- Trump, having apparently misdiagnosed the US economic problems, has implemented damaging anti-growth policies.
- The Federal Reserve (Fed) is in reactive mode and unable to smooth the effects of Trumpism. With fiscal responsibility thrown out of the window, bond vigilantes play judge, jury and executioner.
- The consequence is fiscal headroom is being widened for the rest of the world (ex. China). Many countries will use it to de-risk away from the US.
- Without a credible alternative, the erosion of the US dollar as the global reserve currency implies a partial return to commodities as official reserve assets and accelerated adoption of crypto-currencies by the private sector. The transition towards fiscal dominance in developed markets will accelerate.
- China shows no sign of any political willingness to change its predatory export-driven model. Further stimulus is needed.
- The European recovery is delayed not derailed; labour markets will be the real test.
- Such genuine concerns offer an opportunity for active managers willing to look beyond the wall of worry to find attractive opportunities.
- Caution is warranted in sovereign bonds given widening deficits. The long-end of the curve is unattractive as term premium is increasing. Real rates are preferred and careful credit selection to focus on instruments with appealing yields above inflation.
- A barbell strategy in FX takes advantage of ‘winners’ on various sides of the Trump trade.
- In equities, tech is still appealing but valuation matters. Europe and emerging markets are still underowned, underappreciated and undervalued. They provide fertile hunting ground for stock pickers.
Economic perspectives - Raphaël Gallardo, Chief Economist
A trade war like no other
Prior to the shock of the second trade war, the global economy was on a modest recovery path. Now, assuming a durable US tariff spike of 15%, we estimate global growth will be trimmed by 0.5% (US -1.0%, China -0.5%, Euro area -0.4%) down to 2.4% in the coming 12 months.
In the US, the drop in consumer and business confidence already portends a sharp slowdown in private domestic demand. The labour market should reflect this ebbing of “animal spirits” as soon as Q3 2025. The incipient deflation in new home prices will also reduce the tailwind of housing market wealth effects. And for low-income households, the rise in default rates on consumer debt suggests all savings buffers have been exhausted.
Unlike previous slowdown, this soft patch cannot be smoothed by a proactive Fed and an easing of borrowing conditions on the long end of the curve. Indeed, the persistence of above-target inflation will force the Fed to be abnormally reactive. And Trump’s threats on its independence mean Chair Powell will be inclined to delay further the next rate cut.
The long end of the curve will also prove rigid due to rising term premium. Bond vigilantes are bearing their teeth after the Republican majority showed a total disdain for any remaining fiscal guardrails, while at the same time hurting America’ s potential growth through immigration curbs, assault on innovation capabilities and the rule of law in general.
Wrong diagnosis = wrong solution
Trump’s ascent to power exploited some legitimate concerns among US voters, not the least the explosion of wealth inequalities. And as any populist leader, Trump came up with a simple solution and an external scapegoat: unfair international trade.
The obsession with trade deficit is all the more bizarre given the US, as a developed economy, has a ‘normal’ specialization in services, where they enjoy a 1% of GDP surplus. Its current account deficit is far from alarming and there is no manipulation of the external value of the dollar by the large US trade partners. If the US does have an external deficit, it has more to do with an excessively low national savings rate, driven by an abyssal full-employment fiscal deficit and a 4% household savings rate, itself the product of powerful wealth effects in equities. And if the stock market is so high, it is because foreign investors have been piling into US tech companies’ stocks.
It is no surprise that, armed with the wrong diagnosis, Trump comes up with solutions that actually aggravate the problems. First, tariffs and immigration curbs are stagflationary shocks that weaken the fiscal path and make the valuation of US equities even more demanding. Second, the new tax cuts are supposedly temporary or funded by backloaded spending cuts expected to start after the end of Trump’s term. They convinced foreign bondholders that any sense of fiscal prudence is out the window. Third, the attempts to coerce trading partners into a revaluation of their currencies versus the USD in tense trade talks are an invitation for foreign investors to either dump their US assets or hedge their forex risk. Lastly, the infamous ‘Section 899’ addition to the fiscal bill sounds like a declaration of ‘capital war’ to the rest of the world, meaning sovereigns will not be able to defend themselves from abusive market power exerted by US corporate behemoths.
