Market Update: Summer starts with less spring

In other political news, the UK Defence Review provided more justification for tax rises. German Chancellor Merz’s one-on-one with Trump went about as well as it could. And, as we discuss below, the European Central Bank (ECB) cut interest rates.

US-China negotiations moved along, but the two sides’ characterisations of the telephone conversation notably differed. The miniscule progress hardly affected markets. Still, it is a positive that Bessent and Lutnick will lead the US team in next week’s dialogue.

Equities were helped by lower government bond yields, making risk assets look more attractive. The reason for falling yields is less comforting for investors: the latest economic data are soft, particularly in the US. That has been part of the reason for a weaker dollar too.

US markets outperformed others in sterling terms this week – and have been strong in dollar terms for the past two months. But dollar weakness has taken the shine off, and US stocks have performed in line with the UK and Europe when adjusting for currency effects. If the dollar stays soft, it will be tough to for US stocks to regain their previous supremacy.

Bad growth news is (maybe) good equity news.

US economic data looked strong last week, but less so this week. In particular, the focus has been on employment. The non-farm payrolls advanced by another relatively strong 139,000 jobs in May, although the April print was revised down by 30,000.

However, other employment data show a fairly uniform softness. Initial weekly jobless claims continue to rise, and the four-week moving average has now moved up into nervy territory above 230,000. Both the ADP payroll numbers and the Challenger Gray report on job cuts suggest that companies are becoming less inclined to hold onto under-utilised workers – particularly in the services sector.

Policy uncertainty is probably skewing the data (like the import rush ahead of tariffs) which would explain the muddled signals in recent weeks. But we said before that the US labour market was precariously balanced – companies not firing, but not hiring either – and the latest data suggest ‘not firing’ part will break first. Given last week’s business sentiment surveys were so strong, we will have to wait for more data, but weaker employment data will certainly make the Federal Reserve think. Bond traders upped their expectations of interest rate cuts, with two now predicted before the end of the year.

The return to sogginess has brought down yields on long-term US treasury bonds. You would think weaker growth expectations – and hence weaker profits – should hurt stocks, but markets rallied in response. That is probably because the data suggests only mild economic softening, and high bond yields have been markets’ biggest concern recently – driving up borrowing costs and making equities look riskier. Lower yields took the pressure off relative equity valuations, a bad-news-is-good-news story.

Is the ECB hawkish or bullish?

The move down in US yields did not have much of a knock-on effect on European bonds. In fact, German and French government bond yields spiked on Thursday. That is despite the ECB cutting interest rates for the eighth time in the last year. Europe’s benchmark rate is now just 2%, significantly below the US’ 4.5%.

Bond traders expected another ECB cut, so the news did not move prices (the inverse of yields). They did not expect, however, ECB president Christine Lagarde’s accompanying statement that the bank’s rate cutting cycle is nearly over. That was taken as a hawkish signal (preferring higher rates) given Eurozone inflation is stable around the 2% target. But markets also took it as a sign of economic confidence – that the ECB is no longer as worried about European growth. The euro rallied against the dollar in response.

It would be easy to interpret the euro’s gains as dollar weakness – especially considering sterling strengthened in equal measure. There is something to the weak dollar narrative (see below) but we should recognise the UK and Europe’s strength – the two best equity markets year-to-date. The yen, for example, barely moved against the dollar this week, thanks to weaker than expected Japanese data.

Dollar weakness begets dollar weakness.

Still, the dollar’s weakness is important for how investors value US assets, particularly stocks. US assets make up most of the world’s total asset value, but they have seen significant capital outflows this year. The key driving force behind those outflows is the fact that US asset risks have increased (both in measurable volatility terms and intangible ‘safe haven’ terms), while the potential returns have not.

For investors outside the US, currency volatility is one of those risks. Many commentators have talked up the fact that the S&P 500 is now in positive territory year-to-date, for example, supposedly showing the resilience and attractiveness of US markets. But for British and European investors holding the S&P, returns remain negative in 2025. So, even though volatility has come down in the US, global investors holding US assets are experiencing raised volatility.

We are all aware that the intangible perceptions of the US as a “safe-haven” are under pressure, but we have now had more than three months of higher tangible price-risk measures. This is sustained enough to impact risk-reward metrics (like Sharpe ratios) which many investment decisions are based on. We have argued for a while that this will lead non-US institutional investors to reduce their US allocations, reinforcing the flow of capital away from the world’s largest economy. Sure enough, on Wednesday the Financial Times reported that some of the world’s largest investment managers are doing so.