Ninety-nine red flags

Realpolitik again 

In the early 1990s, Germany was at the centre of a re-alignment of the global security system. German unification was the beachhead for replacing Soviet influence in eastern Europe, to be followed over the coming decades by the extension of the European Union (EU) and NATO to countries that had been behind the Iron Curtain. But this came at a financial cost, requiring huge expenditure in Germany to rebuild the east and normalise living standards between the two parts of the country. Bond yields reflected the burden this would put on public finances, and on 1 March 1990, 10-year German bond yields rose by 34 basis points (bp). It took three years for bond yields to fall back to end of December 1989 levels (7.5%).

Pricing the new reality 

History does not always repeat itself, but it often rhymes. Germany is again at the centre of the global security system realignment. Except this time, it is because of the potential withdrawal of the US security guarantee for Europe, rather than securing the collapse of Soviet influence. Germany, along with other European countries – including the UK – is having to increase defence spending. Markets do not yet know how big this will be, what form it will take, and over what time horizon it will happen. They do know, however, that there is no choice other than for governments to commit more of their budgets to defence. It will mean more borrowing – either via individual states or through some EU mutualisation. The 10-year German government bond yield rose 30bp on 5 March in the wake of the suggestion that Germany will need to spend €500bn in the coming years to boost defence and rebuild infrastructure. The 10-year yield ended last week at 2.4% - as I write this on Friday morning it stands at 2.84%. To the close of business on Thursday 6 March, the ICE German Government Bond index lost 3.1% since the end of last week.

US away 

These political developments are of historical importance. They have been prompted of course by the ongoing Ukraine conflict, and by the stance of the US Trump Administration. Washington has signalled the US is no longer willing to shoulder what it sees as an unfair burden - providing global economic security by playing the role of consumer of last resort, and playing the role of global peacekeeper by providing unlimited security and military aid through NATO funding.

Changing assumptions 

All of this is upending global trade and political relations. It is creating uncertainty in markets as well as in diplomatic circles. There are clear investment implications, the most obvious being that the mode of policy making employed by Trump is one that generates uncertainty, reflected in increased volatility in financial markets. The potential for disruption to trade and capital flows is clear, and in turn this will impact consumption and investment decisions, as well as economic policy. Previously held assumptions about growth, inflation, monetary policy, and long-term borrowing costs are all being challenged. What was supposed to be the Trump trade - US bond yields and equities higher - has been turned on its head. Meanwhile, the European narrative is now about fiscal spending, “making Europe great again” growth initiatives, and opportunities for European stocks to continue to outperform. Even though the European Central Bank (ECB) reduced its deposit rate again on 6 March to 2.50%, there is much less certainty that it can continue to cut rates to below 2.0% this year. As ECB President Christine Lagarde said at the press conference following the rate decision, “there is uncertainty everywhere”. Growth and neutral interest rate assumptions may need to be revised higher. That, and the prospect of a huge increase in European government bond supply, is why yields are rising.

Upside-down Trump trade 

There is not much spare capacity in the US economy even though there are tentative signs of the data flow softening.  The noise around tariffs, DOGE and broader budget initiatives means that convictions on growth, inflation and the path of interest rates cannot be strongly held. If economic activity is disrupted, it becomes harder to value corporate revenues and cashflow. This should mean higher risk premiums on US equities and credit. The S&P 500 equally weighted index price-earnings multiple is around 20 times, according to Bloomberg. The risk is that the multiple will contract and earnings growth forecasts will be lower. For credit, spreads are in the bottom decile of their range of the last 10 years. Given recent years’ good macroeconomic backdrop, US markets are priced for perfection. Perfection, however, is looking somewhat elusive. The consensus earnings per share 12-month growth rate forecast for the S&P 500 peaked in December and has been coming down since. The market is now looking for the Federal Reserve (Fed) to cut rates three times this year.

Euroboost 

For Europe, the game changer is the increase in borrowing costs. The rise in yields has been impressive. Only Germany has any real fiscal space to expand debt so other countries will be relying on the EU to provide concessions on how defence-related spending is treated. But borrowing will increase and there might need to be savings found in other areas of spending. As such it is hard to see what the net effect on growth will be. Some argue that pure defence spending has limited multiplier effects. We need to see what the balance is between pure defence and broader infrastructure spending – today’s warfare depends on technology, communications, logistics, as well as manufacturing hardware. But shouldering more of the defence burden and potentially having to adapt and respond to US tariffs could turn out to be positive in terms of the European growth outlook. That is the way European equity investors are viewing things.

