Another busy week with plenty going on in financial markets, economics and politics. Equity markets have been mixed – European indices have fared stronger than their US counterparts, but the tariff news in the past 48 hours has taken European indices down from all-time highs.
US equities have weakened thanks to softer economic data as well as notable declines in some of the Magnificent 7 stocks. Political news has been dominated by the German elections and the theme of Europe stepping up defence spending given the collective view in Europe that continued US support under President Trump is far from guaranteed.
The economic data this week has given more credence to the narrative that the US consumer is softening somewhat, with consumer confidence considerably weaker than expected, and showing the largest month on month fall since the summer of 2021, when inflation and the Covid-19 delta variant were in the ascendancy. Along with the fall in overall sentiment, there was an increase in inflation expectations, while expectations for the labour market weakened. While the sentiment surveys show a marked difference in the respective outlooks of Democrats and Republicans, it is clear that elevated uncertainty over the impact of tariffs, cuts to federal spending and to employment are impacting consumers. The Federal Reserve will be paying most attention to the inflation expectations element, given one year ahead inflation expectations now sit at 4.8%, well ahead of the pre-covid average. Any consistent signs that inflation expectations are becoming de-anchored will likely see the Fed calling time on any hopes for any further interest rate cuts. The softer flash PMI data was also notable in the US, with the US PMI services data in ‘contraction’ for the first time in over a year. Manufacturing PMI was a little healthier, but the input prices component also highlighted inflationary pressures, with the survey at the highest level since 2002. The UK and European composite data were both in ‘growth’ territory, though at the country level the data was more nuanced, with UK, German and French manufacturing remaining stuck in the doldrums, while the services sector fared much better in the UK and Germany. France appears to be suffering an economic hangover from the Paris Olympics, which caused a notable spike higher in the services data, only to be followed by an almighty slump.
The market mood has been soured this week not just by signals that heightened policy uncertainty is impacting consumer sentiment, but also by further comments from President Trump on tariffs. On Wednesday Trump proposed 25% tariff against the European Union but with limited detail, with Trump mentioning “cars and all of the things”. Trump said “we have made a decision and we’ll be announcing it very soon”. Yesterday delivered further headlines, with Trump confirming that proposed 25% tariffs on Mexico and Canada will go ahead next week, after a one month delay. Trump also said he intends to hit China with an additional 10% tariff on top of the 10% tariff imposed earlier this month. Trump said his plans for “reciprocal” tariffs impacting a broader range of trading partners would go ahead as planned on 2 April. The only tariffs actually implemented so far are on China, but if (and it remains an ‘if’) the 25% tariffs on Mexico and Canada go ahead, there will be significant impacts to growth in the two countries, and upside risks to inflation in the US, on top of the evidence we are already seeing of inflationary pressures picking up.
In terms of the German elections, and the outcome was broadly as the polls predicted with the CDU/CSU bloc led by Friedrich Merz taking ‘victory’, if taking 28.6% of the vote can be described as such. Merz has already entered into coalition talks with the SPD party that leads the outgoing government, and their combined seats in the new Bundestag will give them a parliamentary majority. The narrow majority, however, is nowhere near the two-thirds threshold to make constitutional changes to the debt brake that restricts the budget deficit to just 0.35% of GDP. Given the unwillingness of any party to work with the far-right AfD party, who secured a record 20.8% of the vote, and dominated in the east of the country, making constitutional changes will not be easy. Friedrich Merz said he wanted to move quickly and avoid protracted coalition talks, with the aim to form a government by Easter. A CDU/CSU and SPD coalition is very familiar territory, with this structure having supported three out of four of Angela Merkel’s terms as Chancellor.
Merz said that Germany had to fundamentally remake its security arrangements and end reliance on the US, describing President Trump as “largely indifferent” to Europe’s fate. He added, “it must be an absolute priority to strengthen Europe as quickly as possible so that, step by step, we actually achieve independence from the USA”. As the week progressed, a somewhat unconventional proposal emerged that could allow the debt brake to be amended under the outgoing parliament, which is still in session for several more weeks. Merz signalled his intention to discuss the idea with other parties. A simple reform to the debt brake, specifically focussed on defence spending may well have enough support to pass the threshold to allow the debt brake to be loosened. If nothing else, the fact that parties are considering such manoeuvres does point to increased political resolve to address some of Germany’s structural challenges. The German economy is smaller now than it was before the Covid pandemic, and it appears that without additional government spending, stronger economic growth will likely remain elusive. Such spending will likely need to go far beyond defence spending, but given the current geopolitical backdrop, increasing defence spending is the clear priority.
Talking of which, the UK Prime Minister announced an increase in defence spending, to 2.5% of GDP from the current 2.3% by 2027, three years earlier than previously planned. Keir Starmer said he expected defence spending to increase to 3% of GDP during the next parliament. Starmer made clear the reason for the additional spending, saying “Russia is a menace in our waters, in our air space and on our streets.” The immediate increase in spending of £5-6 billion will be met via cuts in the overseas aid budget, which means it will have no net impact on the public finances and will not impact the OBR forecasts due next month.
Both Kier Starmer and French President Emmanuel Macron have met with President Trump this week, emphasising the need for Europe to take a role in the talks over ending the conflict in Ukraine. Macron urged Trump to pledge military “backup” for European troops that could take on a peacekeeping role if a ceasefire is reached. When asked over support for European troops, Trump said “we will have a backing of some kind. Obviously, European countries are going to be involved. I don’t think you’re going to need much backing.” Trump also said he was open to an “economic deal” with Russia, saying that they had held “very good talks” over ending the war in Ukraine. Keir Starmer’s meeting with Trump yesterday made no progress on Ukraine but did elicit some loose promises on a trade deal for the UK. President Trump did however give his support for NATO’s Article 5 which obligates collective assistance if a NATO member country is attacked, but said on Ukraine “I don’t like to talk about peacekeeping until we have a deal”. President Zelensky will meet with President Trump today in a meeting that will hopefully smooth some of the personal animosity that has built over recent weeks. Zelensky is set to sign a minerals deal with the US to jointly develop their natural resources after the US dropped a demand for the right to $500bn in potential revenue from the deal. The deal has no reference to US security guarantees for Ukraine, despite earlier suggestions the text would commit the US to a “free, sovereign and secure” Ukraine. Trump’s argument yesterday was that a “backstop” was not needed because Americans working in Ukraine as part of the soon to be signed minerals agreement would serve as a deterrent against possible Russian attacks.
We are in a period of heightened economic and political uncertainty and this is starting to weigh more heavily on both financial market and consumer sentiment. This uncertainty may well be prolonged until we have more concrete data on the size and scope of US tariffs and the economic fallout as a result. Meanwhile, consumer sentiment is increasingly fragile, and inflationary pressures are persisting. Given equity markets are coming off the back of a very strong run, it comes as no surprise to see some steam being blown off. What is positive is earnings momentum is solid and we are yet to see the softer survey data trickle into hard economic data. All the same, the market mood is certainly less ebullient and without more certainty further volatility will not be a surprise.
Sourcce: Columbia Threadneedle Investments as at 28 February 2025
