Overview
Since Liberation Day on April 2, global markets have seen a broad-based rally across risky assets. Global equity markets are up, high-yield credit spreads have narrowed, and gold and bitcoin have rallied — all despite largely flat long-term bond yields and only a modest, on net, across most developed economies. The latest BofA Global Fund Manager survey shows cash levels (as a share of AUM) are at the lowest levels since 2021 as investors have broadly rotated out of cash and into assets. The rally has been fueled by a variety of confluent factors. Economic data has shown greater resilience than expected in early April, while price pressures have so far proven less widespread than anticipated. Additionally, the US has announced a number of deals and concessions with trade partners, though policy uncertainty remains extremely high and these agreements are largely non-binding frameworks rather than formal trade deals. Meanwhile, countries worldwide have announced fiscal spending increases as they seek to reduce reliance on the US, particularly in defense. Finally, strong risk appetite continues among both retail and institutional investors.
Looking ahead, market pricing looks overly optimistic given the latent risks. Investors today may be complacent with respect to risks to the economic outlook and financial markets stemming from geopolitical tensions, emerging mercantilist policies, or a challenging fiscal outlook especially in the US. Many investors, accustomed to the benefits of globalization, have not had to reckon with geopolitical and fragmentation risks. Many have never lived through a prolonged downturn in US equity markets and have only experienced equity downturns where the most profitable strategy was to buy into equity market corrections, often on the back of central bank support. While the equity rally and the underlying robust risk appetite may continue for some time, risk-asset valuations appear to be increasingly stretched and predicated on expectations of monetary policy easing in the US. Today’s constellation of asset prices and concentrated exposures in US dollar and US equities may turn out to be a challenging environment for investors, raising the probability investors could see a period of more mediocre returns:
While the US economy has so far proved more resilient than expected despite tariffs set by the US Administration at levels not seen since before WWII, the most recent data shows some softening in the US labor market and in consumer spending. Meanwhile, price pressures are increasing at a time when inflation is still uncomfortably above the Fed target. Just this week, July CPI data showed headline inflation at 2.7% and core inflation 3.1% – both readings well above the Fed’s target. And that’s all before the full impact of trade and immigration policies has materialized (e.g., changes in immigration policy take 6-12 months to impact the labor force, tariff impact has been delayed thanks to front-running by importers and reportedly reluctance to fully pass on higher costs to consumers). Directionally, the US new trade and immigration policies will likely be stagflationary – the question is to what degree, who will ultimately absorb price pressures (firms or households), and the extent to which other economic forces may partly offset these pressures (e.g., AI capabilities build-out, resilience consumer and firms balance sheets, etc.). For example, recent GDP data showed that AI-related capex likely contributed to around half of US economic growth in the second quarter.
An additional risk is that the US economy and consumer spending is increasingly reliant on household wealth, with important distributional implications – US household savings rates are below pre-COVID levels and US households have the greatest share of wealth concentrated in corporate equities today than we have seen in decades. As a result, a pullback from risk taking and prolonged equity weakness could have significant implications for consumer confidence and spending appetite.
The Fed is facing a difficult tradeoff treading the delicate balance of containing inflationary pressures while promoting maximum employment. While the Fed is rightly focused on price stability to prevent an unmooring of inflation expectations amid heightened uncertainty about the outlook, the risk of a wait-and-see approach is that it may find itself falling behind the curve in the event of a more pronounced economic slowdown. At the same time, cutting too early without a clear indication of whether inflationary risks will materialize or not, would pose a threat to its credibility in the event of a more sizable and persistent rise in inflation in coming months. To complicate things, the Fed is facing political pressures from the Administration, and a threat to its independence that could severely impact its inflation-fighting credibility.
