Tariff-ying or tariff-ic?

Let’s start with the bad news. Forecasting the Trump administration’s next policy moves is challenging, and we see a number of events that may drive renewed volatility for US markets over the next few weeks.

We expect the US to announce tariffs on most major trading partners on 2 April. Differing global views on the nature of “reciprocal” tariffs could lead to a cycle of tit-for-tat escalation in the weeks thereafter. US inflation data on 10 April could contribute to shifting Fed rate-cut expectations. March retail sales on 16 April are another potential source of volatility given the focus on US consumer spending. Moreover, first-quarter earnings will be released from mid-April through early May. The direct and indirect effects of tariffs and trends in AI monetization will be high on investors’ agendas and could contribute to further volatility.

Now for the good news: News flow could become more positive toward the end of the second quarter. Although the Trump administration has expressed a willingness to tolerate economic “disturbances,” recent comments also suggest some flexibility in its reciprocal tariff plans. So far, the threat of tariffs has been followed by negotiations to soften them.

Also, House and Senate Committees are working on a budget reconciliation bill that would confirm the extension of the individual personal income tax cuts and the return of some expired corporate tax breaks under the 2017 Tax Cuts and Jobs Act (TCJA). Although the actual budget may not pass until later in the year, progress in negotiations would likely boost market sentiment.

We also expect the Fed to cut interest rates at its 18 June meeting if it sees signs of the labor market softening. A resumption of monetary easing could help instill confidence that a “stagflation” scenario would be less likely, support equity markets, and reduce volatility.

Fundamentally, we estimate that—all else equal—the effect of tariffs would knock around 2 percentage points off 2025 S&P 500 earnings growth in our base case. We now expect 6% earnings per share growth, and we have accordingly reduced our year-end target for the index to 6,400 (from 6,600). But this also means that, in our view, there is still meaningful upside by year-end. Despite weaker economic sentiment data, we believe the US growth and earnings backdrop remains positive, and key structural drivers like AI demand are intact.

We note that previously elevated investor positioning in US stocks has now normalized. US investor sentiment has also turned bearish. At the March equity low, only 19% of respondents to the American Association of Individual Investors’ (AAII) weekly surveys were expecting stocks to be higher over the next six months—lower than 98% of all readings since the survey began in 1987. Historically, when fewer than 25% of respondents to the AAII survey are bullish, a year later US stocks are 16% higher on average (with an 85% chance of a gain, compared to a 9% increase for stocks with a 78% chance for all 12-month periods over the past 35 years).

Figure 2: Weak investor sentiment toward US equities is usually a good contrarian indicator

Average S&P 500 returns after <25% of AAII respondents are bullish and all periods

While uncertainty related to AI monetization may also have played a role in the recent market volatility, we continue to believe that low-cost models like DeepSeek’s R1 will successfully coexist alongside leading frontier models and do not undermine the structural AI trend. Scale increasingly matters as large language models develop to become reasoning models. R&D intensity, measured as R&D spending divided by revenues, is higher in the US, at 13.5%, compared to 8% in China. However, this higher intensity is supported by the robust gross margins of US cloud platforms, which stand at around 70% versus 50% for their Chinese counterparts. We believe this advantage allows US companies to invest more heavily in R&D without sacrificing profitability.

We therefore recommend that investors take advantage of the current US market volatility and use the below “accumulation strategies” to build medium- and longer-term exposure to US equities and companies exposed to AI.

The threat of geopolitical crises, a change of government in Germany, and the Trump administration’s aggressive stance on tariffs have spurred European leaders into action, with the German parliament approving plans to ease the country’s fiscal restraints and exempt defense spending exceeding 1% of GDP from the country’s “debt brake.” While the funds will take time to come through, if Germany were to lift defense spending beyond 3% of GDP, we estimate the additional government expenditure could exceed EUR 1 trillion cumulatively over the next decade.

As we consider how investors should respond, we believe it is important to separate the short term from the longer term:

Looser fiscal policy in Germany, higher EU defense spending, and a potential Russia/Ukraine ceasefire are positive factors for European equities. Longer term, they can raise Europe’s trend growth, drive innovation, and potentially lower energy costs. We raised our index targets in February to reflect the emergence of these positives, and we forecast solid earnings growth of 5% in 2025 and 8% in 2026.

Near term, however, we believe it’s important to stay measured about a market (Stoxx 600) that has delivered as much performance in the year to date—around 8%—as it did in the previous 13 months. With drivers like greater fiscal spending now well known, we believe their ability to spur further gains for broad European equity markets may prove limited in the near term. The MSCI EMU currently trades on a 14.4x forward price-to-earnings multiple, above its historical average of 13.4x, though in our view valuations are supported by a decent fundamental outlook for the region.

