February ended mixed, with U.S. equity markets in negative territory and Europe and fixed income in positive territory.
- S&P 500: -1.42%.
- Nasdaq: -2.76%.
- Stoxx Europe: +3.27%.
- All Country World Index EUR: -2.41%.
- Global Fixed Income Index EUR: +1.39%.
U.S. indices are falling and European indices are rising? These investors are crazy. What’s going on? Market volatility has increased due to concerns about inflation, Fed reversal and economic growth risks.
Since September 2024, U.S. inflation has risen from 2.4% to 3% in January 2025, creating uncertainty about the Fed’s path of interest rate policy. Since September 2024, inflation in the United States has risen from 2.4% to 3% in January 2025, creating uncertainty about the Fed’s interest rate policy path. The next data, to be released on March 12, will be crucial in defining market expectations.
In addition, the Trump administration’s recent tariff policy could add inflationary pressures. An increase in tariffs would make imported products more expensive, which in turn, would impact the general price level. If inflation continues to rise, the Fed could halt the cycle of interest rate cuts, a significant blow to investors who were expecting a looser monetary policy.
This scenario revives a concern that no one wants to face: stagflation, an environment characterized by low or no economic growth coupled with high inflation. For central banks, stagflation represents a complex challenge, as raising interest rates to contain inflation further slows growth, while lowering them to stimulate the economy could exacerbate inflationary pressures.
If this scenario were to materialize (although this is not the current situation), it is likely that the Fed would choose to cut interest rates. Why?
- Structural fiscal deficit in the US.
The Trump administration has pushed through tax cuts without commensurate spending cuts, resulting in a persistent fiscal deficit.
The graph below shows the evolution of federal revenues and expenditures as a percentage of GDP, as well as the fiscal deficit in gray. Although the economy is not yet facing a severe crisis, the deficit remains high. If GDP were to contract due to a recession, the fiscal deficit could increase significantly, making sustainable fiscal policy even more difficult.
Source: CBO and own elaboration.
If interest rates rise, government spending on interest payments will also increase. Currently, interest spending on U.S. debt already exceeds defense spending, making a high interest rate environment a significant problem for public finances. For this reason, the U.S. government is not well served by a high interest rate environment. In this context, it is not surprising that President Trump has openly criticized the chairman of the Federal Reserve, accusing him of failing to adequately manage inflation.
2. Do debt-heavy governments prefer inflation?
You probably already know this, but let’s put the question bluntly: do governments care about inflation? Here’s a hint: politicians like to spend… and spend money that is not theirs. When government spending exceeds its revenues, the most common solution is to resort to debt issuance. But, if a government has a high level of indebtedness, would it benefit from high inflation?
Let’s look at a practical example:
- Let’s imagine that I borrow €20,000 from a friend and commit to pay it back in one year.
- In that year, inflation rises by 10%, which means that the prices of goods have increased in that proportion.
- In real terms, the money has lost value and the same €20,000 can now buy fewer goods.
If with that money I bought an asset that appreciated with inflation (10%), at the end of the year I can sell it for €22,000. When I return the €20,000 to my friend, in terms of purchasing power, I am returning less than what he lent me.
- Who has benefited? Me, because the money I owe has lost value and my asset has increased in price.
- Who has been harmed? My friend, because he gets back the same nominal amount, but with less purchasing power.
The same principle applies to governments: when there is inflation, public debt is reduced in real terms, which eases the financial burden. Therefore, governments with high deficits and large financing needs tend to benefit from inflation. The big question is: if the government benefits, who is the loser? There I leave it, as Juan Ramón Jiménez would say: “No la toques más, que así es la rosa” (Don’t touch it anymore, that’s the way the rose is).
Despite the uncertainty surrounding growth and inflation, European markets have outperformed U.S. markets in recent weeks. In our view, this responds to a process of capital rotation, where investors are reducing their exposure to large growth technology companies in the US and directing their capital towards more defensive and value stocks, a segment in which Europe is better represented.
What factors are behind the decline of U.S. mega-companies?
High valuations
- As we have commented on other occasions, many of these companies are trading at demanding multiples, reflecting optimistic growth scenarios.
Increased risk aversion
- In uncertain environments, investors tend to prioritize prudence, which implies reducing positions in more volatile assets, such as growth stocks.
Inflation and interest rates
- If inflation picks up again, the likelihood of the Fed raising or keeping interest rates at elevated levels is higher.
- A high interest rate environment, without solid growth to justify it, has a negative impact on growth companies.
But then, should we exit the market in fear of lower growth, inflation, etc.? It does not have to, in this chart below you can see how February’s falls are caused by the famous Magnificent 7, but if we exclude these 7 from the index, it even rises by 0.39%.
Source: Bloomberg
In this context, rather than a market exit signal, what we are seeing is an adjustment in investor preferences, with a shift towards neglected sectors and assets that are attractive in terms of valuation.
There is a universe of opportunities beyond these seven companies, full of equally attractive companies that are, however, being ignored by a large part of the market. This omission is not necessarily due to a lack of managerial ability, but to the influence of a cognitive bias known as “herd bias”.
This phenomenon leads many investors to concentrate their positions in the same companies, not only because of the dominant market trend, but also because of a logic of professional protection: in case these investments turn out to be unfavorable, the responsibility is diluted among the majority, reducing the risk of labor retaliation. Consequently, the search for opportunities outside the market consensus is relegated, despite the potential that these less visible companies can offer.
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