Direct From Dowding: February 2025

Hello there, and thanks for joining the seminar today. So as before, I'll speak for about 25 min, giving some thoughts and themes in terms of how we're looking at the world at the moment, and then hopefully leave some time for some questions.

But look as ever, it seems, on the macro side, more than enough to talk about and fill time with, and I guess it's only been, I guess, just over a month, isn't it, since Trump was inaugurated and entered the White House. But it feels like it's been more than 100 days already. Given the noise, the furore that the incoming President has managed to create in a relatively short space of time.

But I think it's worth actually reflecting for a moment for all of this noise around Trump, all of the things that maybe we can spend some time speaking about, actually the past month in financial market terms has actually been a relatively quiet period. If I'm honest.

If you look at treasuries, obviously we saw a big move up in treasury yields in the run up to the election, and then post the election, but literally over the course of the past month yields have been, relatively speaking, range bound. We've been sort of chopping up and down a little bit.

But the reality is that the front end of the yield curve remains anchored relatively close to where the Fed's cash rate is. Fed cash rate’s at 4.3. You've currently got the two-year sitting at 4.2, with the long end of the curve up at 450, sort of 470 at the long end, on the 30-year asset.

And from that point of view, in a way, it's almost we're in a situation where the bond market itself doesn't really have much of a catalyst to drive yields one way or another. We've heard from the fed. The fed is on hold for the time being, and ultimately we'll be sort of looking at how conditions prevail later in the year, when it comes to assessing what needs to happen to monetary policy at that time.

Of course, if we do see slower growth. If we do see a move towards lower inflation, it does give the fed maybe room to ease some more.

But, on the other hand, if we see some of the new Administration's policies coming through with a more inflationary hue, we've tended to think that there would be more of a push for the fed to actually need to hike rates, not cut again, were we to see core Cpi hitting up around 4% that would be consistent with core pce, the fed's favoured inflation measure being around about 3 and a half.

But that being the case, rates for the time being, going nowhere, that anchors the front end, and you've reached a bit of a status quo waiting for the next catalyst to really drive price action in markets and by extension it's been relatively quiet in credit as well. We've seen strong issuance met with pretty robust demand.

But in terms of US credit spreads, it's certainly been true, particularly in IG, that you've effectively run now into a bit of a valuation wall at an index level. The OS spread levels are pretty much unchanged over the year to date, and part of this is also down to the fact that swap spreads have actually been moving a bit wider. Swap spreads have been tightening through the course of 2020. They've been going a bit the other direction over the course of the last couple of weeks, which is something I've been writing about in my weekly note that I send out some of the reasons why we think that trade has made some sense, but that's turned into a bit more of a headwind for credit spreads.

And so, although economic conditions are pretty benign and you're not too worried about default risk, at the minute we are in a situation where valuations have become more challenging for credit. So credit has gone pretty much sideways.

But otherwise I think there is plenty to talk about in terms of Trump, and I think it is odd in a way. I mean, it does kind of sit kind of uneasily, doesn't it? This idea that we've got all this volatility going on in the political and geopolitical environment. Yet markets themselves are relatively stable, and I'm not sure that those conditions can really persist.

And so I thought, just sharing a few thoughts in some of the key policy areas that have been up for discussion. Firstly, when it comes to tariffs here, I think the thing to say on tariffs that has been sort of very evident in a number of the conversations that I've had with policymakers in DC over the course of recent weeks has been this idea that yes, tariffs are going through. Yes, it's something that the Administration wants to see the revenue from. And ultimately the US administration feels it's justified in raising tariffs in a way, as something of a consumption tax.

If you think about the US economy, they don't have a general sales tax at a Federal level in the way that we have VAT in Europe, for example, and that means that if you're in Washington, you actually have this assessment that in the US you're producing goods and sending them for export that come into European markets. But European governments, they slap on their VAT onto those imported goods. So European governments are taxing US exports. So why shouldn't the US government be taxing European exports or other global exports in a similar fashion given they don't have that sort of sales tax.