For private foreign investors and corporates, Section 899 is a Damocles sword hanging over future dividends and profits realized in the US. All these policies have in common the increased risk of a disorderly and self-reinforcing unwind of the ‘US exceptionalism’ trades, whether we assert that these trades had reached ‘bubble’ levels or not.
Beyond the dollar
The end of 15 years of ‘US exceptionalism’ trades implies a structural bear market for the US dollar. But does that also mean that the greenback is at risk of losing its status as the world’s reserve currency?
America’s standing is eroding on many counts, but no other fiat currency is about to outshine it.
The Chinese renminbi is not convertible. The euro area is an unfinished currency union lacking the backing of a unified Treasury. Japan is in advanced demographic decay.
Absent credible alternatives, central banks are reverting to gold. We believe this will be enlarged by sovereign wealth funds moving towards other strategic commodities, that are not directly ‘monetizable’ like gold, but are also storable and offer geopolitical insurance in a more unstable world: oil, copper, lithium etc.
Likewise, for the private sector, which, for the first time in its history, also has at its disposal a non-confiscable asset, fully integrated into the payment systems of most convertible currencies, and devoid of any sovereign risk: fixed-supply cryptocurrencies.
The international monetary order is thus bifurcating towards a ‘barbell’ of backward-looking ‘commoditization’ of reserve assets held by the official sector, and a drift towards cryptocurrencies for both the functions of exchange medium and store of value in the private sector.
These emerging trends reflect the shift from a rules-based unipolar system to a more anarchic multipolar regime. They will by themselves breed instability. Sovereigns competing for a finished stock of commodity assets will fuel international tensions. The commoditisation of official reserves and the increasing adoption of cryptocurrencies by the private sector will reduce the demand for government bonds, thus making sovereign debt trajectories even more dangerous. . These mutations will thus contribute to the quasi inexorable shift towards a regime of fiscal dominance, where central banks are forced to monetize unsustainable public debts, at the cost of inflation and financial repression.
Stimulus on the cards for China
China had a decent first half thanks to the fresh stimulus injected since September 2024. But there are signs that the durable goods trade-in program is running out of steam.
More stimulus will be needed by the Autumn. We still expect to see only an incremental dose of cyclical support from fiscal and monetary authorities.
For now, there is no sign that the leadership is contemplating a fundamental change to the current techno-mercantilist predatory growth regime. The targeted liquidity measures have stabilised home prices in tier-one cities, which reduces the drag from negative wealth effects on consumption, and the urgency to reverse domestic deflationary pressures. And Xi Jinping used his leverage over critical segments of high-tech supply chains to force Trump into a trade truce with tariffs capped at around 40%. We assess the cost of these new tariffs will be around 0.5% of GDP, thus manageable with another targeted consumer subsidy program.
Europe marches on… for now
In the euro area, the recovery is delayed, not derailed by the trade war.
The new US (dis)order, means a redistribution of growth to the rest of the world. Europe will gain fiscal space. It is heavily incentivized to spend on de-risking supply chains and export routes away from the US, from re-creating an independent military complex to building new commodity infrastructures and digital infrastructures.
Labour market developments will be the key swing factor in how the region prospers. Corporate profits, have been squeezed by high real rates and labour hoarding. This could test the employment resilience and thus endanger the domestic demand recovery story. This is particularly true for France, which has shown a steady deterioration in employment since the second half of last year, a trend that could accelerate with the unprecedented required fiscal adjustment.
Despite the risk of an inflation undershoot on the back of a four-dimension shock (euro strength, energy deflation, tariffs and trade diversion), the European Central Bank (ECB) revealed at the June meeting an aversion to test the range of neutral rates. We still expect another cut in September, but the bar for monetary easing has been raised.
Investment strategy - Kevin Thozet, member of the Investment Committee
Facing the ‘wall of worry’
The first half of the year saw the world’s dominant reserve currency issuer behaving like an emerging market, with a simultaneous fall in bond indices, dollar indices and equity indices. After years of complacency, this served as a stark reminder that active investing – and the ability to be flexible – has a clear utility function.
