— Sun Tzu
“Build your opponent a golden bridge to retreat across.”
Equity markets endured powerful sector and geographic rotations in February, most notably in the last ten days. Capital has flowed out of US and growth equities and into European, Emerging Market (‘EM’), and value equities. These erstwhile laggards are catching up and the momentum seems to be building. Indeed, it was maintained despite NVIDIA beating market expectations for earnings late in the month. In addition, ‘growth’ has lost ground to ‘value’ even as sovereign bond yields have fallen across the curve in both the US and Europe. This is an interesting change in dynamics; typically, lower rates favour faster growing companies with higher terminal values (that can be discounted back at these low rates) and smaller near-term cash flows. But not this time. Perhaps the latest moves are the start of a broader mean reversion for stocks?
“Growth has lost ground to value even as sovereign bond yields have fallen across the curve in both the US and Europe.”
In our newsletters, we have often highlighted the risks inherent in sky-high valuation multiples for Big Tech stocks even as we endorse the transformational potential of artificial intelligence (‘AI’) and related innovations. Everything has a price, even the most innovative companies’ shares. And when most of the implied present value of those shares is tied to highly speculative earnings, their prices are more vulnerable to market chatter and swings of sentiment and narrative supremacy. The volatility of NVIDIA shares following the DeepSeek breakthrough in late January is a case in point. The current rotation is another. It may run out of steam. But it may yet transform into a more persistent trend. Either way, it has already underscored the relevance of diversification in stocks.
President Trump dominated the news in February as his administration continued to strike hard and fast in those policy areas that he promised to disrupt on the trail. One such area was trade; and, here, the President started the month with a bang. On 1st February, he announced 25% tariffs on Mexico and Canada (excluding energy) and an additional 10% tariff on China, ostensibly all in response to “the extraordinary threat posed by illegal aliens and drugs”. The tariffs were several orders of magnitude greater than those that Trump used in his first administration, which were on $350bn worth of Chinese goods. Indeed, these new tariffs would cover some c.40% of US imports, worth $1.35tn! China, Canada, and Mexico all announced counter-measures. Stock markets sold off and the Mexican peso, Canadian dollar, and other exposed assets swung wildly.
But just two days later – and one day before the tariffs were due to kick in, on 4th February – a deal was reached to delay those on Canada and Mexico by one month (to 4th March). In return, Canada and Mexico promised to provide the US with additional border security assistance. Cue a market relief rally! Still, the tariffs on China did go ahead; and, just one week later, on February 10th, Trump announced a major expansion of US steel and aluminium tariffs (which fall most substantially on Canada and Mexico anyway). Finally, late in the month, the President doubled down on the new deadline for implementing tariffs on Canada and Mexico and threatened to put a 25% tariff on the EU ‘very soon’. When is very soon? No one knows. But the EU is expected to respond in kind.
Significant trade disruption will hurt the world economy – perhaps profoundly in the short-term – and the US is far from immune (as markets are starting to signal). President Trump may be unfazed by fighting trade wars with all of America’s largest trading partners at the same time. But this is a questionable strategy, likely to magnify the economic costs for the US while arguably reducing US leverage in each bilateral negotiation. To be sure, it is unclear how long any of these tariffs will remain in place or, in the case of the tariffs on the EU, when they will come into effect. But, the persistent uncertainty is likely to damage consumer and business confidence in the meantime, perhaps as much as the tariffs themselves, and lead to investment and hiring delays. Indeed, this is already starting to show: in February, US consumer confidence declined at its worst monthly rate since August 2021, according to a Conference Board survey; and the services sector appears to have shrunk for the first time in two years. Together with substantial federal job losses courtesy of the DOGE unit and the large scale deportations of illegal immigrants, the outlook for the US economy is deteriorating. The pace of change is increasing the attendant risk.
“Persistent uncertainty is likely to damage consumer and business confidence in the meantime, perhaps as much as the tariffs themselves.”
Softer economic data led to falling bond yields, a narrowing of the US rate differential with Europe and Japan, and a weaker dollar as investors dialled up US rate cut bets and dialled down growth forecasts. Interestingly, the US Treasury rally and decline of USD came despite inflation still being sticky, trade disruption increasing economic tail risks, and the dollar’s status as a safe haven that tends to rally when investors get jittery. The US Treasury curve is now very flat indeed: the US 10Y yield finished the month at c.4.2%, close to the level of the 3m yield and within 20bps of the 2Y yield. And with this change in curve shape, there has been a change in duration’s relative appeal. For the past few years, we pursued a barbell strategy in fixed income that combined very short term bonds to generate yield with very long term bonds to hedge recession risks. But with a flatter curve and elevated policy uncertainty this highly specific approach is losing its appeal compared to a broader mix of maturities. A gradual portfolio transition is needed.
Finally, there were a string of major developments around the war in Ukraine in February as the new US administration tries to make good on President Trump’s pledge to end the conflict quickly. The US surprised Kyiv by announcing that American and Russian negotiators would meet in Saudi Arabia in mid-February (without Ukrainian negotiators) to explore a possible peace deal. This would be the first direct contact between America and Russia since Russia invaded Ukraine three years ago and it ended the former non-cooperative isolation strategy. America also seemed to accept that Russia would keep at least some of the territory it had seized in Ukraine as part of any deal. This significant early concession caused consternation in Europe given that negotiations are yet to begin. And finally the US raised loud doubts about the extent of US security guarantees for Ukraine in the long-term. President Trump continues to believe that Europe should have greater responsibility for European security. This means Europe spending more on defence. He suggested that Poland, which spends 4% of GDP on its defence, was a model ally that had the full backing of the US. If Europe does not take Trump seriously now there is a chance that he will pull the US out of NATO and engage with European states bilaterally instead.
Regrettably, on the last day of February, Zelensky and Trump had a heated row in the Oval Office and in front of the cameras over the extent of US security guarantees. This has thrown a minerals deal that Ukraine and the US had previously agreed to sign into doubt. If Zelensky wants the US to guarantee peace in Ukraine, the road runs through that deal. These are worrying times.
One sector that is highly likely to benefit from the new European geopolitical backdrop and the seemingly inexorable trend towards a more multipolar world is defence. Substantial increases in European defence spending will be necessary under all likely future scenarios. The war in Ukraine continues to absorb large quantities of NATO armaments, and stockpiles of these will need to be replenished – even if and when the war concludes. In addition, given the low level of trust between Russia and European NATO countries, the threat that any peace proves temporary will remain under any plausible deal. Furthermore, higher defence spending by European states will be encouraged by the US, which has signalled its desire to pull back personnel and materiel from Europe. This desire partly reflects Trump’s specific foreign policy outlook. But Europe should not wait to see if the US position changes under a future President. Besides, there is a bipartisan desire for the US to focus its resources on the Pacific theatre, where China’s rise is seen as a greater threat to the country’s interests than Russian revanchism.
“One sector that is highly likely to benefit from the new European geopolitical backdrop and the seemingly inexorable trend towards a more multipolar world is defence.”
All of this is to say that large increases in defence spending in Europe are highly likely for the foreseeable future, and this should support defence stocks in Europe, the US, and friendly states in Asia. Guidelines to spend 2% of GDP on defence, a commitment that few NATO member states had previously bothered to honour, are already presented as inadequate. And we expect that the new German chancellor (victorious from elections in February) will build a more stable coalition able to double down on rearmament in the coming years.
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
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