And in a way, the narrative here is you can think of a more generalised tariff, almost a bit akin to a sales tax, albeit a sales tax that is exempting domestic produced goods. And so from that point of view I wouldn't be at all surprised at some point as we go through this year you end up going through a path where you end up with tariffs being legislated. 25% has been a level that Trump has been throwing out, but I don't think 25% is what you'll see in terms of a more general universal tariff. That's more likely to settle at a rate we think around 10% and effectively, you're threatening 25, but reducing to 10 on the basis of good behaviour. So as long as you're not hitting with reciprocal tariffs on the way back, that's the hope for sort of landing spot when it comes to tariffs.

But that legislative process is going to take a number of months. You'll have to put reconciliation bills through Congress. I think that you'll probably need a couple of bills to get that done, and we're probably talking about a timeline that extends pretty much to the end of this calendar year.

In the shorter term the focus has been more on executive orders, and what's being done there. And of course, later this week we'll be waiting to hear the latest in terms of the proposed Canadian and Mexican tariffs, which were obviously delayed by one month to the start of March. That timeline is coming around now. So later this week we'll hear whether they get moved another month to the 1st of April or whether tariffs are being imposed, but albeit at a level that's been reduced from the 25% level that was originally suggested, on the back of the fact that we've had some cooperation around the US border from the Mexicans and things around drug imports when it comes to the Canadians, if you like.

So we'll wait to see what happens there. But this is the narrative that we see on trade, and effectively, the way that we see tariffs working, I think, for the rest of the global economy. This is a negative supply shock that impacts demand. It's disinflationary in the context of the US itself. It's more of an inflationary impact, more of a one-time inflation push higher. So this is something that does bias to think that in the short term you could end up seeing inflation moving a bit higher rather than a bit lower. Another reason why not to expect interest rates to be coming down anytime soon. But that's part of the narrative in terms of what we're looking at in terms of the tariff discussion.

We then have the moves to clamp down on immigration. We're seeing evidence of that, perhaps tightening labour markets. That's something that could be a threat to the upside on wages but could also come with a bit of an adverse impact, perhaps, on consumption. But we will be keeping a close eye on how this is impacting certain sectors that use a lot of migrant labour.

And then, in terms of other things going on, I think there's been a lot of interest around Musk and the Doge and the layoffs that are being announced. I would say that a lot of those layoffs, because you've ended up with this promise of paying wages until September, some of these layoffs, if that's how they work, they may not actually hit the payroll reports for a number of months yet. So you won't see this showing up yet.

And at the time being I think the amount of headline reduction that's actually been delivered is relatively modest. The question is, how much further is going to be done here? How successful is this administration going to be in terms of really reforming the levers of government and really stripping out a lot of bureaucracy and driving down a lot of cost and achieving really material cost savings?

There's an open question there, but some people have been asking me whether that's going to lead to a much lower US deficit. I think that's kind of unlikely. In a way. I think that any money that's getting saved will end up being passed on in terms of additional tax cuts. But when it comes to fiscal policy, I think that as long as the economy is growing as it currently is, and tax receipts are therefore relatively robust, I think we're in an environment where the deficit basically stays unchanged to where it was last year around 6.5 to 7% of GDP.

So fiscal policy is neither adding or subtracting to growth this year and from that perspective, again, that means overall debt levels should be climbing and over time. This is a reason to believe in more yield curve steepening. I'd note that here and now, today the yield curve, from a historical point of view, actually is really quite flat and given the elevated level of debt levels, we do think over time you're going to see more of a steepening bias in terms of US rates.

The other area, obviously, that has got a lot of attention is Trump's actions overseas in terms of Ukraine. Obviously my own take on this, I've been rather alarmed and concerned and disappointed at some of the language that Trump has been using. And there's a risk here that we could actually sort of move towards Trump trying to push for a deal which, if it comes without security guarantees for Ukraine could end up being a deal that never really gets off the ground, or a ceasefire that doesn't really end up lasting.

It does look like a bit of a bad peace outcome. But I guess from a US perspective this doesn't matter an awful great deal. And it's kind of been interesting speaking with my US colleagues really sort of to observe how relatively little a lot of the overseas part of the agenda that the US advancing is really sort of hitting the tapes and concerning people domestically, domestically inside of the US.

