Markets calm but trouble still bubbles
Posted 9 May 2025
Despite the India-Pakistan hostilities, markets remained calm this week. Measured price volatility came down substantially although, due to global economic uncertainty, implied future volatility – the cost of insuring your assets against sudden losses – is still relatively high. But investors seem to feel that US trade wars will be sufficiently resolved and growth will resume.
Near-term risks are decreasing but we believe that markets still discount a growth path which is unduly optimistic. While progress on trade deals is encouraging, this year’s economic activity has already been damaged by global trade uncertainty, which remains substantial. The longer these threats loom, the harder it will get for companies to meet profit expectations.
Markets shrug off political tensions.
On Tuesday, Germany’s new Chancellor Friedrich Merz stumbled at his first hurdle – failing to get a majority confirmation from his own coalition government. The Bundestag approved him in a second vote the same day, but it was embarrassing nonetheless. Many called it a stark reminder of Germany’s political division and broader socioeconomic issues.
That is a bit of a stretch. Merz’s rivals are entitled to a bit of schadenfreude, but the CDU-SPD coalition’s agenda remains on track, even if it may no longer be referred to as a ‘grand’ coalition. For investors, it is like the papal conclave – intriguing, but practically irrelevant.
More importantly for Europe as a whole, Merz quickly and energetically engaged with Macron, Tusk and Trump, and emphasised Germany’s role in resolving Europe’s issues internally and abroad. This positive attitude towards European cohesion could and should benefit the region’s growth prospects.
Military escalation between two nuclear powers is certainly not irrelevant, but markets largely shrugged off the India-Pakistan conflict all the same. Indian equities dropped somewhat, but are still higher than a month ago. We are no geopolitical forecasters, but, from the latest news, it feels like both nations are more interested in showing their own citizens how tough they are than starting a war. In any case, markets focussed more on India’s positive trade negotiations with the UK and US – which we cover separately.
The speed at which trade deals are being done – like yesterday’s US-UK ‘deal’ announcement – is certainly helping the mood. That ‘deal’ lacks specifics and, to most people here, seems unfair to UK goods exporters. Remarkably, that is exactly how Trump portrayed it to the American public. But, because it keeps the focus away from services (see chart below), Starmer is probably right that this is the best that can be done for now.
Meanwhile, equity markets seem to be returning to the narrative from the start of the year, that Trump’s excruciating tariff threats are just “the art of the deal”, and will fall back again. We still have our doubts (see below) but Trump’s tariffs certainly have given world leaders an incentive to negotiate.
The BoE cuts, but the Fed is in a bind.
There were two major central bank meetings this week. They concluded in The Bank of England (BoE) cutting interest rates by 25 basis points, as expected, but the 7-2 vote margin among committee members was less decisive than hoped (2 voted for no cut, 5 for a cut of 0.25%, 2 for 0.5%). Meanwhile, the US Federal Reserve left rates unchanged, earning chairman Powell a now-customary rebuke from President Trump. Both banks are stuck between precarious unemployment and potential inflation.
Bloomberg called the BoE’s decision a “hawkish cut”, causing a sharp fall in bond markets’ implied probability of another cut in June. Taking a step back, though, expectations of where UK rates will be 12 months from now rose only slightly – and are still well below forecasts from the start of April. Britain is firmly on the path to lower rates, and that will help the economy.
US monetary policy is less certain – because US government policy is so uncertain. In purely economic terms, there is a strong case that the Fed should cut rates: the jobs market is weakening and markets think tariffs will weigh on growth, ultimately pushing down inflation. But no central bank would be comfortable cutting rates when they expect a sudden price rise and fewer workers, – due to the recent stop to immigration, which hitherto helped replace retiring baby boomers.
Trump said Powell is “Too Late” to support the US economy, and in a sense he is right. What the president seems to be missing is that his own policies are stopping Powell from moving any earlier.
Are markets too optimistic?
Markets’ trade deal optimism is counteracted by the EU’s retaliatory tariff threats, and Trump’s threat to tariff films made outside the US at 100%. The latter is particularly concerning, because it drags services into discussion that previously centred around goods. Ironically, when you include services (e.g. IT/Tech, which the US exports in abundance), Trump’s claim that America is being ‘ripped off’ by countries not buying its products is substantially altered.
(Although, Europe’s goods-services trade situation is diametrically opposite to that of the UK).
Investors are mostly treating these proposals as idle threats – and they might be right. But, this arguably underestimates the disruption caused by the threat itself, which can suppress business activity in the meantime. The film industry, for example, often has several years between production and profit, and productions can quickly shut down when those profits are made less likely – as we experienced after the pandemic.
The suppression of activity is becoming a big concern for the US economy in particular. The US jobs market is in a precarious balance: not many companies are hiring, but neither are they firing. If that balance tips towards layoffs, it usually ends in recession.
Access to credit can also seize up, with bank loan officers tightening their lending standards. We will have to watch the attitudes expressed in the Fed’s senior loan officers survey next week. Credit problems often cause companies to let employees go and, as we discuss in a separate article, credit stress has been increasing for smaller and mid-sized companies. Further restraint would be unhelpful.
The longer those problems go on, the more it weighs on the economy. Crisis can be averted – if Trump makes good on his pro-growth promises, or the Fed cutting rates sharply. But the president seems unwilling to do so, and the central bank is unable. Markets are currently pricing in a positive resolution to all this, and we hope they are right. But just as at the start of this year, they seem to underestimate the risks.