Market Know-How 2Q 2025
Nexus
A set of sweeping "reciprocal tariffs" announced by the Trump administration on April 2 has sparked the latest bout of risk-off sentiment, adding to escalating uncertainty for investors. Economies, financial markets and geopolitics have always been interlinked. But in recent years, the nexus has become more complex, as governments have introduced tariffs and other protectionist measures in response to a more fractured geopolitical landscape. We believe this creates both complex challenges and new opportunities.
The evolution from a world of US unipolarity to a more fractured and multipolar geopolitical landscape has significant ramifications for policymakers and investors alike. Long-delayed investments in areas related to security and defense have been catalyzed by recent developments, perhaps most notably in Europe. This has tangible consequences for fiscal dynamics, alongside relative growth and inflation rates across economies, but also for bond issuance and global capital flows—the net impact of which may be to make exchange rates more volatile in response to a fluid geopolitical-economic nexus. For investors, questions around whether to hedge FX exposures become paramount.
Similarly, in a world in which performance across and within economies, asset classes and sectors may become more dispersed, strong flows into purely passive investment strategies until now may be partly supplanted by demand for a more active overlay: active ETFs therefore look set to become a more widely utilised building bloc within multi-asset portfolios.
And for firms with complex, international supply-chains, the lessons to be drawn from both the debilitating experiences of COVID and the recent geopolitical disharmony, include a need to build-in enhanced resiliency to production processes. This suggests a continued and accelerated shift away from "just in time" production models, to "just in case" industrial bases in which there is equal regard to both efficiency and robustness. The resulting adoption of "China+1" models may be to the benefit of economies such as India which can offer large pools of skilled labor and comparatively lower costs of production, while being situated in jurisdictions that are not at the epicentre of current geopolitical confrontations.
In this latest edition of the Market Know-How, we unpack various elements of that nexus of geopolitics, economics and financial markets, to think about solutions around not only where to invest and which asset classes, but also how to invest. Each dimension of that question requires careful consideration and, potentially, a re-examination of pre-existing approaches to investing.
Short-Term Macro Themes
We expect global growth to remain resilient amid robust private sector fundamentals and looser monetary policy. That said, downside risks have increased and the US exceptionalism narrative—an important driver of markets for the past few years—faces an increasingly uphill battle amidst ongoing US policy uncertainty and Europe’s wake-up call.
US Exceptionalism No More?
- Our base case scenario is still one in which trade and policy uncertainty eventually subsides allowing global growth to remain resilient, the disinflationary process to continue, and central banks to cut rates further, albeit with regional differences. However, recent data have put US exceptionalism into question.
- We have always been of a view that the sequencing and the details of the Trump Administration’s policies, together with the broadening of AI-related capital spending, would be key factors in sustaining US growth this year. Since the start of 2025, a much tougher stance on tariffs, extensive DOGE cuts, as well as a focus on fiscal austerity and the release of new AI models in China have challenged US growth expectations. At the same time, an unprecedented U-turn on fiscal policy in Germany, combined with EU defense spending, have significantly improved prospects for the European economy, pointing to a reduction in the growth gap between the two regions.
Tariffs, Tariffs Everywhere
- On April 2, President Trump announced a broad "reciprocal" tariff plan with two parts: a 10% baseline tariff on imports from all countries (excluding Canada and Mexico) starting April 5, and additional tariffs on major trading partners from April 9, including China, India, Japan and the EU. Our colleagues in Goldman Sachs Global Investment Research estimate that reciprocal tariffs and other tariffs announced year-to-date would raise the US effective tariff rate by 18.8pp to roughly 21%.
Source: Office of the United States Trade Representative, Macrobond, and Goldman Sachs Asset Management. As of April 1, 2025.
- If the announced tariffs are implemented and maintained, they could materially raise growth risks in the US and globally over the coming year, while lifting inflation and potentially complicating the response of central banks. Estimates suggest that the tariffs announced so far could increase US core PCE inflation by nearly 2%, while reducing growth by 1-3%.
- The lasting macro and market implications will depend on various factors, including the duration of proposed tariffs, retaliatory actions, and fiscal support offsets. Assuming limited retaliation from other countries, we expect the negative growth impact to outweigh inflation risks outside the US, strengthening the case for central bank easing in economies such as the Euro area, UK, and emerging markets. The Fed previously indicated that tariff-related inflation might be 'transitory,' suggesting a willingness to resume rate cuts in response to growth risks. However, with inflation still above target and facing upside risks, clearer evidence of weakness in employment, consumer spending, and business investment will likely be needed for the Fed to act.
