Global politics turn business

Posted 21 February 2025

We end the week on a slightly downbeat note, not borne out of the astounding shifts in US foreign policy, but because US domestic service sector sentiment seems to have sagged. The US 10-year bond yield has dropped back to below 4.5% after a midweek push to 4.6%.

US investors will be focused on their on domestic backyard. But for us on this side of the pond, US foreign policy was all anyone could talk about this week. President Trump’s desire to deliver on his election promise and end the war in Ukraine – probably on terms favourable to Russia – became evident very quickly. However, the nightmare scenario for European politicians was the White House’s apparent recasting of Russia as a new ally and old allies as antagonists. Markets struggled a little in response, but nothing like you might expect given the historic significance.

We have to take these developments seriously, but must also avoid sensationalism and rash conclusions. Markets are not overly concerned, but some risk signals have notably increased. Any more uncertainty may be harder for investors to take.

Europe to borrow for defence – will it be enough?
We should start with what we know: European governments will have to spend more on defence, because the US will refocus its defence efforts in the Pacific and elsewhere. Politicians on both sides of the Atlantic have long called for this, but the US policy shift now makes it certain. This will benefit European defence stocks, which soared at the start of this week.

We can also be very confident that this spending will mostly come from higher public borrowing, rather than tax rises or spending cuts. Europe’s economy is too weak to withstand a significant tightening of fiscal policy and, even though EU nations have always struggled to agree on deficit spending, defending the bloc’s eastern border will be seen as imperative. That is most likely why European government bond yields rose much faster than US yields this week, on the expectation of significant new issuance. UK yields are now back above US treasuries, and the discount of German vs US yields has narrowed substantially.

Whether the week’s yield moves will be enough, or European yields will have to go higher to secure the continent’s defence, remains to be seen. Similarly unclear are the potential effects of this spending: fiscal expansion will probably benefit growth, but it could also be inflationary – which is probably why European stocks beyond the defence sector sold off. Interestingly, the UK could be pretty well placed, in terms of leading Europe’s defence sector. Britain has the highest military capability in western Europe, but is in need of extra funds. Europe has those funds, but lacks the capability.

Markets will depend on US sentiment – and that’s uncertain.
Markets seem unsure what to make of all this, broadly speaking. The continued rise in gold prices would suggest some investors are looking for a safe haven beyond the US dollar and US government bonds, but there are other factors influencing bullion markets too – as we discuss in a separate article. The threat that Trump’s tectonic shift poses to the world order seems significant but global stock prices did not react too badly, a brief sell-off on Thursday notwithstanding. In aggregate, most major indices have changed little from a week ago.

Investors’ apparent nonchalance could be seen as an expectation that Trump’s anti-Ukraine rhetoric is mostly “the art of the deal”. But under the surface, we are starting to see risk premia – the return demanded for a given level of asset risk – going up. That suggests investors might be nervous after all, just uncertain where to keep their money. Really, the key factors for broad market sentiment are how US investors feel, and how global investors feel about the US.

As such, the latest economic data out of the US is crucial to watch. JP Morgan’s surprise indices (measuring how the economy is faring relative to economist expectations) have actually started turning down for the US – and up in Europe – but that is probably more a reflection of how overexcited markets were at the start of the year rather than how they feel now.

And that relative move has had more confirmation today with the “flash” purchasing managers’ indices (PMIs), a crucial measure of business sentiment. Europe’s data was mildly less good than hoped, with the UK manufacturer data showing a marked fall back, as did France’s service data. The overall composites were a little below expectations. However, the US data released this Friday afternoon shows the service survey falling to 49.7, below the neutral 50 level. Given how strong optimism was in December, we feel this marks a notable shift. Below is a chart showing the service PMI data for the US, Eurozone and the UK:

Don’t overreact; don’t underreact.
Britons and Europeans are, understandably, more negative than anyone else about the US’ attitude to global politics. Global survey data shows the UK and Europe think Trump will be phenomenally bad for our interests, but this feeling is not shared by most of the world. As such, we have to recognise our own potential to sensationalise or catastrophise about the news – neither of which are helpful reactions for long-term investors. Our uncertainty is not the same as catastrophe, and there are reasons to think Trump’s latest actions are merely “the art of the deal” and could end up with vastly different results than current global events suggest.

But we also cannot pretend that Trump’s latest actions will not have consequences for global markets. The international financial system has been built on the stability of a US-led western order, itself is based upon democratic institutions. Trump seems determined to disrupt the current system, and his rhetoric gives little indication that his views are based on those principles. Rather, in dealing with other nations, the America First agenda seems to about gaining purely material transactional and short-term advantage. He is running a business and doing what he can get away with.

For investors, this negative perspective might bring about mild outcomes, such as less appetite for risk and long-term global investments. A terrible outcome would be the fragmentation of global investment markets into ring-fenced regions – capital controls and restrictions around foreign ownership.

A positive perspective could involve a reshaping of European politics to become more business-friendly and less bureaucratic, with the US reaffirming its commitment to support its natural democratic allies after a swift set of peace processes. In that case, institutional stability would be strongly re-established, with a better path to growth. Optimistic investors would benefit enormously. We think one way to gauge whether asset allocation should be adjusted is to develop scenarios and look for indicators which identify which path is becoming more probable. These indicators are likely to be focused on both political and economic signals.

So far, while there have been many things to throw into the mix, we have not seen one of our significant indicators trigger. Markets have dealt with disruption and uncertainty well, but we will be watching confidence indicators. From start of the year, some of these have faded and further disruptive actions are increasingly unhelpful. We will get a better sense of how this might pan out after Germany’s election on Sunday. Europe’s response will be crucial to watch.