This week in the markets: another week, another tariff; inflation and growth in focus this week; but investors hang onto risk assets despite the uncertainty.
Just over a month into 2025 and it’s hard to keep up with market-moving developments. Two weeks ago, it was the Deepseek drama; last week, tariffs on Mexico, China and Canada; this week it’s tariffs again, but this time a targeted levy on steel and aluminium imports.
As it happens, the latest development puts the same three countries in the cross-hairs. The three are the biggest exporters to the US of the two metals, accounting for nearly half of all US imports. But the tariffs will also bring South Korea, Brazil and Germany into the net, the next three biggest exporters.
Steel is traditionally a lightning rod for tariffs and trade wars, a key building block of globalised trade. The fear, as with all tariffs, is that the levies will add to input costs for a wide range of US manufacturers. In 2023, the US imported $82bn of steel and iron, and $27bn of aluminium, in both cases about twice as much as America exports.
So, the metals are a key element in the US’s trade deficit with the rest of the world and an obvious target for tariffs. They were also used in Trump’s first term, when a similar 25% tariff was imposed on steel and 10% on aluminium, although exemptions were subsequently granted to both Mexico and Canada.
So far, investors have largely taken the uncertainty on trade in their stride. The narrative around Trump - that he will be unpredictable but overall a positive for growth and financial markets, has just about held.
Although the imposition of tariffs has hit sentiment in the short term, investors are wary of being too bearish and markets have tended to rebound quickly from short term corrections. The safety-first approach has favoured holding a bit of everything - growth, cyclical and defensive stocks, for example - but not yet involved a wholesale retreat to the safety of cash.
The US market has run out of steam after the autumn Trump rally, but the S&P 500 is still hovering above 6,000 as investors focus on positive corporate earnings and the prospect of modestly lower interest rates. On this side of the Atlantic, the FTSE 100 has soared to new highs on the back of a strong dollar, which tends to favour British dollar earners and exporters.
The VIX index, a measure of how anxious investors are about future market volatility, stands at 16, which is below its long-term average, suggesting markets are relaxed about prospects. Shares continue to look like the asset class of choice for investors, perhaps on an over-optimistic assumption that while Donald Trump may be an unpredictable policy-maker he is above all a pragmatist who sees the financial markets as a gauge of his success.
Bond markets are also adjusting to the reality of Trump 2.0, with fixed income managers trying to determine whether tariffs will lead to higher inflation and interest rates, or weaker growth, falling inflation and rate cuts. Perhaps both will be true, one after the other. And that is leaving bond yields in something of a range.
Other investors are turning to diversifying safe haven assets like gold, which in the past week has hit a new record high of nearly $2,900 an ounce. Investors, including central banks, continue to be big buyers of gold as a port in the storm against a backdrop of concerns about the credibility of paper currencies like the dollar.
Against all this uncertainty, when the newsflow is constantly shifting and unpredictable, it makes sense to stand back and assess what we know. In terms of the direction of the market, the bull market remains intact, 28 months on from the low point of October 2022. It feels less energetic now, with only 62% of companies above their 200-day moving average. That sort of negative divergence, a lack of momentum, is typical of the mature phase of a bull market, when more and more investors have been pulled into the market and there is less prospect of new money driving the market higher.
The equal-weighted S&P 500 index, a guide to the breadth of market sentiment, is also below its recent peak and the rally from the last correction has lacked strength. Just 53% of stocks are above their 50-day moving average.
We are now well into the fourth quarter earnings season, and so far it has been a good one. With around two thirds of results in the bag, more than three quarters of them have beaten expectations. That has dragged the expected growth rate to 13%. It was just 8% at the start of earnings season and it suggests that for the year as a whole, earnings will be 11% higher than in 2023. Earnings are the long-term driver of markets, so the growth rates of the past four years - 48% in 2021, 9% in 2022, minus 3% in 2023 and now 11% for last year go a long way to explaining why markets have rebounded so well from the pandemic lows.
At the same time, interest rates, while not falling anything like as much as was hoped for recently, are now back at close to a neutral level, at which they neither stimulate nor constrain the economy. Easier monetary policy and still rising earnings, together with a robust jobs market suggest that even with valuations at a historically high level there is no obvious need for the stock market to correct. The bull market can keep going even if the rate of growth is likely to be lower in the years to come than in the recent past.
Much will depend on the influence on equities of the bond market. Although interest rates are not rising, bond yields might do so if investors demand a higher rate of return to compensate them for the risks of earning a fixed income in an inflationary world. Having left the zero-interest-rate world behind, bond yields are now competitive with the income stream from shares and that means equities have to work harder to keep the support of investors.
An interesting side effect of a higher bond yield environment is that the two main asset classes tend to become more correlated. When they both offer an income of 4 or 5%, any small rise in bond yield (implying a small fall in bond prices) tends to be matched by weakness in share prices too. That’s important for investors because it removes the diversification incentive to hold both bonds and shares. And investors need to look further afield, into commodities and real estate, for example, to create the balance in their portfolios.
Looking into this week, the tariff story will no doubt dominate. But there are some key data points to watch too. US inflation is due on Wednesday, with a slight slowing in the rate of price rises expected, although probably not enough to encourage the Fed to cut interest rates again. It said last month that it was in no hurry to ease further until the data supported such a move. The year-on-year rate of core inflation in America is predicted to be 3.1%, down from 3.2%, with the headline rate unchanged at 2.9%.
Here in the UK, the focus is more on growth than inflation. Thursday sees the latest GDP data, with the economy forecast to have contracted modestly in the final three months of 2024, following a period of no growth in the prior three months. That is close to a recession and bad news for the government’s trumpeted mission to boost growth. Fears of stagflation - sluggish growth and persistently higher prices - are back.