Markets are adjusting to a major turn in the political consensus

By Johanna Kyrklund 

We’ve had a dramatic start to the year – DeepSeek’s disruption of the artificial intelligence (AI) narrative, a seismic shift in defence and infrastructure spending out of Germany and of course “Liberation Day”. As a result, we initially witnessed significant divergence in performance across and within asset classes and, more recently, a severe correction.

As always, we need to take a step back to gain some perspective. We’ve talked a lot in recent years about a major shift in the investment regime driven by a rejection of the political consensus which dominated Western policy from the 1990s onwards; a focus on fiscal rectitude combined with loose monetary policy and a highly globalised economy.

The challenge with this model, particularly in the 2010s as interest rates moved to zero or negative and wage growth languished, was that it didn’t work for the majority of people in western democracies. As a consequence, in recent years we have seen the emergence of a new, populist political consensus focused on a more proactive fiscal policy, protectionism and anti-immigration.

This might appear to be a chaotic combination of events but really it’s all symptomatic of the major turn in the political consensus that we’ve outlined. President Trump’s definition of “tariffs” is flawed but he has been clear about his views on international trade for many years. We might not like his framework and his philosophy, but his policies have been consistent.

Tariffs: basis for pricing risk is becoming clear

Certainly, Trump’s opening salvo pointed to higher tariffs than we were expecting. It remains to be seen what the outcome of negotiations will be. However, our economic forecasts are being adjusted downwards and the risk of recession has increased as companies cope with the disruption to their supply chains.

Now, the reaction of the rest of the world will be critical. The countries on the tariff list are making their decisions to either retaliate and escalate the trade conflict or to contemplate reducing their trade imbalance with the US. How long this takes will also matter for markets.

But we have to remember that what markets hate the most is uncertainty; bad news can be priced. Trump’s framework, laid out on a physical chart, is clear. One might dispute the approach – they haven’t actually used tariff rates and non-tariff barriers, rather they took each country’s trade deficit with the US and divided it by the country’s exports to the US. But by applying the principle of imposing 50% of the calculated rate they have laid out a clear starting point for negotiation.

This might feel like a game of snakes and ladders, but at least we are beginning to understand the rules and markets have a basis for pricing these risks. China’s response darkens the global growth outlook but, again, at least now we are learning about their reaction function. We are rapidly moving from risks which are unknowable to risks which are analysable.

Government and central bank responses will also influence market moves

Aside from the trade negotiations, markets will also be driven by fiscal and monetary responses to weaker growth. The Trump administration remains committed to tax cuts and the release of the debt brake in Germany is helpful.

Similarly, the Chinese leadership is considering measures to stimulate the consumer market. Monetary policies might be more divergent. Tariffs are generally deflationary for Europe so we expect rate cuts to be accelerated there. The situation is more complex in the US due to the short-term inflationary impacts of higher import prices so we expect the Federal Reserve will be slower. Ultimately, we do expect policy to turn more reflationary in response to the tariffs which should help to mitigate some of the impact.

In the medium term, we need to be careful, however. The ultimate constraint on looser policies will be the consequences for inflation and debt levels, and the willingness of bondholders to accept this. If debt levels are seen to be unsustainable, or if the commitment of policymakers to some form of fiscal responsibility and inflation control is questioned, we could see yields on bonds rise.

There has been some volatility in US government bonds. But for now, we judge this risk to be low. Central bank independence is still intact and concerns about growth are capping yields on bonds, but we are watching the pricing of inflation and bond/equity correlations closely.

Linking this back to what we at Schroders have termed the 3D Reset (the disruptive impact of deglobalisation, demographics, decarbonisation on the global economy), we have moved from a globalised regime with deflationary shocks of the 2010s, to a deglobalised regime with inflationary shocks.

Diversifying regional equity exposure

Lastly, let’s focus on the US. As mentioned above, US exceptionalism has been partly driven by the ability of the US to sustain higher levels of government spending due to the dollar’s reserve currency status as well as its dominance of the technology sector. Disrupting the international trade system does cast a shadow over this trend. In addition, the extreme concentration of the S&P500 in just a few companies exposes investors to an unusually high level of stock specific risk, as the recent DeepSeek news demonstrated.

Combined with our expectation that Trump is provoking a reaction from governments in Europe and China which could be more stimulative for markets, we are diversifying our equity exposure away from the US.

Looking long term, the structural issues raised by the 3D Reset are more relevant than ever demanding flexibility and a deep understanding of risk to cope with the crosscurrents. To misquote Bette Davis “Fasten your seatbelts, it’s going to be a bumpy ride”. There are plenty of opportunities, but we need to look beyond the winners of recent years.

Johanna Kyrklund is the Group CIO at Schroders.

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