All of this is occurring against a backdrop of large fiscal deficits and high public sector debts – this is a global phenomenon. The passage of the One Big Beautiful Bill in the US sets the stage for US fiscal issuance to remain very high, just as the supply of long-term debt from other advanced economies is set to rise. For example, earlier this year Germany relaxed long-standing debt limits in order to increase spending on defense and infrastructure (and while there’s been no change in EU-wide debt limits, EU finance ministers are actively debating how to balance debt reduction goals with investment needs). In Japan, elections have recently taken a more populist turn, increasing the odds of greater fiscal spending, just as the Bank of Japan is dialing back its purchases of Japanese government bonds. The large and growing supply of government debt that must be absorbed by the private sector is likely to put upward pressure on long-term rate (potentially crowding out the private sector).
Despite this backdrop, equity market valuations remain elevated relative to history, especially in the US. This optimistic pricing could prove justified if, for example, recent technological advances and AI innovation continued to support robust revenue growth (with US companies capturing even more global market share) or even more elevated corporate margins. However, stretched valuations do leave equity markets more vulnerable to shocks and exposed even to more modest disappointments (and for non-US investors, disappointing equity returns could stem from ongoing dollar weakness as we saw earlier this year if their US equity investments are unhedged). It is worth noting that many unexceptional US companies are trading at exceptional valuations (i.e., elevated US equity valuations is not just a big tech story). Many US companies are also highly exposed to the cost burden imposed via the US tariffs – for example, we have recently seen Apple’s CEO take extraordinary actions to appease the White House in an attempt to avoid paying high tariffs.
While these risks suggest reasons for caution, market participants have largely shrugged off such concerns and continued rotating into riskier assets. The performance data below illustrates this dynamic clearly. The table highlights market action year to date, since Liberation Day, and since our last Roundup. While there are idiosyncrasies across economies and different asset markets, the broad rotation into risk assets remains the dominant theme.
This next set of charts take a step back and provide a longer historical perspective across financial assets. Equities are trading at all-time highs and US exceptionalism remains more or less intact (despite US dollar weakness since the beginning of the year and some equity market underperformance even in local currency terms earlier this year, US equities outperformance over the last few years is very much intact). Credit spreads continue to be very narrow by historical standards. Gold and Bitcoin have also rallied significantly in recent years. Long-term rates, after rising sharply from their pre-covid lows, have stayed within recent ranges. The only sign of economic weakness reflected in markets is in some modest easing expected in short-term rate markets.
Geopolitical Uncertainty is Still High – but Investors Have Learned to Be Complacent Regarding Geopolitical Risks
While there’s been some walk-back in the sky-high tariffs that were threatened back in April, US effective tariff rates remain well above the start of the year and are still the highest trade barriers the US has seen since before WWII.
Moreover trade policy uncertainty remains high. The policies already enacted will have adverse macroeconomic consequences that are still likely ahead of us (with delays in flow through to consumer prices due to front-loading earlier this year by US importers and some reported reluctance by firms to fully pass on higher costs to customers). In addition, there will likely be knock-on policy consequences in terms as other countries reshaping their own trade alliances and implementing with policies designed to reduce reliance on US markets.
Despite the reasonably seismic reshaping in the global economic and financial order, market moves have been fairly modest since Liberation Day. This may in part be due to complacency – many market participants today have never lived through a prolonged equity market downturn. These investors have only experienced an environment where the most profitable trading strategy has been to buy aggressively into any equity market downturn. This isn’t just about the most recent retail investors’ “buy the dip” mentality data shows that public pensions have increased their risk exposure over the past 30 years, investing more in publicly traded stocks and in private markets (like private equity and private credit), as they continue to bet on a long, nearly endless bull market.
One perspective on the rise in investor risk appetite that’s played out in recent months is provided by the Bank of America fund managers’ survey – the latest reading points to the lowest cash levels (as a share of AUM) since 2021 at least.
The US Economy has Provided Surprisingly Resilient – but the Effects of Tariff and Immigration Impacts are Trickling Through
Importantly, consumer and business confidence have improved and inflation expectations have come back down some – likely as tariff threats were walked back, some semblance of non-binding deals with US trading partners were announced, and tariffs didn’t immediately flow through to the prices faced by consumers or small businesses.
