Markets focused on the US tax bill, and tariffs again

Last Friday, tariffs came back to the forefront with Trump saying that a 25% tariff must be paid by Apple if phones sold in the US are not made in the US, and “recommending a straight 50 % tariff on the European Union” from 1 June, before swiftly extending trade negotiations until 9 July after a conversation on Sunday with European Commission President Ursula von der Leyen.                           

The outcome of negotiations with the EU, and other countries, remains uncertain. It’s almost impossible to know which country/sector will settle at which tariff rate. At face value, tariffs are a downside risk to the economic growth of the targeted country, but they’re a burden to the US economy too. Tariffs bring a stagflationary impulse (slowing growth, rising inflation) possibly leading the Fed to hesitate with further rate cuts (see below). That said, we think market and economic pressure may push Trump to soften his stance as has been the case recently. 

With uncertainty lingering, we maintain a diversified allocation across asset classes and regions so that a wobble in one part of the portfolio could be compensated by a rise in another. As the US remains at the epicentre of policy uncertainty, we’ve diversified away from US equities and the US dollar. For instance, we recently bought Japanese equities and, in euro-denominated portfolios, swapped some of our US equities for a version that offers protection from currency movements. In sterling portfolios, we increased our exposure to UK equities and gilts, a defensive play (the former) and a market offering attractive yields (the latter). We still own an equity ‘insurance’ instrument in flagship funds and other portfolios (where client knowledge and experience, and regulations and investment guidelines, permit) that partly cushion a fall in equities. We also own gold and inflation-protected bonds as risk mitigators. 

In our latest note, we referenced that the market’s attention was starting to shift to Trump’s spending bill and the large and growing US fiscal deficit (-6% of GDP). One would expect tax cuts to boost growth and, in turn, the stock market. However, last week, both US bonds and equities fell. So, what’s happening here? 

It’s because markets expect that Donald Trump’s landmark “big, beautiful” tax bill, which the US House of Representatives passed last week, will widen the fiscal deficit and lead to more debt. The independent and non-partisan Committee for a Responsible Federal Budget estimates that Trump’s tax bill will increase debt by more than USD 3.3 trillion over the next 10 years, pushing federal government debt from 100% of GDP to a record 125%. Moody’s, the credit rating agency, cited this significant rise in debt as a reason for stripping the US of its AAA credit rating. 

This is a source of concern for the bond market. The 30-year US Treasury yield breaching above 5% marks a first pain point. The next would be if the 10-year Treasury yield breaches 5%, too. A meaningful reduction in the budget deficit should soothe investors’ concerns. However, there are no signs of this happening right now as the Senate looks set to pass the bill, too, which is the last step before it’s signed into law by the president. We share the market’s concern, which is why we hold fewer Treasuries relative to our long-term allocation, preferring European and UK government bonds in euro and sterling portfolios, respectively, particularly short-dated ones to mitigate the impact of interest rate and inflation volatility. 

Last week, German first-quarter growth was much stronger than initially expected (+0.4% vs -0.2% initially estimated). It’s Germany’s best performance since the third quarter of 2022, in part an indirect effect of the US trade policies. The steep rise in US tariffs prompted German producers to ramp up production, with exports surging in March. Frontloading means that this better-than-expected performance could be a one-off. May’s purchasing managers’ indices (PMIs) fell just below 50, the threshold separating expansion from contraction, primarily due to market uncertainty impacting services activity. Manufacturing activity continued to recover, though, which is an encouraging signal. In addition, the new German government has access to significant fiscal room for defence and infrastructure investments, which will likely support growth. Our overweight position in European equities (including the UK in sterling portfolios) should benefit over the medium term, given the extra defence and infrastructure spending in Germany and across the continent, although it will come with bouts of volatility in the short term. 

This week marks the beginning of the release of the euro area inflation number for May. France (Tuesday) kicks things off with Germany (Friday) next, and overall eurozone inflation is due next week (Monday 2 June). With inflation around the European Central Bank’s 2% target, we think the central bank could cut interest rates again on 5 June. On the other side of the Atlantic, the release of the minutes of May’s US Federal Reserve meeting (Wednesday) will likely confirm that it will hold rates until policy uncertainty clears. 

On Thursday, investors will focus on the second estimate of US GDP for the first quarter, following the unexpected contraction registered with the first estimate (due to surging imports to beat the deadline for tariff implementation; higher imports reduce GDP, potentially suggesting a temporary effect), alongside core inflation for April on Friday. Japan’s data for April industrial production, retail sales and the labour markets are also due: expectations are solid numbers and we’ve recently opened a tactical overweight in Japanese equities, an attractively valued market with solid earnings growth and good diversification properties. Lastly, on Saturday, China’s official PMIs for May will show to what extent recent tariff turbulences may have influenced activity.