US-EU deal welcome news in markets with little room for error

The US and the European Union (EU) have reached a trade agreement, averting a worst-case scenario of a more damaging trade war. Although the latter was most definitely not a base case, and thus market reaction is likely to be contained, this is still good news for the global economy given that some uncertainty has been removed from one of the largest bilateral trade relationships in the world.

Similar to the deal with the UK and others, details are yet to be ironed out, but we do have a few numbers that are important. The headline tariff rate will be 15% which includes autos and other significant sectors (i.e. good news as 15% is lower than current tariffs) but does not include steel and aluminium (i.e. bad news as these will still be subject to a 50% tariff). The EU will also spend $250bn per year over the next three years on US energy products, invest $600bn in the US, and continue to buy US military equipment. Again, details are scant but at first glance it seems the energy import number will be almost impossible to achieve. Taking Eurostat data, the value of all energy imports in the EU in 2024 was €360bn. A back-of-the-envelope calculation puts the US share of these monies in the region of €60-70bn last year. The agreed foreign direct investment (FDI) of $600bn (assuming it’s spread over three years) looks more reasonable; the US Bureau of Economic Analysis estimates that last year, the increase in FDI from Europe amounted to $204.7bn. Regarding the military spending, there is no set number at this stage but it is not a surprise that Europe will continue buying weapons and other military equipment from the US, though we expect these amounts to gradually decline as Europe ramps up its own military industry.

Similar to the UK agreement, this is a suboptimal outcome for the US, the EU, and the global economy, but at the same time it is one that the economy might be able to withstand without cataclysmic consequences at the macro level. Forecasters have already adapted their projections incorporating a tariff rate in the region of 10-15%. In addition, markets have had a few months to digest what this sort of outcome would mean for corporates and growth projections; the conclusion seems to be that certain sectors such as autos will take a large hit, while the rest will be impacted indirectly via suboptimal growth rates but will live to fight another day. One of the main points behind this conclusion is that the services sector, which represents approximately 90% of the economy in countries like the US and the UK, will only see a minor direct impact. Another implicit one is that the unemployment rate will only increase slowly and not by much in the coming quarters. We see merit in these assumptions, but we do acknowledge that history suggests a slow and steady rise in unemployment is as rare as a slow and steady widening in credit spreads, and therefore caution is needed in asset allocation.

Again, markets had already priced in some sort of deal along these lines, which is why we expect a positive yet muted reaction to the news. In other words, markets projections have been validated at least for now. With spreads at close to all-time tights in certain markets, it is quite important that “positive” base cases actually come to pass as the margin for error is small. In fixed income, the technical picture remains very strong with new issues multiple times oversubscribed. In secondary markets we are finding it much easier to sell than to buy bonds at the moment, another sign of a robust technical picture. Although there are some signs that retail monies are excessively optimistic, with “meme stocks” making a comeback for example, we do not get the impression that institutional monies are following the same path. Investors still look to be treating underperforming businesses with the appropriate caution. As an example, while CCC rated issuance in Europe has picked up from the lows of previous years, it remains low by historical standards. Senior secured bonds meanwhile have accounted for 61% of total primary issuance so far this year, a historic high, at the expense of more subdued senior unsecured deals.

The favourable technical picture does not tell the whole story though. Fundamentals remain solid, with earnings releases so far bringing no negative surprises from a credit point of view. Banks have posted good numbers so far with low non-performing loans, decent margins, and healthy returns on equity. When corporate fundamentals are good, the chances of a recession are relatively low, technicals are strong, and spreads largely incorporate all of the above, the result is tight spreads. As asset allocators, our approach to this situation is to maintain an overweight in credit but focus on higher quality and relatively short-dated bonds, in addition to keeping plenty of dry powder to deploy if spreads were to widen. While the news of the US-EU deal is welcome, we do not see this as reason enough to change that approach.