Europe Plays Defense
- Talks of a potential long-lasting ceasefire in Ukraine have intensified since President Trump took office in January. While the economic impact of an end to the Ukraine war will depend on what kind of deal is eventually reached, a ceasefire could boost Euro area GDP and lower Euro area inflation if it led to significantly lower European natural gas prices, stronger consumer confidence and business sentiment, and higher expenditure for reconstruction.
- Even if a peace deal between Russia and Ukraine were to be reached, geopolitical tensions would remain extremely elevated, requiring a re-evaluation of security and defense policies across countries. Faced with reduced support from the US, both Germany and the EU Commission have announced plans to increase defense expense. In addition to a €500 billion off-budget fund to finance additional infrastructure and climate protection investments over 12 years, and increased deficit limits for the federal states, Germany’s CDU/CSU, SPD and Greens agreed on an exemption of defense spending above 1% of GDP from the debt brake limits. At the same time, the EU Commission announced it would mobilize close to EUR 800 billion by 2030 “for a safe and resilient Europe”, of which €150bn of new joint EU borrowing that would be lent to EU governments to fund pan-European capabilities in areas such as air and missile defense, artillery systems, missiles, ammunition, drones and other needs, and €650bn in additional fiscal space at national level, outside of the scope of the Excessive Deficit Procedure.
- The economic impact of this increased defense spending will, of course, depend on the type of expenditure and whether it is imported or produced locally. Europe bought a substantial amount of military equipment from non-EU suppliers immediately after Ukraine was invaded by Russia. Assuming that imports of military supplies are gradually substituted with domestic products and that the higher spending initially focuses on equipment and infrastructure, GIR estimates that additional spending on defense will have a fiscal multiplier of 0.51, so a cumulative €800bn increase in investment would boost EU GDP by €400bn, which is equivalent to ~2.5% of GDP2 over four years. With a large part of “ReArm Europe” expected to be financed at national level, government finances are going to be increasingly stretched, putting upward pressure on inflation over the medium term.
China: The Best Is Yet to Come
- Top policymakers reiterated their supportive stance in March, placing increased priorities on consumption and high-tech manufacturing, even though so far announced stimulus fell short of previous fiscal packages in 2015 and 2020. That said, the Ministry of Finance hinted at the possibility for extra-budget funding arrangement later this year if growth downside risks were to emerge, and the PBOC pointed to continued monetary policy easing, though the exact timing of RRR cuts and policy rate cuts could be somewhat data dependent. We expect the government policy to remain reactive, but also more flexible in response to the uncertain external environment and trade policies.
Central Banks: Walking a Tightrope
- Central banks are walking a tightrope this year, having to balance inflation risks stemming from tariffs and increased fiscal stimulus in some countries, as well as growth risks as a result of trade and policy uncertainty. While our base case is for continued disinflation and rate cuts, there is a risk that inflation in the US may re-accelerate due to tariffs, or a clamp-down on immigration, forcing the Fed to halt its cutting cycle prematurely even as the economy slows further. Regardless, we think that the Fed is unlikely to cut rates before June, given heightened policy uncertainty.
- Meanwhile, the case for the ECB to cut below 2% has weakened following announced fiscal plans in Germany and at European level. That said, recent tariff announcements have strengthened the case for further ECB easing. Finally in Japan, recent data confirmed that inflation is becoming more entrenched. We therefore expect the BoJ policy normalization to continue, especially in the event of further Yen weakness.
Long-Term Macro Themes
In our view, the next economic cycle will be characterised by higher inflation, elevated interest rates and heightened macroeconomic volatility, driven by 6 key factors. Thus, we believe investors need to position their portfolios for CHANGE.
CHANGE
Climate transition – High level of debt – Ageing demographics – New finance – Global fragmentation – Evolving technology
Source: SIPRI, NATO and Goldman Sachs Asset Management. As of April 1, 2025. Data for China, Russia, Ukraine and South Korea are SIPRI estimates. 'Latest’ refers to 2024 for all countries but for Japan, South Korea, India, Taiwan, Russia, Ukraine, Switzerland and China that have data as of 2023. The available 2024 data points are NATO estimates. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved.
- Geopolitical instability, rising cross-continental tensions and global fragmentation have placed defense spending at the forefront of national priorities. This has led to a significant increase in defense budgets across a number of countries and we expect this trend to continue in the near future. We believe that the rising uncertainty stemming from the geopolitical landscape present long-term macro and market opportunities for investors.
