The three things investors should know this week
The new White House continues its “shock and awe” advance, imposing tariffs on Mexico, Canada and China and challenging Congress for the right to control the budget.
As a result, central banks and monetary policies are diverging, with the US adopting a more hawkish stance and the EU ready to cut rates deeper. The BoE is still balancing between persisting inflation and growth challenges.
Portfolio managers are looking beyond the benign picture of global equity and bond markets and recognise that systemic risks are on the rise. We live in a different world now than we did a decade ago, or maybe even three weeks ago.
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Summary
The US President continued his re-shaping of the American and global economy imposing 25% tariffs on Mexico and Canada and an additional 10% on China beginning on 1st February, promising that Europe is next. Additionally, he issued executive orders to freeze foreign aid and federal funding (it was rescinded but may well be rewritten and could cause a demand shock). At the same time, DeepSeek, a Chinese Large Language Model that rivalled ChatGPT, threatened investment in AI and reduced the price of Nvidia’s stock towards fairer valuations, with no major spillover.
We are entering a new era of global de-synchronisation. Decisions by the US Federal Reserve and the European Central Bank last week tell us not just a story of interest rates, but how different regions see their futures diverging. For the short term, we see likely higher inflation, despite last week’s benign core Personal Consumption Expenditure number which, however, reflects a previous economic paradigm, and we have questions over medium-term growth in the world’s largest economy. The EU, is going a different way. Disinflationary pressures are stronger, with wages not nearly as adaptable as in Anglo-Saxon economies, and China finding more fertile ground to sell goods at lower prices. As for the BoE? The UK’s central bank is in a bind. On the one hand, it faces persistent wage inflation. On the other, growth has been lacklustre, and with its main trading partner, the EU, in the doldrums and the other boarding up the trade gates, as well as higher inflation reducing fiscal space, GDP upside is limited.
What should investors do? Take a look up and see that chips are in the air and that is very difficult to say where they will land. Simply put, portfolio managers need to look beyond the benign picture of global equity and bond markets and recognise that systemic risks are on the rise. We live in a different world now than we did a decade ago, or maybe even three weeks ago… So steps can be taken to manage risks within portfolios.
Week Ahead
The week ahead is shaping up to be another interesting one. Markets will be waiting for the US President to issue new executive orders, as well as to further explain his tariff strategy with Europe. It is also interesting to see the sort of response coming out of the countries that have been subject to tariffs. Will they take their complaints to the (defanged) WTO? Will they respond in kind? Will they simply seek to export somewhere else? From a macro perspective, markets will be focusing on PMI numbers (although they are historic by now, and don’t yet tell the story of what’s ahead), and US payroll data at the end of the week.
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Another predictably eventful week is behind us, and a more eventful one lies ahead. The US President continued his re-shaping of the American and global economy imposing 25% tariffs on Mexico and Canada and an additional 10% on China beginning on 1st February, promising that Europe is next. Additionally, he issued executive orders to freeze foreign aid and federal funding (it was rescinded but may well be rewritten and could cause a demand shock). Meanwhile, internal political convulsions for the world’s largest economy were amplified. So many things happened, each with significant geo-economic ramifications, that will likely affect most portfolios, one way or another.
At the same time, DeepSeek, a Chinese Large Language Model that rivalled ChatGPT, threatened investment in AI because of its open-source nature and lower cost, requiring fewer and bigger chips. It certainly rocked the boat and threw Nvidia off its supposedly unassailable perch, a tactic whose effects are not too dissimilar to “dumping” of physical goods at very low prices. To be sure, there was no spillover, and Nvidia is now trading at more palatable valuations.
But let’s go back to the bigger issues. A better way to understand everything and put it into context is to see the larger force at play: the re-ordering of globalisation.
If you are a market economist or an investment strategist, globalisation is a very good thing. Inflation was down, growth was steady and somewhat predictable and the world economy was humming in a synchronised way, like a well-oiled machine (most of the time anyway). Identifying big trends (Financial Engineering, Quantitative Easing, Fourth Industrial Revolution) was the key to riding the “right” wave and repeatedly creating “alpha” for portfolios. The hard part of the job was to know when to get off each wave and onto the next. Just one move like that created Wall Street legends, like Michael Burry or Kathy Wood.
Well, goodbye to all that.
Globalisation was sparked by the internet and primarily fuelled by the business partnership between America and China, where one would export disinflation and the other would share the growth. It was not on executive initiative that American producers used the World Wide Web to find cheap suppliers in China. But both sides saw potential and made sure the infrastructure and a working framework (China in the WTO for example) was put in place. Now, authorities on both sides have squarely decreed that business alone could not drive such a megatrend and that a partnership forged by market forces was not politically palatable anymore. The future of globalisation is uncertain. It may well die, taking us back to a wilder age of commercial mercantilism and bilateral relationships. Or it may survive within a differently arranged global order. For the time being, what we are experiencing is the volatility between eras.
