Market inflection points abound

Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist 

Stocks and the dollar rose solidly on Tuesday even though markets lacked a central, driving force - signs of weakening economic activity, cooling labor markets and disinflation are all reasons for caution, but risk appetite continues to be fueled by hopes that U.S.-China trade tensions will soon ease. 

In my column today I look at why foreign investors' exposure to U.S. assets may not be as high as feared. If it's not, the potential downside for Wall Street and Treasuries from diversification may be less severe. More on that below, but first, a roundup of the main market moves.

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Evidence is mounting that global economic activity is slowing, but this is failing to move the dial much for markets. Investors know growth is slowing and that the second half of the year will be challenging, so that's already 'in the price'.

Hopes of a de-escalation in the trade standoff between the US and China, and for bilateral deals between the US and other key trading partners soon are supporting risk assets. 

The S&P 500 hit a three-month high on Tuesday, while the Nasdaq and MSCI World index climbed to levels last visited in February. It is the strength on Wall Street, most latterly tech, that is lifting global stocks as benchmark Asian and European indices are flatlining.

On the whole, policymakers continue to stress that they are data-dependent and will move on rates carefully and calmly. That was the message from various Fed officials this week and Bank of England Governor Andrew Bailey on Tuesday.

It's a slightly different - although no less challenging - situation in mainland Europe, where figures on Tuesday showed disinflationary forces are driving consumer prices as much as anything else. 

Euro zone inflation dipped below the European Central Bank's 2% target in May, cementing expectations rates will be cut this week and later this year. Meanwhile, Switzerland experienced outright year-on-year deflation for the first time in four years, raising the possibility that the Swiss National Bank may soon reintroduce negative interest rates. 

Canada's central bank is expected to hold interest rates at 2.75% on Wednesday for a second meeting. Growth and inflation have been surprisingly sticky this year, and rates have been slashed by 225 basis points since last June.

As UBS analysts note, markets are generally at an inflection point, waiting for the catalyst that will break them out of the narrow ranges that have broadely held since the US and China announced a temporary reduction on tariffs on May 12. Even Wall Street and the dollar - one creeping higher, the other drifting lower - are awaiting a trigger for a proper breakout.

Could the telephone call between U.S. President Donald Trump and Chinese leader Xi Xinping expected later this week be it?

It is widely believed that investors around the world have a disproportionately high exposure to U.S. assets, particularly stocks, an imbalance that could roil U.S. markets if corrected. But what if these fears are overblown? 

Several eye-popping statistics suggest that America's weight in world financial markets is even greater than its outsized economic might. Most strikingly, the U.S. net international investment position (NIIP), or foreign investors' holdings of U.S. assets less U.S. investors' holdings of overseas assets, at the end of 2024 was $26 trillion. That's nearly 24% of global GDP, up from 16% only two years earlier, a surge driven by foreigners' insatiable appetite for U.S. equities, mainly "Big Tech".

Demand was so hot that, by some measures, the value of U.S.-listed stocks at the turn of the year represented 74% of total global market cap. That share was 60% six years ago, and less than half in 2011. 

But the attractiveness of dollar-denominated assets is now being questioned, as the often erratic policies of U.S. President Donald Trump have upset longstanding economic and geopolitical norms, making governments and investors question whether Washington is still a reliable partner on the global stage.

The concern is that this eroding confidence triggers a reversal of the massive flows into Wall Street seen in recent years that has damaging spillover effects. 

Such a correction may not require outright selling. Given the scale of the flows involved, just less buying among foreign investors could be enough to cast a shadow over the world's most important stock market. 

And the running assumption is foreign investors don't have the capacity or willingness to increase their exposure to U.S. assets, creating a significant long-term downside risk for Wall Street, Treasuries and the dollar. 

"A structural shift is underway: the slow erosion of US economic dominance," analysts at Deutsche Bank wrote on Monday.

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