For the time being Trump continues to enjoy a pretty robust approval rating, and the more the focus is on more of the domestic issues that I was previously covering.

But obviously what happens around the likes of Ukraine has very big ramifications for the rest of the world, no more so than is the case here in Europe. And from a European perspective what has been clear for a long time is that Europe dramatically needs to increase its defence sector. Its defence spending historically, a lot of European countries have sat below 2% of GDP in terms of defence.

There's been some increase over the course of the last couple of years, but still the reality is that Europe is in no position to really operate its own defence. And so you're going to need a multi-year commitment to see much higher levels of defence spending, we think, in order to ensure that Europe can actually be more independent in terms of its own security, and less reliant on the US as we move into this new future that we now find ourselves in.

This has led to a suggestion that we get to about three and a half percent of GDP being spent on defence. That would be adding about one and a half to 2% in a number of European countries. But the issue there is that it's difficult to do that in terms of the national budgets and the European framework for budget stability. And that's why there's been discussion about funding this outside of the European budgets more at a European super level in the context of a EU defence package.

And so if that's something that gets done, and it looks like it has been largely agreed. This is something that actually adds a little bit to European integration, which could be a bit of a beneficial factor for spreads, perhaps.

But I think the reality here is that Europe is dealing with a very difficult situation. If you end up with an outcome where the US pulls back from Ukraine, if you end up with an ongoing conflict, there's a possibility, of course, that leads to a total Russian victory. You end up seeing that I think there will be panic across Europe.

There will also be a tidal wave of refugees heading west and you can already see on European society some of the stress that is being exerted on the back of inward migration. And that's something which is a real issue.

I'm half checking the time here because there's almost so much to cover, isn't there on terms of the macro. But events in Ukraine are something that we're playing plenty of attention to. Otherwise, in terms of the European economy, I think we would say, even if you do end up with this sort of fiscal spending that is going to be targeted towards defence at the moment, you just have such a lack of a defence sector.

There isn't a lot of shovel-ready projects to actually throw money at. A lot of this is going to be about needing to build capacity in a number of areas, and that won't be done very quickly. You'd also need to be dragging in imports in the short term. So I'm not that convinced that there's going to be a big delta in terms of growth on this in 2025, and certainly not much of a fiscal multiplier in terms of the spending.

So for me this narrative around sort of increased defence spending is not really changing the economic outlook for Europe that much. Of course, it is adding a bit to debt levels which probably infers a steeper European curve, a somewhat less attractive outlook for bunds. And it's also been interesting with the ECB making more vocal noises over the course of the past week. It is now looking like we could see cash rates in Europe continue to decline from two and a half today down to 2%. But once you reach two, I think you're probably in a situation there where the ECB is more likely to run policy on hold with the last sort of half mile on inflation, proving just a little bit sticky.

But that's really the European perspective, in the UK, the UK finds itself in a more tricky spot, because here for the UK to increase defence spending, you have to ask yourself where the money is coming from, because with Rachel Reeves already pretty much failing the OBR estimates, we certainly know that there is no fiscal space. If anything, there's almost pressure to raise taxes or cut spending as we currently stand.

So if you need to find more money for defence, you're going to be making some tough decisions at the moment UK spends around 2.3 of its budget, it's talking about a smaller increase to 2.5, which it may be able to get away with. But in a way, if the UK wants to retain its position, then at a time when everyone else is committing to three and a half, I think that the risk here is the UK is left coming up short. But it's just a testament to the fact that the UK is in a difficult spot.

And all the while we continue to see inflation risks in the UK. So a stagnant economy, inflation risk to the upside. I think it's going to be hard for the Bank of England to deliver more rate cuts in 2025. I've tended to be on the more hawkish side in terms of UK inflation continue to be that way around. And with those stagflationary risks, continue to express a relatively negative view on gilts and also on sterling.

In Japan, by contrast, very different story. The economy is moving along pretty nicely. Inflation continues to tick a bit higher. Wage growth continues to be robust, and on the back of all of this, if anything, it looks like there's some chance that the Bank of Japan may actually start to draw forward some of its monetary policy normalisation.

