Monday Digest
Posted 10 March 2025
The return of regional divergence
US stocks fell once again last week, while European and Chinese shares did well. The background to this was a spike in European bond yields and more political uncertainty from the Trump administration.
European stocks jumped on Germany’s larger-than-expected defence spending package, because European manufacturers have struggled for years and have spare capacity. Firing up the factories will boost growth, even if the goods don’t get used. The real hope, though, is developing economically productive tech and ensuring genuine European cooperation (discussed below). The fiscal boost sent European bond yields sharply higher, which may be uncomfortable for fixed-income investors, but this is ultimately more a growth story than a debt scare.
Elsewhere, Trump imposed tariffs, then took them off again. The administration’s tariff rationale is that they reduce US demand for imports and draw in capital to build US based factories – boosting the dollar and neutralising the impact on consumers. But in reality, the dollar has weakened, because of the impact on market sentiment (and hence capital outflows). The only way to reduce the US trade deficit (Trump’s stated aim) in the short-term is to reduce US demand, but strong demand is what makes the US economy strong. More generally, the White House’s tariff plan requires consistency and forward-planning – the opposite of Trump’s volatile policymaking.
Trump has always been politically volatile, but his economic policies used to be reliably market-friendly, which no longer seems to be the case. This makes US stocks more risky, but it doesn’t mean you should put all your money in European defence. A few months ago, the story was about US outperformance – and that could come back if Trump decides to make good on his tax cut and deregulation promises.
In an uncertain and fragmented world, diversification is your friend. That has always been central to our long-term investment strategy, and it’s important now more than ever. For want of a better phrase, keep calm and carry on.
February asset returns review
February saw a notable change of fortunes for investors. Global stocks dropped 1.9% in sterling terms, while bonds gained 1.2%. The equity fall was largely about US underperformance, while British, European and Chinese stocks meaningfully gained. Last year, investors were excited about Trump’s tax cut and deregulation agenda. Those haven’t come, but tariff threats and disruption have. US stocks fell 2.6% in response, and the dollar sank. Gold prices rose on a mixture of geopolitical fears and supply imbalances.
Despite political fears, European stocks gained 2.3% last month – concentrated on defence stocks expected to benefit from Europe’s rearmament. European bullishness was not just about defence, but second round growth impacts and capital flows from US markets. UK stocks also rose 2% in February, and are well-placed to benefit from European defence spending. Impressively, UK equity has now outperformed the US on a 12-month basis.
China was February’s best performing region, up 9.9% in sterling terms. Growth is improving, thanks to government stimulus – and the release of low-cost AI model DeepSeek suggested their may be more to come. Chinese stocks are, remarkably, now the best performers on a 12-month basis, but investors should be wary of overexposure. Chinese assets are still down on a five-year basis, and Beijing’s fondness for intervention makes them fundamentally risky.
Global bonds performed well in aggregate, with the biggest contribution coming from a fall in long-term US yields, while UK and European yields remained stable. But we should note that the beginning of March has seen more bond volatility.
Commodity prices fell 2.6% in February, due to tariff risks and lower oil prices. Oil’s fall is not just about trade wars but Trump’s plan to boost US oil production. By contrast, industrial metals like copper performed relatively well, due to Chinese growth expectations.
Can guns generate growth for Europe?
Europe’s historic defence spending agreements are expected to boost the continent’s growth. German Chancellor-in-waiting Friedrich Merz announced a plan to exempt military spending from the country’s constitutional debt limit last week, along with a €500bn infrastructure fund. This was followed by 26 EU countries (excluding Russian-allied Hungary) agreeing the European Commission’s €800bn plan.
Defence companies will see the biggest upside – showcased by Rheinmetall shares nearly doubling year-to-date – but the fiscal spree is forecasted to boost the economy overall (by 0.6 percentage points per year, according to the Kiel institute). That’s why broad European stocks have outperformed the US this year.
Growth benefits can only come if the defence spending stays in Europe – rather than just buying American equipment. That’s true for both short-term revenues and any long-term gains from technological developments, but the rise in US defence stocks suggests investors aren’t fully convinced that will happen. Nonetheless, we suspect European leaders will be desperate to spend the money on domestic industries.
The UK has an established defence industry so is well-placed to benefit – but it clearly doesn’t have the same production capacity as the US. Defence spending could therefore be inflationary, as rapidly increasing demand for limited supply is a recipe for price rises. This could lead to a tighter European Central Bank – potentially undermining the growth upside. Politically, though, the ECB will not want to undermine the war effort, so we should expect some leeway.
The real long-term benefit for Europe could be closer cooperation. The EU’s lack of common fiscal policy has long been a barrier for the economy. But once nations agree on joint defence funds, agreeing on other spending might get easier. Germany’s infrastructure fund is a case in point. This is a unifying event for a continent that has sorely lacked unity. We hope that spirit can continue.