Barometer: Buying into Europe's Renaissance

Asset allocation: rotation keeps market supported

The year initially began positively for most equity markets, with well-flagged US policy announcements prompting investors to crowd into a handful of trades built around Donald Trump’s vision of American exceptionalism. Then the reaction set in. In recent weeks, the US dollar has dropped, and US equities have underperformed Europe and emerging markets. 

This reflects new developments coming to the fore. The growth gap between the US and the rest of the world is set to narrow, manufacturing is recovering, services are rolling over and corporate earnings growth is spreading beyond US big tech. It makes for a healthy market rotation, a broadening of investor demand that should keep the markets supported.

The upshot is that we turn more positive on European equities and less so on US stocks, while also favouring US Treasuries and cutting our exposure to European government bonds (for more of which see the Equities and Fixed Income sections below).

But overall, signs of vulnerability in the US economy are not enough to prompt us to turn bearish on equities and bullish on bonds, as previously weak areas of the global economy such as Europe and the manufacturing sector are showing signs of recovery. 

Our business cycle indicators show that while the US economy continues to grow at roughly one percentage point above potential, it will slow back to the trend rate of 2% in the coming year. Over the coming months, the economy will start to feel the dampening effects of President Trump’s policies. So far, cuts to public spending have been modest, despite the noise, though there are indications that serious efforts are being made to trim the deficit. This could weigh on economic activity in the short run. 

And whereas slowing growth might otherwise have led the Fed inclined to trim rates, inflation is also a concern. Price pressure is coming from both strong consumer demand and rising labour costs, which companies are able to pass on. Trump’s import tariffs are only likely to add to this upward pressure. Consumers are already feeling the pinch and appear set to rein in spending (Fig. 2), which reinforces our concerns about a gradual weakening in US GDP growth. 

Economic prospects elsewhere look a little more encouraging. 

Interest rate cuts have started to feed through to the euro zone economy and in particular its manufacturing sector. China, meanwhile, is showing signs of strength – it grew 8% in the fourth quarter of 2024, with positive momentum spilling over into 2025. Credit has been growing and there are signs the property sector is stabilising. We anticipate China will put in place a further stimulus package designed to boost consumption and recapitalise the banks, though this is likely to wait until the full extent of Trump’s tariffs becomes clear.

Our liquidity indicators are moderately positive for risk assets. Of the world's 30 major central banks, 23 are easing policy, four are on hold and just three – most notably Japan – are tightening. 

With private sector credit growing, the Fed can afford to prolong its pause on rates. By contrast the European Central Bank needs to boost private borrowing for the single currency region’s expansion to gather pace. We expect it to cut its policy rate to as low as 1.75%.

Meanwhile, the Swiss central bank will be under pressure to reduce its own rates to zero if it is to keep the franc reined in. For its part, the Bank of Japan should continue to tighten further, but not faster lest it leads to excessive yen appreciation.

Our valuation indicators show that equities remain expensive, while bonds are broadly fairly valued. We think the market is still too optimistic on global corporate earnings, particularly in the US, though earnings dynamics are improving for Europe and remain strong in Japan. US equities returns relative to bonds are three standard deviations above trend and back to 1999 levels. However, some of the premium has come out of US stocks following the market’s underperformance since the start of the year.

In bond markets, there are pockets of value in emerging market local currency debt, which is supported by both a significant interest rate buffer over Treasuries and cheap currencies.

Our technical indicators remain positive for equities, supported by strong trend momentum in Europe and select emerging markets. Gauges for bonds and the dollar are neutral, with no seasonal factors at play over the coming month. Technical signals for US equities have become more positive as retail investors cool on stocks.

However, a negative signal for the market comes in the form of subdued implied equity volatility, which is at odds with rising economic uncertainty. Gold is tactically overbought while Japanese bonds are oversold.

Equities regions and sectors: in search of earnings

It’s all change in global equity markets in 2025. Last year’s laggards are coming out of the shadows, while recent stars are falling prey to profit taking. And the fundamentals we monitor bode well for one traditional laggard in particular: European stocks.

Economic indicators show some signs of improvement in the region, with recovery in consumer sentiment and manufacturing PMIs – albeit from a low base. This has prompted us to upgrade our macroeconomic outlook for the bloc to neutral from negative. Politically, the resolution of the French budget and the outcome of the German election - a victory for the centre right - contribute to increased stability.

Prospects for European corporate profits are also looking a bit brighter: for the first time in two years, 12-month forward earnings expectations in the euro zone are rising faster than those for the US (see Fig. 3). The improvement is broad-based across sectors likely in anticipation of a cyclical recovery of the economy, potential relief from a Ukraine ceasefire and the possibility of increased government spending. Monetary policy is also more favourable in the euro zone – our liquidity model points to four more interest rate cuts from the ECB this year versus just one from the Fed.

US stocks, by contrast, face a steep uphill struggle. Our main concern is that company earnings are no longer providing a counterbalance to what are lofty valuations.  The US market is trading on average price to earnings ratio of 22 times relative to long-run average of our fair-value estimate of 19 times. When comparing the valuations of US and European stocks, the latter still trade at an attractive 30% discount, even after adjusting for sector composition differences.

For all these reasons, we upgrade European equities to overweight while downgrading US stocks to neutral.

