Deals, delusions, and debt: the real state of the US economy

Before the ink was dry on the US/China deal, markets were already celebrating. The S&P 500 climbed over 5% in a week*. The US markets are almost back to the levels seen at the start of the year. Proof, if it were needed, that markets have short memories. 

The question for investors is whether the US stock market is back to the races. It would be good news for the US’s natural cheerleaders, but could be disappointing for those who had hoped the wobbles in the US would usher in a new era of stock market diversification. In this golden era, investors might look again at areas such as Europe, the UK, Asia or small-caps. Could the nascent recoveries in these areas be derailed by a resurgent US?

Whether the US has averted an economic slowdown is open to debate. Yes, it has agreed a couple of skeleton trade deals and unlocked the stalemate with China, but there are still a lot of countries to cover. As Gordon Shannon, a manager on the TwentyFour Corporate Bond fund, says: “The question for investors now is how much of the macro risk remains after the softening of the US stance, and how well that risk is being reflected in risk asset valuations.”

He adds: “We think the trade deals being promised by the US will have to happen if the administration does not want to push the US economy into recession. This does not just apply to China, where a 145% tariff effectively reduces trade to zero (no more trade deficit), but to a host of other countries given the prohibitive level of enhanced tariffs due to kick in at the end of the 90-day pause.”

While it has some deals in the bag, they are more “agreements in principle”, says Gordon. As the UK/Eurozone process attests, true trade deals take a lot longer. What is clear, however, is that tariffs aren’t going away. He adds: “Whatever deals do finally emerge, we expect the effective tariff rate to be a meaningful increase, relative both to President Trump’s first term and to consensus expectations at the beginning of this year.”

While a recession in the US may have been averted, these deals do not get the US back to where it was before. There are still hindrances for US companies doing business around the world and there are still risks to the outlook on both inflation and economic growth. 

Dickie Hodges, manager on the Nomura Global Dynamic Bond fund, says: “As trade deals are announced, and tariff threats pared back, we believe the US economy can avoid recession. However, we do expect the economy to slow as fiscal spending is reduced.”

He believes that markets may also be too optimistic about rate cuts. Dickie points out that markets continue to price more than three rate cuts by the Fed in the remainder of 2025. “Too many, in our view. Inflation is too high for interest rates to be cut.” He believes more rate cuts may be forthcoming if the economy slows, or if inflation is subdued by an end to the war in Ukraine. However, in the meantime, the US economy will not get any boost from lower borrowing costs.

There are other signs that investors are cooling on US assets, even if they continue to like some of its stocks. There has been a small recovery in the dollar, but the benchmark DXY index (which measures the US dollar against a basket of other currencies) is still around 10% below its level at the inauguration**. 

Perhaps more worrying for the US administration is that the wobbles in the bond market won’t fully settle. Last week saw Moody’s downgrade US debt from Aaa to Aa1 and yields on 30-year US Treasuries hit their highest level since 2023, tipping over the psychologically significant 5% mark. There are still clear concerns about the progress of Donald Trump’s vast tax and budget bill. Furthermore, the cost of insuring US debt, as measured by the credit default swap market, is at levels not seen for two years***. 

At the same time, geopolitical relations look as fragile as ever. John Chatfeild-Roberts, manager of the Jupiter Merlin Income fund, says: “Markets remain focused on economics and particularly trade and tariffs. They have breathed a collective sigh of relief (‘risk on’: equities up, bonds down) that both the US and China have found an off-ramp to allow goods to move once more between the two countries, at least for 90 days. But while it is difficult to quantify and to put a definitive number on it, the overarching geostrategic risks are perceptibly rising.”

There is another side to the equation, which is the relative strength of other parts of the world. Here, for the most part, the news is encouraging. Areas such as UK small and mid-cap companies have been swept higher in the broad ‘risk on’ trade of the past few weeks. The Eurostoxx 50 has broadly kept up its momentum over the past month as well. Asian markets have also been relatively strong. This suggests that the diversification trade is not done and dusted and investors may continue to be more imaginative. 

The Bank of America said in a note last week: “The swift rebound means equities have moved from pricing a sharp slowdown to pricing no macro damage from the trade war.” The so-called ‘TACO’ trade (Trump Always Chickens Out) has its appeal. However, the US stock market was already expensive, and the recent rally may increase its fragility rather than proving its strength. Armageddon may have been averted, but that doesn’t mean the US is back to the races. 

*Source: FE Analytics, price in pounds sterling, 5 May 2025 to 18 May 2025

**Source: MarketWatch, US dollar index, 20 January 2025 to 18 May 2025

***Source: Wall Street Journal, 19 May 2025