KMD Economic & Market Update – Summer 2025
Markets bounce back as the world avoids a trade war
Stock markets have staged a remarkable turnaround over the summer. After the sharp falls which followed “Liberation Day” when President Trump announced tariff increases on the rest of the world, markets have rebounded and are currently reaching new highs in the US and UK.
The increase in optimism has been underpinned by several factors. First, the world has not descended into a chaotic trade war as many had feared on 2nd April. The only country to meaningfully retaliate was China which imposed steep tariffs on US goods, but elsewhere countries stood back and agreed to negotiate.
In doing so they recognised that the initial tariffs announced by the president were a starting point for talks. Past experience indicated that this was the President’s modus operandi. The UK was first to agree terms and deals have now been reached with a number of key players such as the EU, Japan, Indonesia and Vietnam. Even China is now negotiating.
Some have described the rally in markets as the TACO trade – Trump Always Chickens Out – a reference to his tendency to back track and not follow through on initial threats. Indeed, the President has extended the deadline for tariff hikes several times, triggering strong market gains on each occasion.
However, whilst such delays may be fuelling the TACO trade, the trade deals reached suggest the capitulation is more on the other side.
Looking at the recent US-EU deal announced at Turnberry on 27 July, US tariffs on EU exports are still rising from around 1% before Trump took office to 16%. The EU is also committed to invest more in the US, whilst here have been little if any concessions on the US side. Judging from the French and German reaction the EU do not look like the winners in this negotiation. Trump is doing exactly what he said would during the MAGA election campaign: leveraging American power to get a better deal for the US.
Meanwhile, the US economy is holding up well. The latest estimates put real GDP growth in q2 at 3%, job growth continues at a healthy pace and inflation remains relatively well contained. The economy will gain modest short term stimulus as the recently passed One Big Beautiful Bill Act (OBBBA) helps boost spending later in 2025 and early next year.
Elsewhere, economic activity is less robust. The UK lost momentum in q2 after a strong start to the year. Some of this is an unwind of spending brought forward to beat tariff increases in q1, but business has been critical of the increase in National Insurance contributions for employers and layoffs and unemployment are rising. As the labour market cools, households appear to have slowed their spending so as to boost savings, a clear sign of caution. Inflation has picked up to over 3% and the Bank of England held interest rates at its June meeting.
Despite these developments the FTSE-100 has risen to new highs. The disconnect can be explained by the international nature of the UK large cap index which has noticeably outperformed the more domestic mid and small cap indices. Weak economic activity is also taking a toll on the public finances and there are concerns that taxes will have to rise again in the Autumn if the Chancellor is to stay within her fiscal rules. At this stage the government are ruling nothing out and there has been ominous talk of wealth taxes.
Looking ahead there are two areas we are watching closely.
The first is on the impact of tariffs on economic activity and inflation. There were some signs of higher prices for imported goods in the US in the latest figures. These were largely offset by lower energy prices and a continued moderation in service sector inflation. As firms run down the inventory built up ahead of the tariff increases we can expect goods prices to accelerate and put more pressure on inflation.
The issue is a major concern at the US Federal Reserve and has been cited by chair Jay Powell as a key reason why the US central bank has refrained from cutting interest rates this year. Of course, the President does not agree and continues to pile pressure on the Fed to ease.
Some companies are absorbing tariff costs in order to keep prices competitive, should they do so in sufficient numbers and the favourable trend in energy and service prices continue, then inflation should be stable allowing the Fed to ease. The point is though that with the economy growing, chair Powell and the Fed can wait. The president’s patience is set to be tested further.
Meanwhile, the Bank of England is in a different position and most economists expect a rate cut in August. The balance on the Monetary Policy Committee has been moving in favour of easing and despite the stickiness of inflation, growth concerns are likely to swing the vote towards another quarter point cut.
The second area of focus is the increase in government debt, not just here in the UK but globally. The OBBBA is expected to add some $3 trillion to US government debt and although this will be partly offset by higher tariff revenue, the net increase is expected to be over $1 trillion according to the independent Tax Foundation. Coupled with higher European borrowing, particularly in Germany with the lifting of the debt brake, there are worries that the supply of government bonds will outpace investor demand. At this stage bond markets are pricing many of these risks in given the level of interest rates, but investors will be vigilant for signs that political pressure will raise deficits further.