Figure 3: Eurozone equity valuations are above their historical average

MSCI EMU, 12-month forward P/E (x) and historical average

Meanwhile, tariffs are a near-term risk for European equities. All else equal, we estimate a low-single-digit drag on earnings caused by first-order effects if a 25% tariff is levied on Europe. But the bigger impact could come from the hit to global GDP growth, as we estimate that every 1% reduction knocks off about 7% from European earnings.

In aggregate, we maintain our Neutral stance on Eurozone equities, and prefer selective exposure to the region. First, our “Six ways to invest in Europe” theme focuses on a selection of stocks exposed to positive European drivers (like pro-growth reforms in Germany or rising security investments), while also seeking to minimize exposure to tariff risks. Our current stock selection tilts toward the industrials, materials, real estate, and utilities sectors.

Second, we like Eurozone small- and mid-cap equities given their significant price-to-earnings discount compared to large caps, the largest in over 20 years. Small- and mid-cap companies have a higher exposure to the improved domestic growth outlook, and also offer exposure to structural growth drivers (including defense) owing to their high industrials weight.

While we retain a selective approach to European equities given near-term risks, a more favorable outcome on tariffs than we expect or a market pullback could create an opportunity for underallocated investors to build up their exposure to a more positive long-term story.

There are some exciting developments taking place in China right now. The release of low-cost, high-performance AI models—including DeepSeek R1, Qwen, and others—underlines China’s AI capabilities, and the recent National People’s Congress highlighted the importance of private tech innovation. Electric-vehicle maker BYD also announced battery charging and driver assistance advances.

However, like with Europe, we believe investors should stay measured about buying into a market after such a strong rally, especially given near-term tariff risks. The Hang Seng tech index is up roughly 25% year to date and has outperformed the US Nasdaq 100 index by around 57 percentage points since mid-September. The MSCI China index has rallied 17% year to date, yet we note that consensus earnings per share estimates for 2025 for the index have risen by only 0.3%.

Figure 4: The Hang Seng Tech index has outperformed the US Nasdaq 100 over the past six months

Nasdaq 100 vs. Hang Seng Tech index, rebased

While US tariffs on China have long been expected, the new round of tariffs could come with a relatively high headline number to serve as a bargaining tool. Overall, we believe greater tariff pressure may trigger stronger policy support to help keep China’s 2025 economic growth target of roughly 5% achievable. Nevertheless, given near-term tariff risks and the extent of the rally this year, we keep a more selective approach within Chinese equities and favor defensive strategies centered on state-owned enterprises.

In Asia overall, we believe the best current opportunities lie in Taiwan. We expect Taiwanese equities to benefit from an acceleration in AI capital spending by US megacap technology companies (the IT sector accounts for close to 80% of the MSCI Taiwan index by market cap).

While the near-term path is uncertain, we expect meaningful upside by year-end for US equities. We therefore recommend using volatility in the second quarter to build exposure to US equities and AI. We also like companies exposed to power and resources, and believe that Longevity will prove to be a transformational innovation opportunity over the coming years. As demand for products to extend healthy lifespans increases, select companies in the health care, medical devices, consumer goods, and real estate sectors are well positioned to benefit, in our view.

After notable rallies in European and Chinese markets, we are conscious that tariffs could prove a headwind in the months ahead. We therefore prefer a more selective approach in Europe and Asia, focused on the beneficiaries of higher European fiscal spending, Taiwan, and state-owned enterprises in mainland China.

Beyond equities, we believe investors should seek durable portfolio income. High grade and investment grade bonds offer attractive risk-reward, in our view. We also see other opportunities for seeking durable portfolio income, including through diversified fixed income strategies, senior loans, private credit, and equity income strategies. In currencies, we believe the US dollar could rally in the near term, but that its strength is likely to fade later this year. We expect the dollar to end the year close to current levels against most major peers, so we like strategies to trade the range in the months ahead.

Figure 5: Gold prices tend to rise during times of economic uncertainty

Gold, USD/oz (lhs) vs. Global Economic Policy Uncertainty Index (rhs)

Geopolitical and economic uncertainty has spurred demand for gold in the first quarter, pushing its price to record highs. We expect further, albeit more limited, gains for the metal, forecasting the price to reach USD 3,200/oz this year. Gold remains a valuable portfolio hedge, in our view.