable because it seems to be a turn in the recent trend of dollar strength.

Often, dollar weakness is a sign that global investors are feeling bullish, but other signals – like soaring gold prices – might suggest markets are feeling wary of risks. This constellation of trends suggests that investors may have reassessed relative growth prospects for the US and the rest of the world this week. For the longer-term, it could also indicate declining confidence in US institutions.

Is US confidence waning?
US consumer price inflation unexpectedly increased to 3% in January – a decidedly unwelcome sign, which caused expectations for the next rate cut to be shifted into the autumn. Inflation is proving sticky all over the world, but in the US it looks like prices are actively heating up. This is true across a broad range of measures – even disregarding the widely reported bird flu shock to egg prices. Clearly, there is no room for the central bank, the Federal Reserve, to cut interest rates in the near term and, while it is still an unlikely scenario, bets on the Fed raising rates have increased.

This might prove a short-term blip. Today, bond yields fell back to recent lows, after January’s US retail sales data was weaker than expected (which may indicate that consumers respond to higher prices by buying less). Even so, inflation is the Fed’s main concern and its stickiness will make them nervous. Policymakers will want to make sure that if businesses are borrowing, it’s for productive investment rather than just to build inventories.

This week’s inflation report coincided with a notable investment flow out of US stocks – reversing the ‘America first’ narrative that has dominated markets for so long. The ‘Magnificent Seven’ US tech stocks have particularly underperformed so far this year, and it is now starting to look like a trend. This may be premature, but if big tech’s weakness continues much longer, it might really become a trend – as technical momentum trades will start stacking against last year’s big winners.

US retail investors were brimming with confidence coming into this year, but that sentiment has at the very least paused. We have not yet seen a confidence shift for consumers – the backbone of America’s economic strength – but that could soon change if inflation stays elevated. Soaring egg prices will be a visceral sign for many, considering how the president’s team politicised the issue on the campaign trail. If sticky inflation is accompanied by Trump’s governmental disruption (thousands of civil servants have already accepted Elon Musk’s invitation to resign) things could get a lot harder for US consumers.

Political upheaval isn’t stopping European positivity.
European stocks were one of the biggest beneficiaries of US outflows this week – a fact made all the more jarring by Trump’s direct negotiations with Putin, and his administration’s warning that Europe’s security will only be second priority going forward, as US defence focus turns towards the Pacific (China). Europe’s rally is partly a recognition that an end to the Russia-Ukraine war is good for European companies (regardless of how much we might morally object to its terms) but partly also a recognition that Europe’s economy is already rebounding from its depths.

Growth on the continent could get even better. One clear implication of this week’s events is that European governments will have to increase their defence spending, which will inevitably have to be funded by fiscal deficits. Fiscal expansion should boost short-term growth and, if it stimulates research and development, it could even have long-term benefits. European politicians are understandably scared about what might happen if Russia is appeased, but sober analysis requires us to acknowledge the potential benefits.

The same reasoning applies to the UK. After the Office for Budget Responsibility’s (OBR) grim forecasts removed the treasury’s fiscal headroom, Chancellor Reeves was adamant that fiscal rules would be adhered to. We think this is a credible promise, but no one should be surprised if an exception is made for military spending. Reeves will also be aware that the OBR’s forecasts were made prior to the Bank of England’s interest rate cut – and the surprising 0.1% growth for the last quarter. Things might not be quite as grim as the OBR suggests.

Do risk signals reveal a deeper American anxiety?
Gold prices have resumed their rally this year and broke new all-time highs through the week. Gold’s initial rise may have been precipitated by Chinese retail demand, or global central banks meaningfully increasing their reserves, in an attempt to diversify holdings away from the dollar. But gold’s momentum is now being sustained by other causes – perhaps such as the shortage of physical metal to support the derivatives market. We will revisit this topic in more depth soon.

However, demand for gold is usually associated with investor fears. If so, what are investors afraid of? Last weekend, the Financial Times published an article by 2024 Nobel-prize-winning economist Daron Acemoglu entitled “The real threat to American prosperity”, where he considers a scenario about spiralling loss of faith in US institutions and relationships.

This week has been challenging in that regard. Of course, America First puts others second and those of us outside the USA have been in that process for what seems like ages. However, friends tell us that their American friends are nervously considering whether they, their children who are about to go to college, or their money should remain in the US.

Concerns about ‘institutional decline risk’ among US investors might not lead to lower aggregate stock prices (well-connected “quality” tech oligopolies might be a safe place to keep your money, for example) but it might increase demand for gold, weaken the dollar and cause a divergence between US bond yields and those in other markets.

If we squint hard, perhaps one can discern the start of these trends although, of course, it is far too early to conclude this is underway. There are many factors which can explain current market moves, and we know that the US is running on a different cycle to the rest of the world. Still, it’s also hard to ignore the news. Long-term investors should not dismiss the signs altogether.