These ideas have continued to push JGB yields higher over the course of the past month, and we're now up above 1.4 on 10-year yields in Japan. And indeed, it's interesting to reflect now that in the past 10 years, if you've sat on Japanese bonds for 10 years, you've ended up delivering negative returns for the sake of your investment.

And so it shows you the extent to which yields have really moved over the course of the last year or two. At this particular point we think that yields have got a bit further to go. We've thought that somewhere between 150 and 175 is where we'll end up in terms of fair value for Japanese 10-year rates. At these sorts of levels we think we'll see more domestic support for domestic fixed income.

So we continue to run a bit of a short stance for now. But I think we've been reducing our position in sizing, and actually sort of voicing the thought that as these interest rate differentials diminish, we could be in more of a moment where the yen is better poised to deliver a stronger performance, certainly against the euro has been our thinking against sterling, too.

Otherwise, in China the economy is still struggling somewhat at a macro level. At a micro level, though the DeepSeek news has got sort of investors in tech pretty excited. And so from that perspective it does show you that there's a danger in becoming too pessimistic about the China story.

But still, from a macro perspective I still see plenty of headwinds for the Chinese economy coming from the US. Coming from the property market. Coming from the fact that the Government hasn't eased policy enough to actually make real rates, that accommodative. Coming from the fact that the Government has not really done enough to empower consumption and is too reliant on exports as the growth driver there.

All of that leaves me retaining a somewhat downbeat macro perspective, albeit it does highlight there are these sort of underlying interesting stories. And to that end if we do end up in a situation where on AI we end up with less being spent to achieve results. There is maybe a bit of a question mark that could actually come back to the valuation of some of the US tech sector around the AI space.

And interesting, just at the end of last week, seeing Microsoft actually looking like it's paring back some of its spend in the current calendar year. You half wonder whether some people have actually been overestimating AI capacity in the short term. But that's something that we will also be addressing as a theme in the weeks ahead.

Otherwise, I think elsewhere in EM we've said that again, like the rest of credit, valuations are tight, but we have seen sort of idiosyncratic opportunities. Like we were big buyers in our EM funds in Lebanon towards the end of last year. Those bonds have rallied pretty much 300% from a price of around seven or eight cents up to 18.

So that's been a trade that has worked well, but actually an area that we actually see more opportunity. My colleague, Polina Kurdyavko was actually in Beirut meeting with the President last week. And so Lebanon has been a story that's interesting us.

In the same way Venezuela, I think, is also becoming an interesting story. And a lot of this comes back to what Trump is doing on the global scene.

But at the same time, we've actually been reducing positioning now in Ukraine; we’ve been long holders, long supporters of Ukraine. But our concern that Ukraine may not be sort of headed in the best direction is the reason we think at this particular juncture, although we're hoping for peace, we think that from an investment point of view, reducing some exposure, there probably is the right way to move.

With that I've realised that I've been speaking for pretty much 25 min. So I'm going to pick up my phone and look to see if there are any questions that have come through again.

And so I think the 1st question is, do I think the pessimism in Europe is overdone?

Look on this question. I'd love to agree with the sentiment. I'd love to say that we've all got too pessimistic about Europe. But honestly, I think that Europe is in a very difficult spot right now. The reality is that if you look at the European economy, the European economy is limping along, you've got growth in Europe which is just under 1%. But the only reason it's there is because Southern Europe has been really strong. You've seen countries like Spain was one of the best performers in the developed economies last year, so Spain has done well. Portugal has done well. Greece has done well, but in Northern Europe you're seeing really stagnant growth, and a really depressed mindset.

Part of this comes back to the fact that energy costs are way too high in Europe. I think the race to go towards net zero in Europe has ended up, we've ended up with energy prices which are two or three times as high as our overseas competitors, and therefore our industry can't compete in autos, in chemicals, in other energy intensive sectors.

And so from that point of view, it's difficult to get that optimistic. And that's even before we start talking about things like tariffs. We know that tariffs are coming. Tariffs will hit autos, they'll hit Pharma, they'll be targeted at other sectors as well. So I do think that you've got a weak starting point and potential for other downsides.

And if the only positive we're talking about is a bit more fiscal spending, going towards defence, I'm sorry I struggle to see how that really should get us that optimistic on the European outlook.