Trump’s tactics, the ambivalence of his reaction function between TACO (Trump Always Chickens Out) which provides a floor to the S&P 500 and TOFU (Trump Occasionally F**ks-Up) which on the contrary tends to cap the appreciation of US equities, high long-dated bond yields and a reversal in long-term trends on the US dollar are all reasons to be scared. But such risks are increasingly visible as reflected by investors’ somewhat cautious positioning. Hence there is a path for risk assets to go higher, a thin one, but there is a path by which the ‘wall of worry’ can be climbed for active managers willing to look beyond the short term to find attractive long-term opportunities.
Fixed income
Caution is warranted on sovereign debt markets: the dog(e) barks more than it bites! The US budget is built like a French one. Germany is spending like it hasn’t in decades and investors are demanding more for lending over the long term.
The combination of this fiscal profligacy and a lack of investor appetite for long-term debt means short-term euro debt is preferred as disinflationary pressure allows the ECB to be proactive. Whereas in the US, five-year maturity bonds stand out, given the Fed’s reactive status: fewer interest rates cuts over the short term calls for more interest cuts over the medium term.
Additionally, as the longer-term inflation risk is still underestimated by markets, real rates are preferred to nominal ones.
Yields in some credit markets offer an island of certainty in a sea of uncertainty. In a scenario where the risk of recession over the short term appears relatively contained on both sides of the Atlantic, the energy and the banking sector look attractive with some carefully selected instruments offering mid to high single-digit yields. And the level of yield is the best indicator of future potential returns and provides a cushion against upward interest rates and spread movements.
But the valuation of risk assets is moving higher, as illustrated by the risk premium for some high-yield segments hovering around levels similar to those seen before the invasion of Ukraine. Or by the level of Italian yields which are at their lowest level compared to Germany since the emergence of the euro debt crisis of 2010. The tightness of spreads in those two markets allows for the integration of protection at a reasonable price.
FX
The dollar smile1 by which the USD performs best both when the US economy grows fast or when recessionary fears are mounting is turning into a dollar smirk. Meaning the ‘safe haven’ status of the US is being eroded and the strike price of the dollar curve is lower than where it used to be.
Not of good omen would say the pessimist. But the optimist says this should be beneficial for other currencies.
Our negative view on the USD is expressed via a barbell strategy.
On the one hand, the Euro and Japanese yen (more defensive assets) which should benefit from further repatriation of assets away from the US or the increasing hedging of currency risk.
Indeed, Europe has huge level of savings and is massively overweight US assets (with 50% or so of invested portfolios in USD denominated assets) and mostly unhedged. An unwinding, or merely a reallocation to European assets could well send the EUR-USD to the 1.18-1.20 range.
And on the other, the Brazilian real and Chilean peso (more cyclical currencies) where the well oriented global trade balances should be boosted by the appetite for the real assets these countries produce.
Copper stands out and Chile’s trade balance too; it is as strong as it was in the 2000’s when China was encouraging home ownership and its real estate sector grew to be the largest in the world. Besides, the upcoming political cycle could see a shift towards more conservatives candidates and hence more orthodoxy or market-friendly policies.
Equities
Massive capex in the technology sector is not sufficient to match strong and fast-growing demand for AI solutions. This is expected to benefit those companies most exposed to the sector. But the starting-point valuation matters for investment returns. Hence we prefer hardware and hyperscalers where valuations are much lower than software. As well as Chinese actors as they have demonstrated their capacity to turn from a copycat to the leader of the pack.
Despite a lot of attention in recent months, Europe and emerging market equities remain undervalued, underowned and underestimated.
The combination of long-lasting fiscal stimulus, monetary easing and attractive valuations as a starting point bodes well for European equity markets. Yet the rise of local currencies can act as tailwind for some. As such, we combine transactional companies with local-to-local business models, exporting companies with high pricing power and companies exposed to the domestic economy in Europe.
In emerging markets, we favour domestic actors operating in underpenetrated sectors. Latin America e-commerce and banking stand out.
All of the above allows us to keep the valuation of our equity portfolios in check, as well as diversifying growth engines and future drivers of performance.