Markets Outlook Q2 2025

Unsettled

That the year has started off on the wrong foot might well be an understatement. If anything, it’s stumbled out of the gates, tripped over a tariff and landed awkwardly in a patch of geopolitical uncertainty. ‘Unsettled’ seems like an apt choice of word to describe 2025 thus far. Unsettled markets have been duly unsettled by unsettling policy from a US administration determined to confront perceived wrongdoings by unsettling the global trade system.

There has been plenty of ‘stick’ from the US administration so far, which was always likely given the experience of the first Trump Presidency and the build up from 2024’s election rhetoric. Recent market volatility has increased because the scale of the words and tariffs being used are beyond the expectations that had built up since the election. The enticing ‘carrot’ has been far less evident. In fact, it has been suspiciously absent – no sweeping de-regulation, extensions to tax cuts or ‘pro-growth’ policy to offset the stick.

We wrote in the last Investment Strategy about how the political world has become increasingly influential in markets and a real source of risk. As we begin to move through 2025, the uncertainty that hurts confidence and markets alike abounds. Whilst hope remains that markets and economies can continue to move forward, the weight of the burden to deliver the anticipated low, but positive, growth has got heavier.

Two wrongs don’t make a right.

If implemented, the tariff policy of the US administration is likely to keep inflation at a higher level and growth lower, a combination which should make the US Federal Reserve more cautious in its approach when it comes to reducing interest rates. The focus on ‘government efficiency’ and tariffs are likely to reduce the appetite from US consumers as price pressures rise. ‘DOGE’, or the ‘Department of Government Efficiency’, sounds awfully like another phrase for austerity – a policy that was not exactly positive for growth here in the UK during the Osborne/Cameron, post-financial crisis period. Together, these are both potential headwinds, raising the threat of slower US growth, hence it is not unreasonable to assume a less optimistic outlook for both US growth and inflation. A recession looks unlikely if the jobs market holds, but slowing growth and higher inflation aren’t comfortable bedfellows for the Federal Reserve to be easing interest rates from here.

As the US administration seeks to “right the wrong” of having just a 25% share of global GDP for its <5% share of global population, there are some powerful forces at work, which could all upset the global economy. The current pertinent question is who will end up stronger from this wave of tariff threats and I’ve struggled to find many economists who think tariffs are a positive force for driving economic growth or lifting the wealth of society.

Between the time this Investment Strategy is being written and released, more clarity on the proposed breadth and depth of tariffs are likely to emerge. “Liberation Day” is set for 2nd April. However tempting it is to bury one’s head in the sand and hope it all goes away, that’s unlikely to help. So, let’s recognise this:

Creating additional frictions and costs will slow down trade. You are only in control of the tariffs you impose, not those that get imposed on you in return. Slower growth and higher inflation are realistic prospects. If raising tariffs result in higher prices this decreases spending. The threat of tariffs is a lose-lose scenario. The longer tariffs get imposed, the longer everyone loses. Short-term tariffs used as a threat to open up foreign markets may work, but as we see in Canada, they do plenty of harm to the appetite of foreign consumers to buy the goods you want to sell them.

The US is employing an everyone-in-it-for-themselves approach to trade and the same attitude is being used in foreign policy too. America’s European allies are increasingly looking at the fabric of their security blanket and seeing risk, rather than safety. This has prompted a response in the UK & Europe, where increased defence spending is the order of the day. Germany has approved large-scale uplifts in both its defence and infrastructure spend; likewise, the European Commission has sought to unlock extra defence spending for member states. There are longer-term economic benefits to this new spending, but these are years away, whilst the economic risks from tariffs are now.

UK Inflation: Pretty Slowly

The inflation genie is still struggling to fit back inside the lamp. In the UK, February’s consumer price inflation fell to 2.8%, which was welcome, but that might be the last bit of good news for a while. The UK’s energy price cap gets set every quarter and from April 1st over 22 million customers who remain on the variable price cap, will see their prices rise almost 10% versus what they were paying 12 months ago. Sadly for Bank of England officials, there is not much they can do to control the cost of gas, nor Council Tax, water or mobile phone charges.

