Tuesday Digest
Posted 27 May 2025
Return of the bond vigilantes
We probably should have expected some stock market pullback, after weeks of recovery. We certainly should have expected that Trump wasn’t done with tariff threats – his, now delayed until 9 July, 50% EU tariff threat hit markets on Friday – but stocks were falling even before that, thanks to higher government bond yields (resulting from planned US tax cuts and the resulting fiscal instability).
This has echoes of 2022, when higher yields put a ceiling on equity returns. Our equity valuation model is sensitive to long-term real rates, which are themselves sensitive to measures of government fiscal risk. That risk isn’t just a US problem: deterioration in the world’s largest bond market would push up yields everywhere – much more than the UK’s budget fiasco of 2022.
Trump’s tax cut plans will reportedly cost $3.3tn in lost revenue over 10 years. Bond buyers hope that tariff revenues will make up much of the shortfall – the inevitable conclusion being that the president can’t afford to lower tariffs any further, which may even explain the EU threat. But lower tariffs are what excited US stock markets over the last month. It’s a rock and hard place: stocks tantrum when tariffs go up; bonds will tantrum if they go down.
This suggests that US stocks and bonds are competing for the same capital. In the past, capital inflows to the US meant they didn’t have to. But with America’s safe haven status under threat, US underperformance is becoming a trend that will be hard to reverse. Higher bond yields have room to come down, for example, but that requires policy stability – which has already deteriorated.
We’ve warned before about US companies facing high debt costs, which are increased by higher ‘risk free’ government yields. For mid and large-cap borrowers, this hurts their refinancing costs and stock valuations. This isn’t recession point, but higher bond yields mean the risk isn’t negligible.
UK inflation unease
UK inflation was 3.5% in April – above expectations and the highest figure since January 2024. Most coverage focussed on tax impacts and Ofgem’s higher energy price cap, but planned one-offs typically don’t raise long-term inflation. More worrying for the Bank of England was surprisingly strong airfares and service prices, suggesting strong consumer demand and wages. They scuppered any remaining hopes of an interest rate cut next month. Even before the report, BoE chief economist Huw Pill argued that rate cuts to now had been too quick.
April’s surprise challenges our previous hunch that UK inflation would be weak, but the underlying numbers aren’t as clear cut. Core goods came in below forecast, for example, while the BoE’s own measure of service prices decelerated from March. Opinions on where UK inflation will be at the end of 2025 are mixed, and it’s worth bearing in mind that, prior to last month, UK price levels were growing at a similar rate to Europe and below the US. Bearing in mind one-offs and seasonal factors (like financial year-end rises indexed to past inflation) we would expect inflation to fall in the near-term.
Bond markets are unsure how much it could fall, though, which is why long-term government bonds sold off and, hence, yields rose sharply. But UK yields are still closely correlated with the US and the difference between the two is narrower than two months ago. Basically, the inflation surprise forced a bond adjustment, but not a panic.
We should also remember that inflation and growth are two sides of the same coin – and Britain’s stronger-than-expected Q1 growth would have contributed to price rises, particularly for wage-sensitive services. That’s why UK stocks didn’t move much in response. Even if inflation means higher than expected rates and yields, the resulting growth should support profits.
UK-EU trade deal a positive for investment
Economically, both the benefits and concessions of Britain’s “reset” deal with the EU have been overstated by politicians. Fisheries are a tiny fraction of the UK economy so, in pure trade terms, the agriculture and energy benefits outweigh the cost of giving Europeans access to our waters. But the long-term economic benefit is still miniscule compared to the estimated costs of Brexit – which is why both sides painted the deal as a starting point, rather than job done.
The real prize for the UK would be the ability to sell financial services into the EU – and Europe would benefit too. The UK has a highly developed capital markets framework, which the EU lacks. Both regions suffer from underinvestment problems: Europeans save too much, while UK investors – particularly pension funds – simply don’t buy enough UK stocks. This is arguably one of the reasons the UK and Europe have underperformed the US for so long.
The UK is trying to address this problem with its “Mansion House Accord”, through which pension providers agreed to invest £50bn in UK businesses. There are rumours of something similar in the EU.
British and European regulators would do well to act now – as both regions have benefitted from Trump-spooked investors moving money out of the US this year. Those flows have already dried up somewhat, after the US president backed down on tariffs. If policymakers want the short-term investment flows to turn into something more, structural changes are needed.
Not only would this boost stock values, it would mean more money for smaller riskier ventures. That means investment in innovation, like AI. Indeed, the US’ strong investment impulse is one of the reasons for its economic and financial outperformance. In a Trump-shocked world, we suspect Britain and Europe’s political will to make these structural changes will be strong.