While much of the adverse tariffs and immigration policy change impact is likely still ahead of us, there have been some emerging signs of stagflation in July and early August.
The labor market is cooling off and consumer spending is slowing. Inflation, in the meantime, remains well above the Fed’s target, and that’s before the tariff pressures have really flowed through to consumer prices (import price indices have modestly ticked up, pointing to rising inflationary pressures).
This does not necessarily mean that the US economy will fall into a recession, as there could be other economic forces providing some offset.
First, the tech firms’ spending going towards building out AI compute capabilities is very large. The chart below shows the share of recent overall US GDP growth that may reasonably be attributed to the AI build-out (practically, the contributions to GDP growth from business investment in information processing equipment and in intellectual property). Around half of the growth last quarter could be attributed to AI investment (assuming these categories of business investment today are largely being driven by the AI capabilities build out).
For the companies driving this capex spending, mostly US mega-cap tech companies, the investment on these technologies is existential to their business models and is largely (albeit not entirely) being funded out of operating cash flows (as these are historically high margin, massively profitable enterprises), not out of borrowing. Thus, AI capex is less sensitive to cyclical economic conditions and changes in borrowing rates compared to business investment of past economic cycles.
That said, AI capex growth has been so large that analysts expect tech capex to continue to grow at a lower rate, so that the peak boost to overall US GDP growth is likely behind us. The mega cap US tech companies are increasingly diverting more and more of their cash flows to capex, and these cash flows are nearly tapped out (for example, Meta recently announced they would tap private credit markets to continue to fund their datacenter build out).
Second, the most recent economic cycle has been fueled largely by fiscal borrowing — businesses net credit creation has been muted and consumers have actually reduced their credit liabilities. For businesses and households, increases in spending must either be driven by income growth, lower savings rates, or borrowing. Historically, economic cycles have been exacerbated by a contraction in private sector credit; but with US business and household balance sheets in the best shape in decades, the private sector is expected to show greater resilience compared to past economic cycles.
US economic outcomes may however be exposed to a sharp, prolonged decline in equity prices . When equity markets rally strongly, households feel more confident and spending increases (so-called wealth effect). Equity market rallies also increase the savings pool that households have access to spend down. The opposite effect occurs when equity markets fall.
Today, the US economy may be especially exposed to wealth effects. US households have a historically high share of their total wealth held in corporate equities and household savings rates are exceptionally low already, creating a significant vulnerability if an equity market downturn were to cause households to increase their savings rates. In terms of distributional effects, the top 20% of households by income have driven a disproportionate share of recent consumer spending growth, suggesting that their behavior may have a pronounced impact on the US economy in the event of sharp equity price drawdowns.
Markets Expect Monetary Policy and Fiscal Policy to Provide Support this Year – but The Federal Reserve is Facing a Difficult Set Up
With emerging signs of economic weakness, markets are discounting modestly more Fed easing compared to pre-Liberation day, even though US monetary policy does not appear to be overly restrictive and financial conditions as a whole have actually eased since early April. One phenomenon that is emblematic is the increase in financial deal activity seen in recent weeks, with investment bankers pointing to some of the greatest volume of deals in months over the last few weeks of July and into August.
Fiscal policy is set to become modestly more stimulative next year. For example, the Yale Budget Lab estimates that the One Big Beautiful Bill Act (OBBBA) will boost GDP growth 0.2% per year in 2025 through 2027. Because of the deteriorating fiscal outlook, it also estimates that the OBBBA will raise interest rates in the long-term.
Combined easier financial conditions and modestly greater fiscal support will likely help offset some of the tariffs adverse impact on economic activity over the next year. But the Fed faces a challenging tradeoff amid elevated economic and policy uncertainty. Easing too late risks falling behind the curve, especially in the event of a significant economic slowdown putting downward pressure on prices. Easing too early, however, without clear signs of limited inflationary effects from tariffs risks de-anchoring inflation expectations.