- Following Russia's annexation of Crimea in 2014, NATO urged member countries to allocate 2% of their GDP annually to defense by 2024. This target is expected to rise over the next few years, reflecting a broader shift in global defense priorities. The subsequent increase in defense spending is evident across many NATO nations, particularly in the UK and Germany. More recently, the war in Ukraine has served as a profound wake-up call for Europe, prompting a reassessment of security strategies and a renewed commitment to improving defense capabilities. This has translated into further increases in military spending across the continent, with nations like Germany making historic shifts in their defense budgets to address emerging threats. However, this surge in defense expenditure is poised to place considerable strain on government finances, especially at a time when many countries are already dealing with substantial debt burdens.
- The surge in defense spending offers diverse investment opportunities across various asset classes. Defense and defense-related sectors (eg. Materials, Industrials, etc.) are likely to benefit from this increased demand. Additionally, raw materials needed for defense equipment production (eg. industrial metals and rare earth minerals) also present attractive investment avenues as defense manufacturing scales up globally. As governments issue more debt to finance military spending, government bond yields may rise, putting downward pressure on prices. Infrastructure upgrades related to military facilities offer further investment prospects on both the public and private side.
Market Themes
Elevated policy uncertainty warrants a more cautious asset allocation, in our view, with government bonds reasserting themselves as a good hedge against growth risk. That said, we remain moderately constructive on equities through year-end given resilient global growth, healthy earnings prospects and ongoing easing by major central banks.
US Growth Deceleration
After four years of above-trend growth, investors have re-calibrated for a slower US economy as elevated trade uncertainty may delay domestic investment and weigh on consumer sentiment. US equity markets now reflect some slowdown in economic growth but remain vulnerable if activity data continue to surprise to the downside.
Key Implications
Investors that are concerned about a more severe growth deceleration may consider pivoting to more defensive and dividend-paying stocks, extending duration by increasing exposure to long-dated bonds and adding alternatives, such as multi-strategy hedge funds or gold, which have historically offered some protection against those episodes.
Inflation Re-Acceleration
The odds of inflation staying above 2% in both the US and the Euro area have risen, although for different reasons. In the US, the prospects of higher tariffs, slower immigration and a rise in inflation expectations may lead to more rapid growth in consumer prices, at least in the short term. In the Euro area, the newly announced fiscal package may create renewed inflationary pressures in the medium term if not accompanied by a productivity boost.
Key Implications
In our view, the best tactical inflation hedges are non-traditional diversifiers like gold, trend-following hedge funds or private assets. That said, investors can also adjust their core exposure by favoring the short-end of the curve within fixed income and high-dividend stocks within equities.
Ukraine Ceasefire
A potential ceasefire in Ukraine could have important repercussions for the European economy. The geopolitical relief could boost business and consumer sentiment and benefit Euro area growth as a result. While European energy prices may move somewhat lower, full resumption of Russian gas flow through Ukraine now seems less likely reducing the potential disinflationary effect.
Key Implications
European equities (DM and EM) may outperform on the back of a valuation boost. Given the extent of the reconstruction job, infrastructure would also probably benefit.
Large China Stimulus
Chinese authorities have become incrementally more supportive of the economy recently, and we think that fiscal and monetary policy stimulus might be ramped up in the event of a further tariff escalation.
Key Implications
Chinese equities would be the biggest beneficiaries of a large stimulus package, especially A shares which have lagged H shares so far this year. Stronger growth and consumption in China would also support Asia credit and European equities, in our view.
Active ETFs
OUTLOOK
Mapping the Growth in Active ETFs
Actively managed exchange-traded funds have gained increasing investors’ interest in recent years. Flows into active ETFs in 2024 have more than doubled from the previous year and we think that this trend will continue. Increased appetite for active management suggests that investors are finding it valuable to allocate part of their portfolios into this space in order to achieve desired outcomes that might not be possible by having beta exposure only. While passive ETFs are mandated to closely track the performance of the index, active strategies are designed to achieve specific goals like generating alpha over relevant benchmarks, enhancing income, or positioning the portfolios to capture dislocations related to duration and credit quality of issuers. We believe active ETFs can complement pure passive plays by offering better risk and return characteristics for investors’ portfolios.
The Case for Going Active Has Strengthened
Indeed, active ETF strategies have outperformed across all asset classes over the past year or so, and in relatively inefficient markets, like small caps and fixed income, active ETFs have delivered consistently superior returns for the last 10 years. The main exception is in the large cap space, where excessive concentration and extended valuations make it difficult to generate alpha in excess of benchmarks. But even there, active exposure has delivered better returns in the past couple of years as market volatility has increased. Given ongoing policy uncertainty, heightened geopolitical risks, and macro volatility, we believe the case for active exposure has strengthened.