We are entering a new era of global de-synchronisation. Market and economic de-synchronisation during the pandemic gave us a glimpse of what it looks like: higher inflation, less efficiencies (so larger output gaps), far less predictability which meant bigger inventories and an advantage for larger corporations who would place larger orders, and widely diverging economies and monetary policies. A word starkly different from 2009-2017 when central bankers worked in coordination to make sure the global economy didn’t spin off its axis.
Decisions by the US Federal Reserve and the European Central Bank last week tell us not just a story of interest rates, but how different regions see their futures diverging. The thinking is that, over the short and medium term, trade wars and a crackdown on immigration will likely result in upward inflation pressures in the US. While the IMF and various institutions see also real GDP acceleration, we would be a bit more reserved on the economic growth side of things. Yes, drumming up domestic production, deregulation and lower corporate taxes may spur growth enough to counterbalance the disturbance, but this will take time to play out. Bond markets are not pricing in significantly higher inflation, so yields could climb further, reducing fiscal space more immediately, while higher inflation may eat into nominal growth. So, for the short-term, we see likely higher inflation, despite last week’s benign core Personal Consumption Expenditure number which, however, reflects a previous economic paradigm, and we have questions over medium-term growth in the world’s largest economy.
Over the short term, this could boost domestic demand, but it will likely cause a lot of issues for US large caps who have 41% of earnings from abroad. Not only will manufacturing likely face serious importing issues and margin pressures, but it is not inconceivable that US companies will find themselves in a more hostile environment abroad if tariffs are already imposed. A threat carried out or repeated on every subject is not an effective deterrent. This is not likely reflected in present valuations which, for US large caps, trade at the top 10% of their historic valuations, despite last week’s Nvidia correction.
The EU, is going a different way. Disinflationary pressures are stronger, with wages not nearly as adaptable as in Anglo-Saxon economies, and China finding more fertile ground to sell goods at lower prices.
Meanwhile, tariffs on US exports will likely reduce demand for goods, political uncertainty in France and Germany and persistent centrifugal EU forces are not conducive to growth, which the IMF has consistently downgraded over the past year.
Tariffs may well increase EU inflation over the longer term, as global supply chains stand to be disrupted again. However, it is a different sort of disruption at the origin (China) and at the endpoint (US) so we could see a very different situation than during the pandemic.
Thus, it is no wonder that central banks diverged, with the Fed taking a hawkish stance and maintaining rates (over the President’s vocal objections) while the ECB dovishly chose to support the beleaguered single currency area and may well do so again.
If there’s anything holding it back, it is the potential for capital flight if interest rates widen too much, but Christine Lagarde seems to prioritise shielding the EU and the Euro at the current juncture.
As for the BoE? The UK’s central bank is in a bind. On the one hand, it faces persistent wage inflation. On the other, growth has been lacklustre, and with its main trading partner, the EU, in the doldrums and the other boarding up the trade gates, as well as higher inflation reducing fiscal space, GDP upside is limited.
Conclusions
As political and economic rifts widen, the global economy diverges. The US is on a path to inflationary expansion, the EU on a disinflationary slowdown, and the UK on a stagflation one. Yet if inflation pulls up globally, stagflation could become a reality for all developed markets. Monetary and even fiscal policy can only do so much in the face of such a megatrend as the reordering of globalisation and the post-WWII world order and the uncertainty this brings. Such a reordering may not happen in the space of months but could take years to complete, on a road with many twists and turns.
What should investors do? Take a look up and see that chips are in the air and that is very difficult to say where they will land. Simply put, portfolio managers need to look beyond the benign picture of global equity and bond markets and recognise that systemic risks are on the rise. We live in a different world now than we did a decade ago, or maybe even three weeks ago.. So steps can be taken to manage risks within portfolios.
The global geoeconomic reordering also means that retrenchments are not necessarily buying opportunities, nor are excesses necessarily going to mean revert. It’s the same for businesses. They must question their models and whether they are resilient in this transitionary phase towards a new world order.
A new world is emerging. Whether it is a better or worse one is impossible to know. Judgment depends on one’s political views and place of residence and is certainly beyond the scope of this humble weekly. Our recommendation is to make no assumptions, open your ears, take good advice where you can find it, and be resilient.
It will be a bumpy ride and we are merely in the beginning.