Market Update: Markets bask in the sunshine

Sunshine and all-time highs this week. US stocks started their 4^th of July holiday in fine spirits. Encouragingly, smaller and mid-cap American companies have outperformed the ‘Magnificent Seven’ tech stocks over the last fortnight, and were buoyed again by Thursday’s strong jobs market report. It got lost in all the negative coverage of UK politics and bond troubles but, remarkably, our equity market set a new all-time high too.

For the US, stronger growth signals and the broadening rally suggest that the recent dollar weakness might reverse – in the short-term at least. But it will take more than a sunny disposition to keep the rally going.

Bond vigilantes rescue Reeves

UK bond yields rose sharply when Keir Starmer failed to express unconditional support for his Chancellor Reeves at Prime Minister’s Questions, and then came back down when he belatedly backed her. Bond investors clearly want Reeves – seen as the key promoter of Labour’s fiscal rules – to stay. They will not allow the treasury any extra borrowing leeway, even less so after the backbench rebellion. While yields are higher than last week, the difference between UK and US yields is slightly narrower (see chart next page).

With minimal public spending cuts, markets believe tax rises are inevitable. Whatever form they take, they will probably be politically unpopular. UK tax hikes are much more popular with UK  bondholders, however. Investors agree with Reeves’ messaging that the best way to support the UK economy – particularly its stalling housing market – is through lower interest rates. Tax hikes can be a growth constraint, but the devil is in the detail, and it depends on which specific taxes are raised and what the revenues are spent on.

Meanwhile, the FTSE 100 hit its all-time high at virtually the same time as the bond market tantrum. The delinking of Britain’s bonds and equities might be related to the evidence that US private equity groups are lining up to buy UK companies. Electronic control and instrument maker Spectris was the largest M&A story this week, its share price nearly doubling from two weeks ago, after KKR topped last week’s bid from competitor Advent. The appetites of the private equity firms are fuelled by the substantial discount (in terms of price-to-earnings valuations) on UK stocks.

Their value calculations are not materially affected by what – in the grand scheme of things – was a relatively minor and short-lived bump in yields. Encouragingly for the UK, US interest itself helps our stock valuations.

Nonchalance over US debt could mean a bounce for the dollar

Bond markets are honest, but they are not always fair. They punished the UK for potential fiscal indiscipline, but the US – with significantly worse public debt metrics – got away with it. President Trump’s “One Big Beautiful Bill Act” (OBBBA) of tax cuts is on course to pass through congress and will stretch the Federal deficit, but investors are focussed on the growth benefits from the embedded fiscal expansion. Perhaps markets are just happy that Trump is still playing nice.

The growth benefits were reinforced by Thursday’s strong US employment market data, which showed a continued rise in the number of workers employed and lower unemployment than expected. The ISM business sentiment surveys also showed a strengthening economic picture. These helped broaden the stock market rally to small cap companies. That broadening seems to be bringing international doubters back into US markets. You could just about write off the US stock rally when all the positivity came from the Magnificent Seven. With smaller stocks pushing ahead, this is clearly a return to US-wide positive story, at least for the moment.

We should therefore expect some reversal of 2025’s US capital outflows – which should support the dollar. After prolonged dollar weakness, many large institutional investors (particularly hedge funds) are positioned against the world’s reserve currency. Short positioning and positive economic surprises are a recipe for a currency short-squeeze that can push the dollar higher.

How long can investors forget their troubles?

However, we should not mistake short-term position covering for a longer-term trend. The long-term case for a weaker dollar is based on the ‘twin deficits’ (more money goes out of the US than in, and the government spends more than it collects) and a volatile, isolationist administration. US assets – particularly bonds – still come with significant risks. The key one is that, with extra tax cuts in the pipeline, US treasury bond issuance will be huge.

To persuade the budget hawks in his party to vote for OBBBA, Trump has emphasised the long-term tax revenues that tariffs will generate. But once OBBBA passes, the president could set tariffs at a lower rate than expected – if he thinks the short-term boost to consumers would help his party in next year’s mid-term elections. Nevertheless, a lack of tariff revenues would create more pressure on bond markets, and market pressures tend to happen quickly.

The bill also includes significant cuts to government-sponsored healthcare, putting pressure on the largest providers of the Medicaid (created under Obama’s Affordable Care Act) public health insurance plans. Centene, the largest provider, saw its share price fall 40% on Wednesday after the management released extremely poor earnings guidance. It is now certain to lose its valuable investment-grade credit rating. Firms in these government policy-related areas are not usually helped out by changing US government policy. In the past, utilities have often been at the sharp end but, this time, healthcare insurers are the focus. There is a real chance that some might go bust. Millions might lose their health coverage, so this could be a big economic and political story in the near future.

The July 9^th ‘deadline’ for Trump’s tariff moratorium is nearly upon us. Where negotiations are substantive but the details are tricky, more tariff suspensions may happen. Some of the trade negotiations (particularly Europe) are said to be going better than expected. Negotiation progress is probably good for equities but less so for bonds, now that tariff revenues are the key for US fiscal discipline.

But maybe “nasty” Trump is returning. He tells us that “10 or 12” letters would go out Friday, with additional letters coming “over the next few days…. They’ll range in value from maybe 60 or 70% tariffs to 10 and 20% tariffs”. Excepting China, the 70% higher level is well above anything indicated before, with implementation as of August 1^st. Yet again, next week promises to be interesting.