Economic and market commentary
Financial markets year-to-date have been dominated by assessments of the likely consequences of the economic policy agenda of the Trump Administration.
Through the March quarter, financial markets seemed to take a more pessimistic view of the likely return implications of that agenda. That pessimism became particularly pronounced in the lead up to President Trump’s “Liberation Day” announcement on April 2nd.
Of particular concern was an emergent fear that the weaponisation of international trade through swingeing tariffs and subsequent retaliation by trading partners would lead to a global trade war and an attendant global recession.
The result was a sell-off in US equity markets. Bond yields declined modestly throughout the March quarter but reversed a large part of that decline in April and May.
With the US Administration walking back the severity of the “Liberation Day” announcements those recession fears have abated a little. Equity markets have bounced even if bond yields remain “sticky”. It is those “sticky” bond yields combined with growing concern about the US budget deficit and “sticky” inflation that might yet derail the equity market recovery from the post-“Liberation Day” lows.
The latent fear remains that even if the watered-down tariff measures are an improvement, it is only relative to a bad starting point. The watering down may mitigate the damage, but may not eradicate it.
Markets are fearful of a “stagflation-lite” scenario where economic activity declines but inflation proves stubborn. Such an environment was thought to limit the ability of the Fed to lower the policy rate which, together with a gargantuan budget deficit, would see at best bond yields remain around current levels.
In recent commentary the Fed appeared to confirm a reticence to contemplate policy rate reductions given already “sticky” inflation and the potential impact of the Administration’s tariff agenda on inflation and expectations thereof.
Those developments took place against growing scepticism regarding the durability of “US exceptionalism” which in the post-pandemic period up until the end of 2024 had seen US equity markets (led by the technology sector) substantially outperform other advanced economies. That has reversed this year even as equity markets rebounded from mid-April. This was manifest in a significant depreciation of the USD versus the EUR so far this year.
Gold has exhibited strong price appreciation. This reflected a weaker USD but also growing scepticism of the “safe-haven” attributes of US Treasury bonds. The US Administration’s questioning of its traditional defence alliances along with a seeming lessening of diplomatic pressure on Russia, all of which elevated geo-political uncertainties, also enhanced the safe-haven assessments of gold. Potential growth in demand for gold at the expense of the USD as part of central bank (particularly Chinese) foreign exchange reserves also may have been a factor.
Locally, inflation data showed that inflation was declining at a rate potentially a little faster than anticipated by the Reserve Bank of Australia (RBA). That saw the RBA announce a decline in the policy rate in February from 4.35 per cent to 4.10 per cent and again in May to 3.85 per cent. Markets are anticipating further cuts from the RBA in 2025. The RBA itself has said that it can act “decisively” to lower the policy rate should the international trading environment deteriorate sharply.
Going forward, the key issues for 2025 revolve around how the Trump agenda might evolve. Certainly, should fears of “stagflation-lite” persist that will maintain the current headwinds to US (and global) equity performance in an environment where expectations of “US exceptionalism” are extinguished.
Of course, President Trump is a mercurial personality, and it is difficult to assess how much of the articulated agenda will be enacted.
That all suggests that there will be frequent episodic bouts of volatility where the potential for seismic shifts in sentiment and the prices of financial assets exist.
May 2025
