The return of regional divergence

Posted 7 March 2025

At the time of writing, global stocks in aggregate are around where they were a week ago in local currency terms, but the fall in the US Dollar means the Bloomberg World index is about -3% in Sterling terms.

Once again, the aggregate picture hides a great deal of variation. US stocks have had another down week, while European stocks – mainly defence companies – have performed well, alongside Chinese shares. The background to this was an historic increase in European defence spending, sharply higher bond yields, and continued political volatility from the Trump administration. We are in a period of deep uncertainty – where the market outlook can turn rapidly. In this environment, holding diversified investments is proving crucial once again.

Germany sends global bonds spinning.

European equities were boosted midweek by Germany’s larger-than-expected defence spending package. This was led mainly by defence stocks – particularly German arms manufacturer Rheinmetall, which has nearly doubled in price since the start of the year. At first glance, it might seem strange that military spending should improve the overall economic outlook – given that defence is the stereotypical ‘unproductive’ investment. But after years of a manufacturing slump, Europe has a great deal of spare production capacity. Getting that going will provide a short-term boost, even if none of the goods produced are used for productive purposes.

The real hope, though, is not just about higher production, but Britain and Europe developing a joint military tech sector that leads to economically productive tech for the long-term. The spending packages already announced might not achieve that on their own but, if they lead to greater European cooperation, the impacts would be immeasurable. We discuss these impacts in a separate article.

Along with the defence boost came a spike in European bond yields – thanks to Germany’s announcement of plans to remove its constitutional debt brake. This reverberated across global markets, even pushing up yields in the US, despite fears about growth in the world’s largest economy. Higher yields mean lower bond prices, which can be difficult for fixed-income investors to stomach. But, we should bear in mind that the German yield spike was not really about public debt fears (despite what old-school German fiscal hawks might have you believe) but rather improved growth prospects. In that respect, it was about right: Europe as a whole is moving from structurally compressive to outright accommodative.

Tariff plan is 5D Chess, but Trump plays checkers.

Trump’s 25% tariffs on Canada and Mexico briefly took effect this week – only to be negated by the president’s delays and exemptions. An additional 10% tariff on Chinese goods went ahead as planned. Now that tariffs are here, it is worth looking at the White House’s economic rationale – offered last year by Trump adviser Steven Miran. Miran has argued that tariffs push up the value of the dollar by reducing US demand for imports and drawing investment-led capital flows to the US. This currency appreciation should, in theory, neutralise the tariff costs to consumers, while raising Federal tax revenues and making American industry more competitive.

The reason the US can do this – so the argument goes – is because of the dollar’s supremacy in global trade. But in reality, the dollar has weakened substantially this year. This is because trade is relatively small component of what makes currencies move; a much bigger impact comes from capital flows.

Trump and his advisers want to reduce the US trade deficit (exports minus imports). One can do that by increasing the volume of domestic production through increased productivity, but that is usually a slow process. The administration hopes to achieve some of this more quickly by firing what they see as unproductive government employees – who then switch into the productive private sector – , but this is also unlikely to move the needle in the near-term.

The other way is to reduce US domestic demand relative to others. But strong US demand is what makes the US economy strong – and a strong US economy is why US assets have beaten all others in recent years.

This points to a general problem of unintended consequences. Maybe Miran’s tariff plan could work in controlled isolation (if Murray Rothbard’s Austrian Economics textbook was correct). But the other parts of Trump’s agenda are working against it. Spending cuts are making US demand weaker, and the isolationist ‘America First Investment Plan’ is disincentivising the free flow of capital. On top of all this, political volatility is making it hard for businesses or investors to feel confident enough to go ahead with capital investment. Just look at the speed of Trump’s back and forth on Canadian and Mexican tariffs this week. The trading environment is changing so rapidly that businesses are struggling to get to grips with the current rules – let alone the future ones. Would-be tariff planners need certainty, but Trump loves to keep people guessing.

In a changing world, diversification is key.

It might feel like Trump’s confrontational style is to blame for market jitters this week – but it is important to distinguish between politics and policy. Trump has always been volatile but, during his first term, his policies were reliably market friendly. That no longer seems to be the case, and it is the policy uncertainty that is hurting investor sentiment.

Our job is to think about how this uncertainty might impact investments going forward. Should you just put your money in Rheinmetall? Not exactly. European stocks may be in the ascendency now, and US stocks lagging, but a few months ago the complete opposite was true. Last year, global investors were so convinced by America’s growth supremacy and Europe’s failings that the current situation would have seemed absurd.

The US economy seems to be slowing now, but this has already led the Trump administration to ease up on tariffs and federal spending cuts. Clearing the obstacles for growth is not the same as boosting it, but we have every reason to think that the popularity-craving Trump will want to unveil some economic stimulus in the weeks to come. If so, the narrative could easily flip back to US growth exceptionalism, or at least rejuvenate the attraction of the globally operating US mega caps.

The point here is not that you should or should not trust any particular investment position. It is rather that, in a deeply uncertain world, diversification is your friend. The outlooks for each region are uncertain, and increasingly desynchronised. In which case, it is best to own parts of each – to get the benefits where they come, and avoid excessive risks. Diversification has always been central to our long-term investment strategy, and it is important now more than ever. For want of a better phrase, keep calm and carry on.