Elsewhere, we remain overweight emerging market equities excluding China and in Swiss stocks, with both regions offering attractive valuations. The emerging world continues to show economic resilience, while Switzerland’s prospects are supported by improving earnings momentum.

Among sectors, we remain overweight financials, which are poised to benefit from accelerating loan growth and potential deregulation under the current US administration. The sector shows healthy earnings dynamics and neutral valuations, making it a relatively attractive "Trump trade".

Our other overweights are in communication services and utilities. The former is supported by healthy corporate earnings and technical signals, despite challenging valuations (it is the most expensive sector in our model, alongside tech). Our trend indicators are all very positive for communication services. Utilities, meanwhile, offer defensive characteristics as well as positive long-term trends such an increase in demand for electricity. 

Fixed income and currencies: US government bonds to build on their rally

As difficult as it is for bond markets to find their bearings amid a deluge of new policies from the Trump administration, there is one development that demands investors’ undivided attention: yields on US government bonds are falling and set to fall further.

Whatever the vantage point, the case for being overweight Treasuries is strengthening. To begin with, signs are that US economic growth is slowing. Recent data show that sentiment among US consumers  - the main reason for the countries’ economic resilience – has declined for the third month in a row. Moreover, capital expenditure in the US contracted in the final three months of last year and looks unlikely to recover any time soon. This moderation in economic activity is in keeping with our own forecasts – we expect US GDP growth to decline towards its long-term potential rate of 2% from the current 3% by the end of the year.

Yet a slowing economy is not the only argument in favour of Treasuries. Fed policies should also help.

Although the central bank is unlikely to cut interest rates sharply this year, it is putting the brakes on quantitative tightening, the process through which it reduces its holdings of government bonds.

Then there are efforts by the US government to rein in borrowing. Under his economic plan, the US Treasury Secretary Scott Bessent has vowed to reduce the country’s budget deficit and bear down on Treasury yields. More importantly, perhaps, he also confirmed that sales of long maturity government bonds would remain in line with previous guidance.

Taking all this into account, we have shifted our stance on US government bonds from neutral to overweight.

Our enthusiasm for US government bonds finds its mirror image in our antipathy towards euro zone sovereign debt. We have shifted our stance on the asset class to underweight from neutral in the expectation that Germany’s new centre right government will ultimately deliver on its pledge to loosen the country’s debt brake, paving the way for a pick up in the supply of Bunds. Under this scenario, investors should expect the gap in yields between German government bonds and their US counterparts to narrow.

Elsewhere, we remain overweight emerging market local currency bonds. Our indicators show  economic conditions for emerging nations should improve further, lifting their currencies.

We also remain overweight gold for now but remain alert to cues that suggest positioning for a short-lived pullback. On the one hand, central banks appear set to continue adding to their holdings as a means of diversifying their currency reserves away from the US dollar and the demand for safe-havens remains high given elevated policy uncertainty. On the other, however, the precious metal has risen to all-time highs of above USD2900 an ounce in recent weeks and our models indicate that the trade is tactically stretched, suggesting some volatility in the weeks and months ahead.

Global markets review: fading Trump trades

Global equities ended the month lower, underperforming bonds as fears that US President Donald Trump’s proposed tariffs on key trading partners will spark a global trade war, dampen economic growth and worsen inflation.

Trump said 25% tariffs on Canada and Mexico would come into force from March 4. Chinese imports would face a further 10% levy, which could trigger possible reprisals from Beijing as its National People’s Congress opens its third annual session later in the week.

Such policy uncertainties encouraged investors to unwind “Trump trades” with US stocks, Bitcoin and the dollar – which rallied in the run up to the inauguration - all coming under pressure.

Chipmaker Nvidia led the loss in IT shares as its quarterly report failed to ease concerns over spending on artificial intelligence technology.

Japanese stocks also lost 4 per cent to hit a five-month low as concerns about the health of the US economy and a stronger yen weighed on exporters.

European shares fared well with euro zone, UK and Swiss shares all rising between 2-3 per cent. The moves reflected signs that corporate earnings momentum is shifting in favour of Europe as the region’s economic surprise indicator – which measures how far data releases beat or undershoot market expectations – stands at a five-month high, compared with that in the US which is at a five-month low.

Emerging market shares proved resilient in the face of trade policy uncertainty as a weaker dollar and the recent pro-business approach from Beijing supported Chinese markets in particular.

In fixed income, US Treasuries gained more than 3 per cent in a rally that saw the benchmark 10-year yield fall to 4.3 per cent, 50 basis points below the mid-January peak and the same level of a year ago.

Japanese government bonds fell nearly 1 per cent as investors anticipated more monetary policy tightening from the Bank of Japan.

In credit, US investment grade outperformed its high yield counterpart, reversing a recent trend after the spread between the two instruments fell below 200 basis points, a level that historically triggers a correction.

Oil prices slid more than 4 per cent because of concerns that a trade war will suppress crude demand and a likely increase in supply from Iraq’s possible decision to resume exports from the Kurdistan region.

In currency markets, meanwhile, the dollar weakened in tandem with a drop in benchmark bond yields (Fig. 5). 

Gold rose 1.5 per cent in the month, sending the current total market value of outstanding gold – mined and proved reserves – to about USD25 trillion, equivalent to the market value of MSCI All Country World index without the US, for the first time.