SOLUTIONS
Source: Morningstar and Goldman Sachs Asset Management. Funds considered are domiciled across the globe. ‘SMA’ refers to Separately Managed Accounts. *SMAs flows are till Q3 2024 only. As of April 1, 2025.
Source: Morningstar and Goldman Sachs Asset Management. Funds considered are domiciled across the globe. Median returns for all the funds in particular category are considered till December 31, 2024. Please see page 14 of the publication for additional disclosures. As of April 1, 2025.
India Equities
OUTLOOK
Capitalizing on India’s Compelling Growth Story
Rising global uncertainty due to escalating trade tensions, heightened geopolitical risks and the ongoing decoupling between the US and China, calls for allocating capital to economies that are structurally and fundamentally strong in the long term, and somewhat less exposed and potentially even benefiting from some of those dynamics. We believe that India’s growth story presents one such investment opportunity. Strong underlying fundamentals like favorable demographics, rising per capita incomes and ongoing structural reforms, should ensure that India’s share of global trade and growth continues to rise. Industry sources predict that India will make up 6% of world imports, 5% of world exports, 19% of the world working population and 18% of world GDP by 2050. Yet, the MSCI India Index still only represents less than 2% of the MSCI ACWI Index’s market capitalization. As the economy grows, we would expect its equity market to grow with it. Indeed, historically, strong GDP growth has translated into robust EPS growth for Indian equities.
Valuations – A Dissipating Conundrum
We think that now it’s a good time for investors to capitalize on India’s growth story. In the past few years, high valuations have been a major hindrance for investors looking to add Indian equities to their portfolios. After the recent correction, MSCI India’s one-year forward P/E ratio is now trading below its 10-year average for the first time in two years. What’s more, while foreign investors have taken profit on their holdings after years of strong performance, domestic investors have been buying the dip, which should put a floor under prices. Indian households are under-allocated to equities and over-allocated to cash, compared with other EM. With the RBI cutting rates, we think the reallocation of household wealth away from bank deposits into equities is an additional structural tailwind for Indian equities.
SOLUTIONS
Source: Bloomberg, World Bank, OECD, Department of Business and Trade (UK) and Goldman Sachs Asset Management. *GDP based on 2015 USD Purchasing Power Parity. Please see page 14 of the publication for additional disclosures. As of April 1, 2025.
Source: Bloomberg and Goldman Sachs Asset Management. Monthly data, latest as of March 2025. ‘P/E’ refers to price-to-earnings. As of April 1, 2025.
FX
OUTLOOK
Assessing the Dollar's Sensitivity to Trade Uncertainty
The widespread expectation of continued US economic and market exceptionalism at the start of the year has faced scrutiny, evidenced by the dollar's lagging performance despite trade uncertainty. Weaker growth in the US, stronger economic prospects in Europe and delays in the implementation of tariffs have all been contributing factors. This has surprised many investors as the historical relationship between trade uncertainty and the dollar has usually been positive. Indeed, a simple regression analysis points to a stronger dollar with the current level of trade uncertainty, all else being equal. That said, the increasing worry among investors is that tariffs will hinder economic expansion in the U.S. to a greater extent than in other countries. A softer US growth picture is generally consistent with a weaker dollar, unless it morphs into a negative growth shock that spills over to the rest of the world, triggering the upside tail of the “dollar smile”. Further dollar weakness would require evidence that the US economy slows more sharply and more idiosyncratically than we currently expect.
To Hedge or Not to Hedge, That Is the Question
Investors might wonder whether it is prudent to hedge against further possible currency movements. For dollar-denominated assets, the decision to hedge or not to hedge currency exposure for an investor outside of the US will depend on hedging costs. Assuming limited retaliation from other countries, we expect to see the negative growth impact to outweigh inflation risks outside the US, strengthening the case for central bank easing in economies such as the Euro area, UK, and emerging markets alleviating some of the downward pressure on the dollar. Therefore, we wouldn’t advocate for hedging unless the costs are low enough or negative. Of course, that assumes that such an investor is willing to accept potential additional volatility stemming from currency fluctuations. We usually recommend hedging diversifiers and risk-mitigating assets within portfolios.
SOLUTIONS
Source: Bloomberg, Macrobond and Goldman Sachs Asset Management. Please see page 14 of the publication for additional disclosures. As of April 1, 2025.
Source: Bloomberg and Goldman Sachs Asset Management. Cost of hedging is assuming no transaction costs and is calculated as spot/12-month forward – 1. The chart looks at currency pairs in USD/local denomination. As of April 1, 2025.
1https://www.goldmansachs.com/insights/articles/how-much-will-rising-defense-spending-boost-europes-economy
2Based on Macrobond data of €17.9 trillion for EU GDP in 2024.
