Heating up

FAT

For a while it looked as though the FAT (Forget About Trump) trade was gaining ground. The S&P 500 climbed above the 6,000 level for the first time since February while other global stock markets have hit record highs. On the bond side, despite concerns about the US Administration’s “One Big Beautiful Bill” and the deficit ballooning implications, 30-year yields retreated almost 30 basis points (bp) from the high of 5.09% reached on 21 May. Credit spreads have continued to narrow with the US investment grade market falling closer to its first quarter (Q1) levels than those reached in the post-Liberation Day blow-out. Despite the US announcing further tariff increases on steel and aluminium, markets were taking the view that deals would be done with America’s major trading partners, and as such the trade war-induced global macro shock would be manageable. Slower growth yes, but no slump. The view has been that the US President won’t risk an economic and market meltdown again.

Turn the heat up 

However, the spring season’s hopes seem to be giving way to signs of what could be a long, hot, sticky summer. We are approaching the 9 July deadline when Trump will make his next move. Bloomberg reported he will be sending letters to trading partners setting out levels of bilateral tariffs to be imposed if no deals are reached. Markets will be focused on that, with the risk that recent setbacks to his political standing (the fall-out with Elon Musk and the backlash against the deportation operations in Los Angeles, for example), could provoke Trump into a more aggressive stance on trade. Hard to predict, for sure, but it’s also difficult to price in much upside.

Markets are not trading like we are set for a weaker growth outlook. There is only one 25bp Federal Reserve (Fed) interest rate cut priced in for the remainder of 2025. The stock market is once again trading at a very high multiple. As mentioned, credit spreads are tight. After a surge in earnings downgrades earlier this year, analyst forecasts have become more balanced again. They are still looking for earnings per share growth of 10% for the S&P 500 over the next year, with average earnings per share at $259 for this calendar year and $294 for 2026. Given where the index trades now, this implies a 2025 price-to-earnings ratio of 23.3 times and 20.6 times for next year. US equity market valuation metrics continue to flash red. Thank goodness for technology stocks.

Another Middle East shock 

Faced with the risk of a re-escalation in trade tensions, markets now must deal with more geopolitical concerns following Israel’s attack on Iranian military installations. Unsurprisingly, oil prices have risen, and equity index futures have fallen. Often, these geopolitical shocks have a passing impact on market prices, but the risk of a meaningful oil price increase on a conflict between Iran and Israel adds to the macroeconomic uncertainty.

When, and if, prices rise

US inflation has been coming down but tariffs and oil prices suggest this trend may partly reverse. The latest data showed consumer price inflation at 2.4% in May with prices only rising 0.1% on the month. Core inflation was 2.8%. The Fed has not met its target for inflation. Interestingly there has been little in the data’s details suggesting that tariffs are causing prices to increase at the retail level, but one explanation for this is that retailers are working through the inventories they built up before the levies were imposed. Soon enough, prices will have to rise as companies replenish stock (at higher prices for goods that are imported). The one-year zero coupon US inflation swap rate – a type of derivative - currently stands at 3.0%. It reached 3.8% on 9 April but a year ago, it was just 2.2%. Higher oil prices, a continued weak dollar, and more tariffs provide a combined risk of higher US inflation, making the Fed’s job even more difficult.

My view is that markets are likely to see more volatility in the weeks ahead. Macro risks, which have been dormant since late April, are re-emerging. This largely reflects the fact that a lot of the economic data has hinted at resiliency. Employment growth, despite having slowed, remains positive. Inflation has behaved. But look at the Institute for Supply Management (ISM) data. The manufacturing headline index has been below 50 (the supposed growth-no growth divide) since October 2022 (except for the prints of 50.9 and 50.3 in January and February of this year). In the details, prices paid by manufacturers have increased and new orders are weak. The services index from the ISM has also been declining and fell to 49.9 last month.

Risk is expensive 

The equity market is most at risk of a correction as macro and political risks materialise. Credit spreads could also rise again, even though credit market fundamentals are still solid. Where does this leave bonds? The market rallied in June, but I think it could go further, especially if the data starts to put pressure on the Fed to cut rates in the second half of the year. Tactically, I think the summer might be a period of bond market outperformance. At the very least, there are good reasons why volatility might spike higher again – tariffs, the budget, inflation, civil unrest and geopolitical shocks. 

Are bonds ok?

Is fixed income the place to be? There are lots of bond bears. The narrative is the deteriorating fiscal outlook in many countries. Most advanced economies, with the notable exception of Germany, have seen a meaningful increase in government-debt-to-GDP ratios over the past decade. According to the International Monetary Fund, debt ratios have surpassed 100% of GDP in the US, UK, France and Canada. Japan’s is expected to reach 235% this year. Yet, bond yields are no higher, and in some cases, are substantially lower than they were in 2015. For bond bears this observation won’t sit comfortably. Rising debt levels are supposed to push bond yields higher, establishing a vicious circle of higher debt levels, rising interest costs and intractable deficits. The intensity of the narrative comes and goes, but there has not been a debt catastrophe. Not yet anyway. The nearest we came to it was in 2012 with the Eurozone crisis when there were fears that countries who did not demonstrate enough commitment to staying in the bloc would not be able to continue to fund themselves. Greece was dealt with, and since then yields on what have been known as the peripheral members of the Eurozone have shifted lower relative to those on the debt of the core members of the single currency area.

Higher structural risk premiums 

Don’t get me wrong. Fiscal trends are a concern. Despite the average coupon on outstanding debt being a lot lower today than a decade ago, interest costs have been rising since monetary policy was tightened in 2022. National debt management offices have been trying to reduce the duration of debt by shifting issuance to the shorter end of the curve – hence Trump’s ongoing insistence that the Fed lowers rates to help reduce federal interest payments. Higher interest costs when debt-to-GDP levels are above 100% add to concerns about debt sustainability and provide a constraint on politicians increasing spending on other areas – health, education, and productive capital projects. Extreme bearishness draws on the idea that, eventually, governments may resort to debasing the real value of debt by monetising deficits and creating much higher inflation.

But cyclically, bonds should perform in a risk-off environment 

We are not there yet. But there is the risk of markets reacting badly, and quickly, to a deteriorating fiscal situation – as they did in the UK in September 2022 and in France in March 2024. These structural risks need to be balanced against cyclical ones. The long-term outlook might be for permanently higher bond yields but that does not rule out the opportunity for bond markets to rally as economic risks rise and central banks ease. In a hot, sticky, volatile summer, I believe there is certainly more chance of losing money in the stock market than in bonds.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 12 June 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.