The Bank of England will also be watching the increase in employer national insurance costs that begin at the start of the new tax year. The National Living Wage will rise in April by 6.7% for over 21 year olds and 16.3% for 18-20 year olds, which will both combine to increase the cost of labour – most impactfully in those lower paid roles, such as in leisure and hospitality. During the post-COVID period we saw how prices in the services sector rose in response to soaring energy costs and higher wage growth and how this helped keep overall inflation elevated. Given this recent experience, the willingness of both the company looking to push through rising wage costs into prices, and of consumers accepting higher prices given the constant media narrative of ‘Awful April’, will be one to watch. Growth and Inflation Numbers: Even Slimmer Pickings Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which are as of 12th February 2025 and so before the release of the fiscal debt brake in Germany and the latest tariff ramifications from the US:

Source: Schroders Economic & Strategy Viewpoint, Q1 2025 (Data to 12.02.2025)

Like a swan, the consensus for GDP growth looks serenely stable on the surface – but beneath, there’s a frantic mess of assumptions, revisions and economic uncertainty keeping it afloat. That GDP numbers play such a key role in setting tax and spending policies should make us all feel a little uncomfortable given the numbers get revised so heavily and are highly unlikely to be accurate when first published. Whatever you think of Rachel Reeves’ Budget, Spring Statement and overall tax and spending policy, the task of meeting fiscal rules – where GDP is one of the inputs – is a bit like playing darts whilst having a go on a bucking bronco. That you have also decided to do so whilst wearing a homemade straitjacket that’s been padlocked tight by the bond market, means you are probably destined to miss…

The Office for Budget Responsibility notably cut UK real GDP growth for 2025 to 1%. Looking further out, the shape of GDP growth has changed too. Worse in the near-term, slightly better in the longer-term.

China: Two Sessions – A Reason for optimism?

In China, the National People’s Congress concluded with officials announcing a slew of policies designed to re-ignite growth and development. China suffers from extremely poor consumer sentiment, with households weighed down by falling property prices and the need for a high savings rate to compensate for a low social security safety net. At the same time, there are strains in local government finances, high youth unemployment, deflation, poor demographics and, of course, rising geopolitical volatility with the US.

Nonetheless, the announcement of a stimulus package coupled with a reform agenda showed policymakers were seeking to move in the right direction. There was increased fiscal spending, boosts to both the amount of local government and ultra long-term treasury bonds being issued, all with the aim of achieving an economic growth target of “around 5%” and inflation of 3%.

Domestic reforms were also touted in such things as increasing flexibility on the timing of holidays, ‘trade-in’ schemes designed to encourage households to upgrade to new appliances and cars, with the aim of encouraging increased spending, and a renewed emphasis self-sufficiency in technology and artificial intelligence.

Whilst there was some positive response in the Chinese equity market, this comes during a period where Chinese equities had been recovering since early 2024, but nonetheless, MSCI China has certainly delivered one of the stronger set of equity market returns in the first quarter, up just shy of 15% in USD.

Hang on a minute. That can’t be right.

Having recently been to Chartwell – previously the family home of Winston and Clementine Churchill for over 40 years, but according to the National Trust website, now no less than a three-paw rated estate, you can imagine how if the walls had ears, they would not only be turning in their grave at missing five-paw status, but they could also tell a tale from the very toughest of times for these isles.

The UK equity market has been the poor relation in global equity markets for so long that it feels like it has taken up permanent residence on the naughty step, now forming just c3% of global equity indices, overlooked for its lack of investment return and ‘old world’ financials, healthcare and energy stocks, rather than those more glamorous technology stocks found over the pond.

Settling at my desk nice and early one recent morning, I ran the below chart. Whilst any chart needs to come with the context of both the starting point (March 2020, was amidst the deep low during the COVID pandemic) and the end point (March 2025, follows a sell off from the market darling, US tech sector), the result still is worthy of print. Despite the unloved label, UK equities haven’t been the disaster you might quite expect; Fidelity Index UK is only slightly adrift from the Fidelity Index World over 5 years. Sure, the broad UK index is well adrift from Fidelity Index US (which tracks the S&P 500), but that is to be expected given the predominant trend of US tech.

