The global economy remained on a solid footing in the first quarter, although financial markets were on tenterhooks due to policy uncertainty emanating from the US. Soon after his inauguration, President Trump launched his trade tariff offensive, as well as job and budget cuts in federal departments. Uncertainty over the extent and duration of tariffs caused especially large declines in US equity markets, which suffered a series of economic data disappointments, notably declines in consumer confidence and a slowdown in household spending. Other regions however, exceeded economic expectations, including China, which benefitted from the announcement of its home-grown Deepseek AI Chatbot App, developed at a fraction of the cost of US rivals. Europe provided the biggest upside surprise, with economic data beating projections and the outlook immeasurably improved by Germany’s embrace of fiscal expansion.

With US markets starting the year at elevated valuations compared with the rest of the world, and with its economy failing to meet forecasts while others beat theirs, there was a pronounced rotation in regional equity market performance during the first quarter (Q1). US markets were the laggards, with the S&P 500 losing 4.59%, dragged lower by the Magnificent 7 shares, which from their peak in February suffered declines of between 15-20%. The tech heavy Nasdaq index lost 10.42% over the quarter. At the same time, the US dollar index lost 3.49% making the market declines even more pronounced when measured in other currencies. Japan’s Nikkei 225 also suffered a hefty 10.72% loss, exacerbated by a strengthening yen owing to the Bank of Japan’s resumption of interest rate hikes.

Other markets fared much better. China’s CSI 300 lost a moderate 1.21% assisted by increased optimism over the country’s AI competencies and a thawing in government’s hostility towards the country’s internet and technology sectors. The UK’s FTSE 100 gained 5.01%, benefitting from the compelling valuations on offer and the heavy index weighting in cyclical sectors, which returned to favour amid the broadening global economic recovery. Germany’s Dax led with a stellar 11.32% gain as the country’s parliament took the momentous decision to remove the country’s “debt brake”, allowing greater fiscal spending and lifting the outlook for the entire region. The Euro Stoxx 50 index gained 7.79%. The MSCI All Country World index (USD based) eased 1.69% in Q1, but the MSCI Emerging Market index (USD based) gained 2.41%, helped by recovery in China and Far Eastern markets, and gains made against the dollar by emerging market currencies. Bonds provided useful ballast in balanced portfolios. The 10-year US Treasury bond yield eased over the quarter from 4.57% to 4.24%, translating into an increase in bond prices. The S&P Global Developed Sovereign Ex-US Bond index provided a solid dollar-based gain of 2.91% in Q1.

During the quarter, the US administration imposed 20% tariffs on China, 25% tariffs on Canada and Mexico, across the board 25% tariffs on steel and aluminium plus 25% tariffs on motor vehicles and parts. Post quarter-end, in his “Liberation Day” announcement on 2nd April, Trump delivered reciprocal tariffs on a country-by-country basis which were far bigger than expected, lifting the US effective tariff rate on all imports from 2.3% last year to around 26% (a 131-year high). Reciprocal tariffs were calculated according to each individual country’s trade balance with the US, and other non-tariff barriers such as currency valuations and foreign investment regulations. Asian economies were especially badly affected, and some countries more than others depending on the level of their GDP exposure to US trade. The US is less dependent on trade than the rest of the world and so should come out best. Its imports and exports comprise 11% and 7% of GDP, respectively. By contrast, imports and exports in the rest of the world comprise 26% and 28% of global (excluding US) GDP.

Yet, an underappreciated consequence of US trade tariffs is the impact of an enforced reduction in its trade deficit on foreign investment inflows. Independent macroeconomic research firm, MRB Partners summarises the predicament succinctly: “A trade or current account deficit must have a financial and/or capital account surplus as an offset. Hence, any reduction in the US trade and current account deficit will have as its corollary a decline in foreign investment in US financial and nonfinancial assets.” The US has run a trade deficit in each of the last 49 years and a current account deficit in 43 of the past 44 years. The quid pro quo is that foreign investment inflows into the US have been vast, amounting to $13.1 trillion over the past 10 years, averaging an annual 5% of GDP. The rest of the world now holds $56 trillion of US financial assets, equivalent to 180% of GDP. A forced shrinking of the trade and current account deficits would lead to an exit by foreign investors, potentially leading to a material compression in US asset valuations.

Germany’s Bundestag, the country’s federal parliament led by a coalition of the CDU and SPD parties agreed to reform the debt brake, the strict constitutional fiscal rule that prevents the federal government’s core budget deficit from exceeding 0.35% of GDP. Defence spending exceeding 1% of GDP will become exempt from the rule. Also exempt, a deficit financed fund for infrastructure worth €500 billion, equivalent to 12% of GDP will be created and spent over a period of 10 years, amounting to 1.2% of GDP per annum. This marks a seismic shift from Germany’s traditionally conservative and debt-averse fiscal policy, with significant consequences for economic stimulus. These policy shifts, which provide a multi-year fiscal tailwind for Germany and the Eurozone at large, triggered a major repricing in German and European financial markets amid positive revisions to economic growth forecasts. The European outlook also benefitted from improving growth conditions in its largest export destination, China and the potential ceasefire in Ukraine.

The global cyclical recovery is unlikely to be derailed by the trade war. In its forecasts published on 27th March, independent research firm Capital Economics forecasts global growth of 3.1% in 2025, with Eurozone growth picking up to 0.9%, Japan’s to 1.0%, while growth in the UK will slow to 0.8% due to its fiscal spending cuts. US growth is expected to slow from 2.8% in 2024 to 2.0% in 2025, but remain the fastest growing developed economy, while amongst emerging economies, China’s growth is expected to slow to a still solid 4.0% pace, or 4.8% according to official government projections. India’s growth is expected to achieve 6.6% albeit below last year’s 6.7% pace. These growth forecasts will be cut back following the severe reciprocal tariff announcements. In the worst-case scenario, according to IMF research a 25% rise in tariffs which is reciprocated in full by all trading partners would knock 2% from global GDP. However, apart from China’s strong response, most countries will likely opt to negotiate with the US rather than retaliate, in which case, helped by offsetting currency effects, the impact on global GDP would be limited to 0.5%.

After a generally weak Q1 for financial markets and the most isolationist US trade policies in over a century, how worried should we be about the financial market outlook? Fortunately, the global economy was strengthening as the year started and despite the trade tariff shock is likely to remain generally strong. The Federal Reserve and other central banks are on standby with scope to cut interest rates if necessary. The Fed put, the belief by financial markets that the Fed will step in to buoy markets if they fall below a certain level, should limit market declines. Trump, who will want to avoid tipping the US economy into recession or being held responsible for a US bear market, is also on standby to launch pro-growth policies and possibly scale back some of his tariffs. With a strong economy, continued earnings growth and both a Fed put, and a Trump put, we would be buying into any excessive market weakness.