Market Update: Complacency or checks and balances?

Last week’s pullback proved to be just a blip in the impressive stock market recovery. On tariffs, markets were buoyed in the early part of the week by the notion of the so-called “TACO trade” (Trump Always Chickens Out) and then, on Thursday, the US Court of International Trade’s ruling that the tariffs already imposed were illegal – though an appeals court quickly suspended the decision, allowing tariffs in the meantime. The trade court’s ruling made markets happy but Trump angry, as did the TACO epithet.

If he behaves according to type, we may be about to get Nasty Trump. Trade talks with Europe are at risk, but China is a more obvious target, given that bilateral trade talks appear to have stalled (at best). US Treasury Secretary Scott Bessent tried to sound conciliatory by suggesting an early Trump-Xi summit, but his president is having none of it, posting that “China, perhaps not surprisingly to some, HAS TOTALLY VIOLATED ITS AGREEMENT WITH US. So much for being Mr. NICE GUY!”

At the risk of repeating ourselves, we still see elevated policy risks in the US, and hence its markets as potentially too positive. We cannot deny, though, that the US economy is yet again proving more resilient than many expected.

Growth comes back into focus – for the Fed too

Stock market positivity was focussed on the US last week – as most other regions traded sideways. It was encouraging that small and mid-cap stocks also rallied. This was not just about investors feasting on the TACO trade; Nvidia’s good earnings report shifted some focus back to AI. Meanwhile, this week’s US economic data releases were comforting. Consumers are still feeling confident and near-term growth in the world’s largest economy looks much stronger than feared. The recessionary warnings of a few weeks ago now seem distant.

Government bond yields ended last week touching the year-to-date highs last seen in January, but eased down after bond demand improved. One might have expected sharper yield falls but, unlike last week’s concerns about rising budget deficits, this week was more about improving growth expectations. Credit spreads (the difference between government and corporate bond yields) came down, easing pressure on companies. Accordingly, US and global Financial Condition  Indicators (FCIs) have eased since the spike in early April.

FCIs are reflexive: better risk appetite causes them to improve, and an improvement in FCIs often encourages investors to take more risk. It feels, at the moment, that markets just want to grind higher whenever they can.

Regardless of how realistic the assumptions underlying this positivity are (see below) the sunnier outlook is also a reflexive problem for US interest rates. Given recent data and easier conditions, the Federal Reserve will likely see growth and inflation as too strong to cut rates substantially this year. Washington’s immigration crackdown makes a rate cut even less likely; companies do not want to fire employees, in case they cannot hire them back when conditions improve.

Markets cool their fiscal fears

Bond markets have signalled fears over unsustainable government debt in recent weeks – particularly in the US. So, it feels like a bit of cognitive dissonance that investors reacted so well to the US Court of International Trade’s tariff ruling. As discussed previously, tariff revenues are practically essential to fund the tax cuts in Trump’s One Big Beautiful Bill.

The White House probably has ways around the trade court’s ruling – which has already been suspended on appeal. Even if it stands, the court has just thrown the issue back to the legislature, and it is very likely that the Republican-controlled Congress will delegate back tariff powers to their president. There are many old-school Republicans who like free trade and are ideologically opposed to tariffs – but they tend to be fiscal conservatives who oppose a ballooning deficit even more.

Unlike the US, the UK government is clearly signalling that it favours fiscal discipline, and people are starting to believe it. We can see this in the fact that everyone assumes the latest spending gap will be plugged with higher taxes, rather than more borrowing. While that might damage medium-term UK growth, it is a decent sign for lower interest rates and long-term stability. That is probably why sterling has been so strong recently.

Unfortunately for Chancellor Reeves, the tight correlation between UK and US bond yields is not going away. That means that UK borrowing costs – and hence the budget outlook – will continue to be directly impacted by Washington’s fiscal indiscipline.

Policy risks are still high 

By his standards, Trump has been nice in recent weeks, much to US investors’ delight. If we know anything about the former (arguably current) reality TV star, it is that he will not take kindly to being called a chicken in front of the cameras. And, with the court now trying to remove his tariff-setting powers, the president will want a show of force.

It went under the radar, but last week the US Supreme Court signalled it would side with the White House in its attempts to remove the heads of ‘independent’ (now in name only) federal agencies. That sort of news would normally panic markets about what it means for central bank independence but, curiously, the court suggested a special independence protection for the Fed. We should not interpret this as a sign that a legal fight over the Fed is not coming, however. Far from it – there are many in Trump’s administration who want to test the limits of executive power whenever they can.

In terms of global political risks, China’s continued economic weakness (household activity data released in mid-May looked dire) is being taken as evidence that Beijing might play nice in trade negotiations with the US, but the reverse is also possible. The Communist Party could seek to make up for the failure of its economic stimulus with nationalist expansion. There have been rumours for some time that Beijing is planning a full blockade of Taiwan in the autumn, and the weak economy might make that even more likely.

Markets are more focussed on the growth positives than these lingering risks. Hopefully, this is a sign of positive long-term sentiment, rather than complacency.