3.5% Bunds? 

Higher sustained borrowing implies that real interest rates will need to move higher and there will be a structurally higher long-term neutral rate. I suspect rates markets will price in this new reality quicker than credit or equities. It is difficult to say where the necessary real rate will be – German real rates were around 5% in the early 1990s. They don’t need to be that high given Germany’s relatively low level of public debt and high level of household savings. Looking at one of Germany’s legacy inflation-linked bonds, the real yield has been slowly edging up since central banks started hiking, but it is low. Prior to this week it was at 0.5%. Real yields elsewhere have been higher (around 1.2% for French, UK and US inflation-linked). Assuming German real yields move to those levels, this implies a nominal bond yield of close to 3.5% (the current 10-year yield is 2.9%). German yields have not been 3.5% or above since before the global financial crisis.

ECB still easing 

Future rate and yield developments also depend on the ECB. The gap between the 10-year German Bund yield and the ECB deposit rate has been above 3.0% before, so even with another 50bp or so of easing following March’s 25bp rate cut, Bund yields could still potentially enter the 3.5%-5.0% range. This is not a forecast, but investors need to think about what might happen. Such an outcome would be difficult for other European countries with weaker fiscal balances. European sovereign spreads versus German bonds have been trending lower over the last year. So have corporate credit spreads. Higher Bund yields will push yields on other government debt higher, prompting new concerns about fiscal sustainability in some countries – especially if they are also going to be raising defence spending. So far, Eurozone corporate bond spreads have been stable, but credit analysts will need to factor in higher overall borrowing costs in this new era.

Euro fixed income becomes less dull 

It is more likely to be the case that the market will price a long-term rate which does not endanger another European sovereign debt crisis. Timing and mutualisation can mitigate the market impact. Bund yields above 3.0% and certainly above 3.5% might be seen as high enough. Fixed income markets can quickly re-price. In the short term that means being exposed to duration might lead to negative returns while the shorter maturity end of the bond market is likely to be less impacted. If credit markets remain stable, short duration credit strategies should do better than all maturity bond indices and portfolios. Once the market thinks enough has been done, then fixed income will look attractive again. In 1990, German bond yields rose 170bp. In 1991 they fell 100bp and another 70bp in 1992. Higher bond yields are not great for equities, or economic growth (or a fixed exchange rate mechanism), but they can ultimately provide for attractive fixed income returns.

Growth less sure for equities 

I struggle a little more with the equity outlook. The disruption to revenues from a huge shift in trade and political relations which impact on US companies and elsewhere should mean lower valuation multiples for stocks. Easy to write, of course, when the S&P 500 has given back its post-Trump victory gains. The market index level is still 13% to 15% higher than it was a year ago. But betting that political risk disappears, and the previous rally continues is wishful thinking. Trump is not going to become less of a source of uncertainty, there is risk around Ukraine, relations with the EU, China and Russia, and his questionable stance towards Canada, Greenland and the Panama Canal. Political risk continues, market volatility continues.

Trump’s world upending everything 

Despite comments to the contrary, I suspect President Trump does watch the stock market. The so-called Trump trade is supposed to mean higher stock prices and higher bond yields as the policy mix generated a more inflationary backdrop. The backtracking on tariffs on auto companies is a realisation that tariffs are very disruptive to supply chains, which could also hit output and employment eventually. Meanwhile, front running of imports led to a massive surge in the trade deficit in January. Disruptions to economic data might be temporary, but for thin-skinned traders and financial market commentators, the mood is changing quickly. The market now has three Fed rate cuts priced in for this year and the terminal rate for the cycle has fallen to 3.3%. I suspect bond yields will move below 4.0% at some point, so the gap between US Treasuries and European bond yields will narrow further. That is a signal for a lower dollar also.

Trump’s world will provide people like me no end of things to write about. The trick is trying to see through it all and come to solid views on markets. Not easy. For now, risk aversion is likely to be the best approach until there is more clarity on some of the most important geopolitical events. The US growth outlook is being questioned, so good for Treasuries and bad for the S&P 500; the European growth outlook may be being revised higher, so bad for Bunds and good for Euro Stoxx. If only it were that simple. Stay tuned.

(Performance data/data sources: LSEG Workspace DataStream, Bloomberg, AXA IM, as of 6 March 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.