Global Policymakers are Responding to the New World Order with Stimulative Policies – As a Result, Elevated Fiscal Issuance Levels are Here to Stay
Rather than responding to the US with retaliatory tariffs, most policymakers around the world have taken steps aimed at reducing reliance on the US, such as increased spending on defense and infrastructure, measures designed to increase domestic investment, or policies supporting strategic industries. Below are some examples:
Many countries are reducing reliance on US defense capabilities and ramping up their own defense spending plans. Most notably, NATO nations agreed to boost defense spending targets to 5% of GDP by 2035 (with at least 3.5% of GDP on core defense requirements, up from a current target of 2%).
- Germany relaxed its constitutional debt break in March and Canada has similarly committed to raising defense spending to 2% of GDP this year.
- Japan and Australia agreed to an arms export deal with Australia acquiring 11 stealth warships from Japan – a major step forward for Japan’s revision of its post WWII ban on arms exports.
- Recently, India has allegedly refused USA’s offer to buy F-35 stealth fighter jets (with limited technology transfer), indicating an obvious shift in its defense strategy. It is now reviewing Moscow’s offer that allows for up to 60% localization and complete technology transfer.
Countries are also increasing investment in infrastructure and committing to policies that incentivize domestic investment. Some examples:
- In June, Korea passed a second supplementary budget for 2025, totaling over $10bln, which focused on targeted investments in infrastructure, semiconductors, renewable energies and logistics.
- The UK revealed a ten-year industrial strategy plan in June, designed to lower electricity expenses for businesses by as much as 25%, unlock billions in investment, and support 1.1 million new jobs up to 2035.
- In the UK, pension providers have been signing on to the Mansion House Accord, which aims to drive long-term investment in the UK. The accord is a voluntary expression of intent to invest at least 10% of funds in private markets with at least 5% allocated to the UK.
- Last year, Canada began looking at ways to incentivize increased domestic investment from Canadian pension funds.
In this context, the supply of public debt is likely to increase for some time. Large fiscal deficits across economies where inflation has been running hot have forced central banks to keep rates elevated at a time when global central banks have moved to shrink their balance sheets, putting upward pressure on long-term rates.
Going forward, continued large fiscal deficits will continue to affect both the shape of the yield curve and the level of interest rates, keeping private sector borrowing costs elevated and raising the specter of a deterioration in market functioning, as seen back in the Spring in the US.
Equity Market Valuations Reflect Optimism, Especially for US Companies
Despite these concerns, equity market valuations (as proxied by forward P/E here) have continued to rise, contributing to more than half of equity market gains (beyond what is accounted for by near-term expected earnings growth) for most major global equity indices this year. At this point, US equity market valuations are close to historical record in the US and reasonably elevated across other developed markets (particularly after accounting for the global post-COVID rise in real interest rates, which should theoretically impact the present value of future cash flows and reduce the price investors would be willing to pay today for those future cash flows).
The fact that valuations are elevated, per se, does not necessarily mean that future equity returns will be lower or that equities are “expensive” – valuations reflect investor expectations for future earnings growth and additional compensation required by investors for bearing equity risk (the so-called “equity risk premium” related to uncertain equity cash flows). One possibility is that investors are rationally discounting stronger long-term real earnings growth prospects for corporations (for example, corporations could benefit from increased government spending in defense). Investors may also be betting that corporations and shareholders will capture a greater share of economic activity (and labor a smaller share) as AI technologies drive down the value of labor, allowing corporate margins to continue to rise to secular highs.