Dig a little deeper beneath the surface and there have been a few gems to be found within the confines of the London Stock Exchange. In red, Artemis UK Select, held in higher risk Core models through the period, one example of a fund that has been able to buck the trend and demonstrate that UK equities have some life left in them and a fund that despite its performance, still shows attractive valuations. In March, at a time when the FTSE 350 was trading on a forward price/earnings of 12x, the companies within Artemis UK Select, still traded at 9.4x forward earnings. By comparison, at the end of February 2025, the S&P 500 still traded on a price/earnings ratio of >20x.

A recent Bank of America/Merrill Lynch survey of Global and European fund managers set an optimistic outlook for equity markets in 2025, but also highlighted how the vast majority saw the US equity market as overvalued and beginning to feel more confident about a more positive outlook for European and Asian markets.

Portfolio Outlook – Moving forward

Fixed income yields remain attractive, but with less confidence in the pace of interest rate cuts in the months ahead, the outlook for returns from the asset class suggest a higher focus should be on the yield that can still be found today, rather than the potential capital growth that could be generated if central banks cut rates more aggressively than thought.

European government bond yields rose in response to the large fiscal support package passed in Germany, which will go on to see much higher spending on defence and infrastructure. This lifted hopes that stronger economic growth is on the horizon, but also lifted government bond yields given the expectation that more debt will need to be issued. Whilst the German parliaments fiscal vote stole the headlines, European governments are still reeling from the folding of the US security umbrella and know more defence spending is now a certainty. Unlike the UK, where the bond market offers very little headroom for the government to increase spending, decades of fiscal conservatism in Germany leave much more room to issue more debt without “Truss-like” consequences.

The cracking of the Transatlantic Alliance marked a turning point in the political sphere, one which will see a higher tolerance for bond markets to fund higher government deficits in Europe. The European Central Bank also continued to cut interest rates, reducing the deposit rate to 2.5%. All of a sudden, European assets are in focus, both across equity and fixed income markets.

In portfolios, we continue to hold a mix of high-quality investment grade corporate credit, flexible strategic bond funds and also government bond trackers. Managing the interest rate sensitivity of this part of the portfolio is now front of our minds.

In the equity world, the US equity is looking more challenged, as it fell under the barrage of White House tariff pronouncements. This uncertainty served up an excuse for areas of the market that looked relatively expensive to sell-off, namely those mega cap US equities named the Magnificent Seven, which have shed over $2.5 trillions in market cap during Q1 2025. In higher risk models and in hindsight, the decision to increase smaller companies in both the UK and the US has hindered returns. Whilst the valuation argument and long-term return prospects for holding smaller companies remains valid, we recognise that these are assets that need a positive backdrop, which is not the present environment. We always practice diversification, so whilst smaller companies have struggled, more defensive equity funds, such as equity income and infrastructure have fared somewhat better.

Conclusion: Biding your time

If, like me, you like nothing more than the quiet times, whiling away a few hours relaxing by a riverside with a warming spring sun helping a blossom tree to contentedly dapple shade upon you, then 2025 is shaping up to not be the year for you.

Whilst January’s market delivered a solid start to the year, as the geopolitical tectonic plates begin to shift under the chill of a Trumpian trade war, February and March descended back to a world of concern, unpredictability and uncertainty.

Unfortunately, the recipe for the year ahead looks like one that contains plenty of ‘oohs’ and ‘aahs’, mostly in response to the emanations coming from the White House.

As individuals, we are acutely aware that an unforeseeable future is a breeding ground for concern, but wasn’t it ever thus? As investment managers, we try to look over the shoulders of the near-term, instead preferring to take a medium or long-term view of markets. There are areas in equity markets where valuations look expensive, but also areas where valuations look more realistic too, such as the UK. Fixed income yields are looking very attractive versus the history of the last 17 years and the prospects more attractive than they have for quite some time.

Here’s to a lazy and uneventful summer…as ever, from all of us in the investment team, Will, Emma, Becky, Kim, Hayley and me, we thank you for continuing to place your trust with us in managing your portfolio and we wish you all the very best for the year ahead.

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