Market uncertainty ramps up as geopolitical tensions rise

Market performance has been challenged over recent weeks. The more benign macroeconomic backdrop that investors had in mind going into 2025 has arguably been shattered. The U.S. administration’s challenges to the global trading and security order have the potential to disrupt trade, capital flows, consumption, investment spending, and government policy.

Going into the new year, it was broadly assumed that the global economy would continue to expand – primarily on the back of strong U.S. growth but with some improvement in Europe and China too. Equally, inflation was expected to hover slightly above central bank targets and generally move lower as policymakers kept interest rates close to neutral levels. In addition, bond investors’ concerns about government debt levels were expected to impose a degree of discipline on governments regarding fiscal policy which in turn would restrict the need for long-term interest rates to move up decisively. In equity markets, earnings could support stock markets and stable credit, and interest rates could support investors’ income returns.

Rising uncertainty

However, in our opinion, we can no longer rely on these assumptions, given the uncertainty created by rapidly changing geopolitical events. Investors now face ambiguity over economic growth, inflation, interest rates, and long-term borrowing costs – not to mention political risk.

Assumptions about corporate revenues, profitability, and cashflows have been markedly hit. All things being equal, this may be reflected in higher risk premiums on corporate assets as businesses face potentially challenging market conditions. In our view, tariffs are a clear threat to revenues; consumer uncertainty is another. Media reports have also suggested a decline in potential merger and acquisition activity. Recent economic data has been less compelling, and there is a risk that the data will highlight continued uncertainty among consumers and firms in the months ahead.

All this could mean lower price-earnings multiples for equities and wider credit spreads on corporate bonds. As we see it, the U.S. market is most at risk as these valuation metrics have been more extreme there than in other markets.

Potential for fixed income markets and the interest rate outlook is the need for European countries to increase defence spending in the wake of the U.S.’s threats to withdraw some of its overseas spending on security, including an actual or de facto U.S. withdrawal from NATO. Ukraine is the focus, and European leaders have pledged to defend Ukraine from further Russian aggression if the U.S. does not continue to offer security guarantees.

Security measures

But even with a U.S. deal, Europe can no longer take unconditional U.S. security support for granted, in our view. Hence, pledges to increase defense spending as a percentage of GDP could necessarily result in more permanent increases. This has been reflected already in higher European bond yields in anticipation of increased spending and borrowing. German government bond yields rose by as much as 30 basis points in a single day on 5 March, following the German government’s announcement that it would seek to massively increase spending on defence and infrastructure.¹  Increased government borrowing and spending both suggest a rise in long-term real interest rates and a structural increase in the neutral interest rate.

Broadly, our sense is that fixed income will re-price very quickly – a higher structural neutral rate will be reflected in steeper yield curves and a higher term premium. Once this adjustment has occurred, bonds will be attractive to investors given higher yields and the potential for income. When Germany experienced the fiscal shock of re-unification in the early 1990s, bond yields rose sharply in 1990 and remained at an elevated level for the following three years. Investors may need to prepare for a similar outcome as Germany again finds itself at the centre of a huge realignment of the European political outlook.

On the equity side, the trend of European outperformance that we have seen so far in 2025 should continue. The U.S. may be able to deliver tax cuts, but U.S. GDP growth has been quite close to its 10-year average growth rate for some time and there is little spare capacity in the world’s largest economy.

A fiscal boost may not allow any significant monetary easing. Meanwhile, there is the potential for more disruption to the U.S. from both tariffs and domestic policy uncertainty. Europe could benefit from increased government spending, and we believe rates are likely to remain at lower levels than in the U.S. European equity valuations have more upside potential versus the U.S, in our view.

The environment is rapidly changing and is highly unpredictable. However, there has clearly been a big geopolitical shift, and this should be growth-supportive in Europe (provided Europe does not actually have to go to war). If Europe is successful in securing an acceptable peace deal in Ukraine, we believe this should boost European corporate confidence as well.

Potential allocation tactics

The heightened level of uncertainty suggests reducing exposure to expensive assets – chiefly U.S. growth equities and U.S. credit. Uncertainty on policy and politics also means uncertainty on corporate revenues, profits, and cashflow. The biggest increase in spending is coming from European governments which could benefit companies in defense, transportation, technology, electronics, and energy sectors.

However, rates could be volatile as markets digest the impact of more government borrowing in Europe. We believe a higher global long-term interest rate – reflecting a higher neutral rate – should reprice fixed income. We are already seeing European bond yields move higher. In the short term, investors may consider opting for less volatile short-duration fixed income assets, particularly in their own currency.

Fundamentally, European equities appear to be a potentially positive area to be exposed to, with opportunities in companies that could benefit from increased spending on defense, security, and infrastructure. And if U.S. growth looks like it is stuttering, longer-term U.S. fixed income looks potentially more robust. Generally, bond markets may price in the new reality quickly while disruptions to equity revenues, profits and cashflows could be longer lasting. For now, exercising some caution is key.