Investing with Eyes Wide Open – mid-year outlook

Markets witnessed extreme levels of panic after Donald Trump shocked the world with his April 2 ‘Liberation Day’ speech. Our proprietary measure of investor sentiment fell to levels comparable only to the Covid-19 onset in 2020 and the Global Financial Crisis in 2008.

Plunging stock prices and signs of instability in the US treasury market triggered a series of backsteps by the White House and a powerful rebound taking the S&P 500 back into positive territory for the year.

However, continued dollar weakness suggests lasting reputational damage and overseas investors are likely to reassess their US asset exposure over the coming months. Meanwhile, although tariffs have come down from the ‘ridiculous’ levels initially threatened, to quote Donald Trump, they are still at the highest level since the 1930s (chart 1). We will be watching growth and inflation data closely to assess lasting damage. Given expensive US market valuations and stagflationary impulses, a bear market could still be on the cards.

Where does this leave us now? Positivity could continue. Large US policy shocks may be less of a feature as the US mid-term elections approach. Equity markets could rally further if the tariff and deportation agenda is deemphasised in favour of tax cuts and deregulation. All the while, the AI revolution continues apace, boosting corporate earnings.

For us, it feels too much like the victory of hope over experience to assume policy shocks are behind us.

However, for us, it feels too much like the victory of hope over experience to assume policy shocks are behind us. The tariff landscape remains fraught and the threat of escalation is real, especially now the markets have recovered. US Treasury Secretary Scott Bessent recently suggested the higher tariff levels could still apply for those who “do not negotiate in good faith”. There’s a clause buried deep within Trump’s recently passed fiscal Bill that allows him to levy higher withholding taxes on foreign owners of US stocks if he sees “unfair tax policies” (by which we suspect he means Value Added Tax…). It’s worth remembering that Trump’s trade deal with Britain, in contrast with recent UK-EU moves, is intended to worsen trade, not improve it.

Chart 1: US Average Effective Tariff Rate Since 1790

Source: Royal London Asset Management

The Investment Clock model that guides our asset allocation is in Stagflation (chart 2), reflecting a weakening global growth backdrop with upward inflationary pressure. This is usually a bad backdrop for stocks, as corporate earnings forecasts are cut while inflation-targeting central banks struggle to make the case for lower interest rates. The data going into this model has not yet factored in where tariffs ultimately end up, however, nor their eventual impact. If we see a global recession, growth will weaken and inflation will most likely fall as commodity prices slide. This would move us into the Reflation phase where central banks tend to cut interest rates and government bonds outperform.

A muddle-through scenario could be bad for stocks in a different way. If US growth picks up again, tariffs could see a sharp rise in US inflation, while acting as a deflationary force for the rest of the world as US-bound exports collapse. This would feel like a move back into Overheat, with US rate hikes on the table and potential downside for the interest-rate sensitive technology sector. We’d expect serious friction with the Federal Reserve should this scenario play out. 

Chart 2: Investment Clock in Stagflation

Source: Royal London Asset Management. Trail shows the evolution of proprietary growth and inflation indicators over the last 12 months, with the teal dot marking the current reading.

Cross currents are finely balanced. Deep uncertainty argues for broad diversification, including inflation hedges like energy and industrial commodities, geopolitical hedges like gold and recession hedges like government bonds, alongside a core holding in stocks. Faster moving events and a more pronounced business cycle also call for active management. While the recent recovery in stocks is welcome, it is not a signal to become complacent. The AI boom could power further strong returns for investors, but the global economy is grappling with the aftershocks of a trade regime in flux and almost anything can happen.

For now, the message is one of watching and waiting – hopeful, but with eyes wide open.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.  Forward looking statements are subject to certain risks and uncertainties. Actual outcomes may be materially different from those expressed or implied.