I'd also say politically, I mean, you look at the German elections over the weekend, and what you see is quite a challenging political makeup here, in a way, with the rise of the far right, you can kind of sense that society is trying to push more to the right, yet the CDU is going to end up in coalition with the Greens, and the SPD is going to be a coalition with the left. And so in a way that makes for a government that may struggle to get a lot of things agreed and a lot of things done.

You see, division and you see growth on both sides of the political spectrum growth in populist parties all across Europe. I also sense a malaise amongst the young in society, a sense that people are relatively pessimistic looking towards the future. When there is this pessimism people want to save, they don't want to spend.

So in many respects we kind of need I dare to say it. I don't want these words to tumble out my mouth, but we kind of need leaders who are going to make Europe great again, don't we? We need leaders who are going to tell us that there is going to be a big, bold, bright, beautiful future for Europe, because at the minute. I'm not sure that any of the current cohort are really demonstrating that, or showing that sort of leadership or that sort of direction.

There's lots that I believe in in Europe. I mean we've got if you look at the number of patents we come up with, it's the same or more than you have in the US. But we seem to be very bad at commercialising these.

There's much that we have here as resource, but the moment it remains untapped. And at the moment I just think that politically, geopolitically, it's just going to be a tough couple of years. So my own thesis in Europe for what it's worth, I'm afraid, is you've got to be pessimistic, and I'm actually looking for things to get worse before they eventually get better.

Perhaps eventually, if we have a proper crisis, that will be the catalyst for a new sort of European energy to emerge. But I can't say that I see it at the moment. And honestly, Merz isn't much of a leader. I mean, you might say he's a bit better than Scholz, but he's not much of a leader. I don't really see him really transforming the agenda. I'd love to be wrong on that. I'll keep an open mind, but we shall see.

Second question. Do you foresee inflation in the US increasing this year?

Well, to my earlier points around tariffs, I think yes, there is more likelihood that you actually see inflation going a bit higher than a bit lower. You currently have core CPI a bit uncomfortably high already. It's running obviously above the Fed's target. But whether you end up hitting towards 4%, I'm hoping that you don't end up in a situation where the Fed does need to hike again.

But yes, we do see the risks to inflation going a bit higher than lower. And it's kind of interesting that Trump got elected on this idea that he was going to come in, and he was going to bring inflation down. He tells people he's going to bring inflation down. I just don't see which of his policies are actually going to lower inflation. Even when he says “drill baby drill”, it's not really done much to lower the oil price. Name me a policy that is actually driving lower inflation at the moment, I can't see one.

And I just have one last question. So, the thoughts of 9% real rates offered by Brazil, and also other attractive real rates in places like Mexico as well.

Now here, look, I think those real rates look very interesting. The issue in Brazil comes back to politics. Is Lula just going to go nuts ahead of the election the next election, and blow up the fiscal and blow up inflation in the process? This is the risk premium that's being attached to Brazil and is being attached to a President with a bit of a checkered track record, such as himself.

As for Mexico, I think that Mexico is a more fundamentally robust story, a more investable story, and I think the other narrative here is that for all of the beating up and all of the hard times Trump is giving to the Mexicans, in the short term renaming the Gulf of Mexico, the Gulf of America, and all of this crap he's been throwing at the Mexicans. I think the reality is that everyone knows it kind of suits the US to end up having a decent, positive, constructive relationship with its neighbour on its southern border. So ultimately, this is where I would be more hopeful that the US will end up with a better outcome.

Risk premium can actually start to mitigate, and I do see scope for Mexico to be bringing rates lower. So Mexican local rates, we think, is an interesting story, same in South Africa as well. But yes, there are stories we want to like, other stories like Brazil we may want to own as well. But I think we need to be very careful not just falling foul of something that looks like it's cheap because of the valuation. There are some big tectonic shifts in the plates that we're standing on at the moment, and you don't want to be caught on the wrong side of those.

With that I think that maybe is a good place to stop. Thanks for joining today. We'll be doing another one of these in a month from now. Love to get your feedback or any questions. Let us know if these podcasts are helpful and useful to you. But otherwise, I hope you've all started the year well and wish you all the best for the month ahead. Thanks bye.