March 31st, 2025 - The "R" word is now replaced with the "S" word.

It is remarkable how fast markets have moved from the "animal spirits", boom scenario to a possible recession and now to stagflation in the US, which would be a nightmare scenario. Perhaps President Trump underestimated the huge effect of his erratic policies on the US consumer, who is now planning to cut spending but also sees higher inflation ahead. Stagflation is the economic term which describes low economic growth, high unemployment and high inflation. In this scenario, the central bank cannot lower rates to help the economy because it endangers a further spike in inflation. Eventually, of course, weak economic activity will impact inflation and provide the ground for monetary easing, but in the meantime both equity and fixed income markets might suffer. It is no surprise that the only beneficiary of stagflation, Gold, reached a record high last week, trading north of 3100$.

We must keep in mind that the stagflation scenario is currently based on the so-called "soft data", or in other words the sentiment metrics. As recent months have shown, sentiment can change rapidly again, to a more positive mood and markets will respond. However, sentiment has an impact on the consumer and businesses willingness to spend and invest and the more time we stay at these subdued levels, then the "hard data" will begin to show the true impact on the US economy.

The US February PCE prices (which is the FED's official inflation gauge) did not show any improvement on the inflation front. The PCE rose 0.33% in February, broadly in line with expectations, but we should note that the 0.33% monthly increase follows on the 0.30% in December and 0.34% in January, three consecutive months well above the pace of the previous six months. In order to reach the 2% FED's target, all other things being equal, the average monthly change has to drop to just 17bp. As a result, the 12-month headline PCE inflation was essentially unchanged at 2.5%. Core inflation rose to 2.8% vs expectations to remain unchanged at 2.7%. The data are consistent with the FED's wait-and-see stance, especially since consumer inflation expectations are also on the rise.

To complicate matters worse, the PCE report showed weak real consumption. Real spending rose just 0.1% over the month of February, following January's 0.6% decline with cumulative revisions of -0.1%. Real spending on goods rose 0.7% over the month, after falling 2.1% in January, and real services spending fell 0.2% in February, after rising only 0.1% in January. All these data do not bode well for 1st quarter US GDP.

US consumer confidence continued to drop like a stone. The Conference Board consumer sentiment tumbled 7.2 points to 92.9 in March, a low since January 2021 and below consensus (94.0). Amidst the ongoing uncertainty in the outlook, the deterioration was concentrated in the expectations index which fell 9.6 points to 65.2, well below the 80 mark typically consistent with recession and the lowest level since January 2013 !

The 2nd of April has been dubbed by President Trump as the "liberation day", when he is expected to announce the final (?) spectrum of global tariffs. Whether these will be better or worse than feared is anybody's guess. What matters is that there seems to be an acceptance of short-term financial pain and a 10% correction on the S&P500 has not caused any concern in the presidential entourage so far.

On the contrary, Eurozone inflation seems to be moderating. The March CPI in France was announced at 0.9%, lower than expectations (1%) and in Spain it fell to 2.2% from 2.9% and also lower than expectations (2.4%). Today we are waiting to hear from Germany, where inflation is expected to fall to 2.3% from 2.6%, while on Tuesday the Eurozone composite number is expected to drop to 2.2%, and very close again to the ECB's target. If we get a positive surprise from Germany, then we could assume that the Eurozone number could drop closer to 2% even this month.

The Eurozone March PMI increased marginally by 0.2 points to 50.4, but less than expected (50.7). This round of PMIs was awaited eagerly to gauge whether the announcement of fiscal expansion in Germany has already helped to lift sentiment in Europe. It is too early to see this reflected in output and orders, but the decline in the 1-year ahead output expectations (-1.7 points to 56.9) is a bit disappointing (even though the German reading was up moderately). The relative stability in the Composite PMI reflects divergence between services and manufacturing. Specifically, the Manufacturing PMI was up 1.1 points to 48.7, the highest level since January 2023. The Services PMI declined 0.3 points to a four month low of 50.4 with declines in both business activity and incoming new business. This is the third consecutive month of improving Manufacturing but falling Services PMIs, which bodes well for future inflation.

In this environment, global equities stumbled for the week. The S&P500 dropped 1.5% and more worryingly failed at its attempt to overcome the 200-day moving average. It now sits just 1% higher from this year's low and is down 5% year-to-date. Nasdaq lost 2.5% and is now back to this year's low and -10% for the year, which could theoretically provide a double-bottom technical formation. Europe also lost 1.5% on average as profit taking kicked in. All sectors were negative on both sides of the Atlantic, with European Energy, however, continuing to perform well with a 1% weekly gain and up 13% for the year.

Bonds rallied both in the US and Europe. The weak US consumption and confidence numbers combined with the benign inflation numbers in the Eurozone brought buyers back into the market. The US 10-year yield fell close to the recent low, trading at 4.23%, while the German equivalent fell to 2.73%, very close to the lowest level for the month of March. Of course, if stagflation fears continue to dominate, the US yield curve will start moving higher again, perhaps taking with it the German one. We would be buyers of 5-6 year EUR bonds on any rise again.

Chart of the Week : European equities have not priced the tariffs risk, as much as their US peers.

The above chart, compiled by UBS,compares the performance of US and European stocks in sectors that are expected to be impacted by tariffs. While in both regions these sectors have underperformed the broad market, the US pricing looks far more advanced. According to strategist, Gerry Fowler, it is interesting to consider how analysts are adjusting sales and earnings forecasts for 2025. In the US, sales and earnings growth estimates have been falling and the sectors more likely to be impacted (e.g., Consumer Durables, Retail, and Autos) have seen some of the more significant estimate downgrades. In Europe, sales estimates are generally up, earnings estimates stable, and there is no obvious underperformance of expectations in the tariff-sensitive sectors (e.g., Autos, Pharma, and Luxury). This creates the question whether EU investors are not yet pricing enough of the actual earnings impact of tariff escalation. This week might provide more information and potential downgrades, which would then create buying opportunities as Europe is about to engage in large fiscal stimulus.

Disclaimer

• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.

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• Sources: Chart of the Week : UBS