Macro Moments Weekly: Discounting Davos

Equities

From prime ministers to programmers, everyone seemed to be caught up in the drama of the past week’s geopolitical events. To pretend that geopolitics did not exist and did not dominate the headlines would be the investor equivalent of locking the front door, turning off your phone, getting out your favourite box sets and watching them on repeat for a few days, fuelled by home deliveries.

Markets are a discounting mechanism; they weigh up probabilities and possibilities of outcomes and offer an educated guess as to their value. They can be wrong, or gripped by mania, as we have famously seen in bull markets such as the ‘dot.com’ bubble or in panics such as the ‘Liberation Day’ crash. But more often than not, markets provide the clarity and certainty of price.

So, what is the message the markets have sent this week, as we have watched geopolitics spin on a Davos-sized¹ axis?

First, that geopolitics is not very important: The price falls for equity markets were only about a percent or so. Did markets’ collectively shrug because investors had learned the lesson of last April and ‘won’t get fooled again?’ Or was it because markets are clever and immediately recognised that the US president might reverse course, so as buyers looked for bargains, sellers stepped away and reached for series one through six of Downton Abbey?

Second, was the threat of a tariff war really new news? We have frequently seen tariffs threatened and used, and then withdrawn, negotiated or negated. If there is already a tariff discount in the security price, then only a minor further discount is needed in the event of reoccurrence.

Third and last, is it that a trade war in goods may not be as concerning as one in services? In Europe, only the French talked openly and immediately about using the ‘bazooka’ of the European Union (EU) Anti Coercion weapon.² Italy, which could have alone blocked its use, instead talked of compromise through NATO, as did others. This, as it turns out, seems to have been the solution.  

Services are so important because over the next few years, the United States will sell to Europe—artificial intelligence (AI). Europe has barely developed an AI industry at all. It will have to subscribe to AI and pay the developers in Silicon Valley for it. If 20% of the population of the EU and United Kingdom³ pays US$27 per month for AI subscriptions,⁴ it would amount to US$2.8 billion per month, or US$33.8 billion per year. Compared with this amount, the pre-tariff 2024 EU annual trade surplus in goods with the United States, at US$198 billion, when partially offset by the US trade surplus in services with the EU of US$148 billion, was a net US$50 billion.⁵

Markets clearly understand that AI matters more than tariffs, and so for equities, the most important comments at Davos were probably those of Jenson Huang, CEO of NVIDIA, which drove technology stocks to new highs and boosted mineral stocks responsible for the rare earths and copper essential to AI microchips.

Bonds

The past week has not raised a heartbeat. The weakness in Japan caused by the upcoming election was significant, raising questions of contagion and increasing the attraction of the new supply of German paper. In foreign exchange, the small selloff in the US dollar has stabilised, whilst gold has held its gains.

Economics

As Davos grabbed attention, we are beginning to see the year-end economic data, and it presents a mixed picture. In the United Kingdom, pay and jobs data confirmed a slowdown in inflation is coming. Although Christmas retail sales were better, food was the sole driver. Also, the Purchasing Managers Index (PMI) data from the UK is eye-catching. Free of the budget announcement and of Christmas, business optimism has jumped sharply. This is in direct contrast to France, where it is in reverse. Across Europe (and the data would have been collected during this turbulent week), there is a slow but stable recovery.

Parting shot

Commentators will want to paint this week as a seismic event, the start of something new, but the markets know better. It is a culmination of several themes building over decades: post-GFC, post-COVID-19, post-Ukraine, post-tariffs, post-globalisation.

Re-ordering supply lines to make them secure, whether that means more regional or national sourcing across a wide range of goods and services, including defence, will take time and money. If this has this become the chief, and vital, political imperative, governments will only expedite this transition if they incentivise corporates to invest.

That would be very good news.