Over the weekend, US President Donald Trump kicked off a ‘trade war’ with its top three trading partners by raising tariffs to 25% on all imports from Mexico and Canada, and 10% on imports from China. Immediately after, Canada and Mexico declared their intentions to retaliate by raising tariffs on US imports, while China announced it would challenge them legally at the World Trade Organization. The European Union has not (yet) been targeted by tariffs. But given how Trump has regularly criticised the EU for running trade surpluses with the US, risks of higher tariffs being implemented after a review on trade in April (or earlier) are rising significantly.
From an economic perspective, almost half of everything the US imports will be affected by higher tariffs, potentially disrupting supply chains and impacting the US, Canadian and Mexican economies. Manufacturing and sectors like automotive, which are deeply integrated in the North American supply chains, are likely to face increased costs, and perhaps some disruptions. We think higher tariffs could impact US growth and strengthen the US dollar, while also increasing risk of higher inflation. That said, a stronger currency would mitigate the impact of higher import prices and US growth is likely to benefit from fiscal stimulus. Given the uncertainties around the implementation of these tariffs, we’re not making changes to our forecasts.
In reaction, equities fell on Monday morning, while the US dollar and bond yields rose. Oil prices also rose modestly, given the lower 10% levy for Canadian energy. Mexican and Canadian assets depreciated the most, but we’re barely exposed to these assets; they account for around 0.5% (equities and bonds alike) of our total holdings in our balanced portfolios. In the near term, we’ll likely continue to have US exceptionalism, which means: (1) a preference for US assets such as equities in our tactical positioning, but a cautious stance on Treasuries on fiscal concerns (unless valuations become more attractive); (2) for the rest of the world, we have no active equity positions and an ‘insurance’ instrument which appreciates when European equities fall as downside risks are mounting, plus we overweight short-dated European government bonds (or gilts in sterling portfolios) as they benefit from downside risk to growth and more interest rate reductions in the eurozone and the UK vs the US.
In the sixties, the Space Race between the US and the Soviet Union caught the world’s attention while boosting economic growth. The launch of the Chinese AI model, DeepSeek, sent shockwaves through markets early last week, starting the AI race between the US and China. While there are still unanswered questions about how DeepSeek has been able to achieve comparable results to its US competitors at a lower cost, what matters to us is the potential economic and market impact of this race.
The recent development of AI models has been inflationary due to the increase in demand for new chips, data centres and energy supplies. However, we think AI adoption will be deflationary over the long term. DeepSeek’s arrival may have accelerated this deflationary phase. Increased competition will likely force the providers of existing models to lower their prices, which OpenAI has already started to do. These lower costs for users could remove some inflationary headwinds for the US Federal Reserve (Fed). This could also help offset future inflationary pressures from US tax cuts or tariff hikes.
For now, we think volatility in AI-related stocks and equity indices will likely persist in the short term. This is one reason why we hold an ‘insurance’ instrument to mitigate the impact of hypothetical drawdowns of US equities. Over the long term, we think AI will remain a structural driver of growth as tech giants continue to invest in the sector.
Last week, the Fed kept interest rates in the 4.25-4.50% range after three consecutive cuts in 2024. Fed Chair Powell indicated that the central bank would hold interest rates for the coming months. We expect most other central banks to lower rates in 2025 (see below) as inflation edges closer to the 2% target and growth slows modestly, while inflation expectations remain well-anchored and financial conditions are still restrictive.
While there’s no rush, we expect the Fed to bring rates somewhat lower by the end of the year, as inflation makes further progress and, eventually, economic growth normalises towards a still solid but more average pace. Overall, equities should continue to benefit from additional interest rate cuts and solid growth. This is why we own more equities than bonds and are overweight in US equities within that asset class. That said, there are significant risks to this base case, given the recent tariff announcements: inflation might be higher and prevent the Fed from cutting rates but, given the positive impulse from fiscal stimulus, US growth is likely to benefit, offering support to US equity markets.
Last week, the European Central Bank (ECB) lowered the benchmark interest rate to 2.75%, and we expect it to continue to lower rates in 2025. We forecast interest rates to end the year at 2%, much lower than in the US. Inflation is around the ECB’s 2% target, and, according to ECB President Lagarde, the economy looks “set to remain weak in the near term”.
On Thursday, we expect the Bank of England will follow suit and lower the Bank rate to 4.5%, eventually cutting to 4% by the end of 2025. That’s why we’re invested in short-dated government bonds in the eurozone for euro portfolios and gilts in GBP portfolios.
Turning to the US, the market’s focus this week will be on the several US jobs reports. Job creation has likely slowed down in January (Friday) after a blockbuster release in December. That said, it probably won’t change the Fed’s mind on holding interest rates for now, as that’s partly due to the Los Angeles County wildfires. Underlying job creation remains strong.
