Living on a prayer?

We're half way there. The first six months of 2025 have seen protection, war, political dysfunction, fiscal profligacy, elevated valuations, another hawkish rethink on interest rates – and inflation-beating returns from many local stock and bond indices.

The bellwether S&P500 index is at new highs, and the world's "riskless" discount rate, the yield on the 10-year Treasury note, is pretty much where it was in early November. Global index returns are flattered by a weak dollar, but most big local stock indices in Europe are firmly higher, and well ahead of consumer prices. Bond returns have been smaller, but in the US and UK markets have also beaten inflation.

These are probably better outturns than our top-down vantage point might have suggested in late 2024. Are capital markets living on a prayer, or have they simply spotted constructive outcomes early?

We know such outcomes are possible:

• Mr Trump's keenness to "do deals" may be greater than his attachment to prohibitive tariffs. The postponement (to July 9…) of the Liberation Day levies may yet be rolled forward, or even made permanent. As we have noted often, he has a point on trade, even if he does make it rather recklessly. We have noted possible parallels with Ronald Reagan, whose idiosyncracies, whether by accident or design, delivered positive results in international negotiations.
• Unless a conflict significantly affects the global economy, interest rates and/or risk appetite, capital markets can be unmoved. Sometimes too the public debate understandably focuses on the most unsettling perspective, overlooking others.
• Political dysfunction is not restricted to the polarised US: here in Europe, governance has been an issue of late in Germany, The Netherlands, France and even the UK (despite the administration's huge parliamentary majority). But as with humanitarian trauma, there is often little read-across to capital markets.
• Fiscal profligacy might be more directly troubling to investors because of its potential impact on borrowing costs and discount rates – especially when (as in the US recently) it affects credit ratings. But as an earlier post reminded us, an empirical link between borrowing and bond yields is hard to identify. Instead, the most visible driver of bond yields is usually the business cycle. This could change of course, but there are no obvious lines in the sand (whether in history, or across countries).
• The US stock market has only been significantly more expensive once before, in 2000 – not a happy precedent. Now as then, technology is firmly in the driving seat – despite a short-lived rotation earlier in the year – and expectations of what it can do for wider profitability look a little naïve. Earnings expectations have been drifting lower. However, the businesses leading the market higher now are qualitatively more profitable, cash-generative and creditworthy than those which led in 2000, and the ascent in valuations has been more gradual.
• Interest rate expectations have often been reset without triggering major market moves – witness the post-2021 normalisation episode as a whole. The latest rethink has been modest in scale – rates are still mostly falling after all – and has been partly driven by a global economy which has (again) proved more resilient than feared, taking some of the sting out for equity markets at least.

Constructive outcomes are surely possible, then – but perhaps not yet jointly probable. We can imagine tactical disappointment resurfacing under any or all of these headings, and it feels too soon to bet against some renewed volatility. As we write, the UK government's latest political pratfall does seem to be unsettling the gilt market (even though the news of extra spending, when it broke yesterday, didn't).

We hope we're not being too cute – after all, we often warn against trying to fine-tune market calls. Markets' resilience to date has not been that surprising: we've been in "wait and see" mode, not more bearish, and are always aware of the global economy's muddle-through capability. We just think that that stance remains appropriate for the time being.

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