That all said, elevated valuations increase equity markets’ vulnerability to earnings disappointments or shocks. In the US, elevated US valuations is not just a story about the magnificent 7 stocks that are the most clear AI beneficiaries. In fact, many “unexceptional companies” (i.e., companies with mediocre earnings growth prospects) trade at “exceptional” valuations (historically elevated P/E level despite relatively elevated real rates). As one other example of the potential “froth” in equity markets today, we’ve seen a slew of companies embrace crypto treasury strategies in an effort to boost their share prices – in a number of cases, the purchase (or even the announcement) of crypto purchases has catalyzed a significant share price rally for this basket of largely unprofitable software companies.
Even for the hyperscalers (companies offering cloud computing infrastructure and services capable of handling very large volumes of data and workloads across a global network of data centers), there are key risks for their long-term earnings to watch – most critically, while AI technologies may allow these companies to grow their revenues, these technological capabilities also come with huge costs. All of the investment these companies are funneling into information processing equipment is cutting into these companies’ cash flow generation – with implications for other investments and for buybacks, as AI investment implies less cash to return to shareholders. Eventually, when depreciation costs come due, there will also be implications for earnings.
It’s also worth noting that US corporate profits relative to total US economic activity are historically elevated – corporations and equity shareholders have captured a greater share of economic activity relative to labor. Of course, AI technologies could mean this trend may continue, but other forces, including tariffs, will likely pressure corporate margins in the other direction.
Special Feature:
The GENIUS Actby Rashad Ahmed
The market capitalization of US dollar stablecoins – digital currencies pegged to the US dollar (USD) – has grown 25% since January of this year and currently hovers around $250 billion. Today, stablecoins are mainly used to facilitate cryptocurrency-related activities but they are expected to grow into an expanding set of use cases now that the GENIUS Act is signed into law.
The GENIUS Act provides the first legal framework for the issuance of USD stablecoins in the United States. Under the Act, USD stablecoin tokens must be backed one-for-one with high quality, liquid, USD-denominated reserve assets such as US Treasury bills, bank deposits and reverse repos. Monthly auditing and public disclosures of reserve assets are required, as are appropriate capital, liquidity, and risk management protocols. Stablecoin issuers must also provide adequate consumer protections and comply with anti-money laundering laws under the Bank Secrecy Act. Stablecoins with outstanding supply exceeding $10 billion will generally fall under federal oversight while smaller stablecoins can opt for state-level supervision. Unlike bank deposits, stablecoins are not insured by the FDIC or any other government agency.
Some estimates of USD stablecoins future growth point to a $2 to $4 trillion market by 2030. Much of these projections are based on the expectations of rapid crypto market development or innovation within the fintech industry. In addition, USD Stablecoins may go mainstream as a digital means of payment. USD Stablecoins may also become a popular cash substitute for those involved in informal, cash-based economies, thereby increasing financial inclusion. Outside the US, USD stablecoins may see some success as a savings vehicle that is more accessible and portable than physical US dollars. Others see the supply of USD stablecoins continuing to grow proportionally with an increasingly global cryptocurrency market.
USD Stablecoins already show signs of deeper integration with financial markets. As of March 2025, USD stablecoin issuers held over $100 billion of US Treasury bills in their reserve portfolios. Some market participants view this as a positive development. US Treasury Secretary Scott Bessent communicated that USD stablecoins and the passage of the GENIUS Act will help finance the US budget deficit while ensuring the reserve currency status of the US dollar. However, USD stablecoin issuers’ growing footprint in Treasury markets also poses financial stability risks. If the USD stablecoin market grows sufficiently large, then the corresponding purchases of US Treasury bills could distort market prices and interfere with the Federal Reserve’s monetary policy objectives. A parallel increase in the supply of US Treasury bills may alleviate some price pressures, but that could be challenging given the already large share of Treasury securities accounted for by Treasury bills. Runs on USD stablecoins could amplify financial distress if issuers were forced to liquidate large quantities of their reserve portfolios to meet redemptions – raising the prospect of the need for a public backstop in a severe scenario. And so long as stablecoins continue to facilitate cryptocurrency market activity, crypto market shocks risk propagating to the traditional financial system, especially given the growing interconnections between crypto with financial institutions.
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