Q4 dominated by “lingering scars” of US-centred shocks

Markets are still grappling with the lingering effects of US trade policy “shocks” despite growth forecasts recovering since the ‘Liberation Day’ tariff announcement in April, according to the latest commentary from Principal Asset Management.

Seema Shah, the firm’s Chief Global Strategist, said higher inflation and growing US dollar weakness were just two of the “scars” sticking around despite global growth forecasts showing improvements even for the year ahead, driving further global economic uncertainty.

“Despite notable policy and geopolitical shocks this year, the global economy has proven resilient. Policy volatility has eased, uncertainty has receded, and AI-driven capex has accelerated—supporting a more constructive outlook.

“Consensus GDP forecasts for 2025 have been revised higher across the U.S., Euro area, and China, reversing the downgrades seen around “Liberation Day.” U.S. projections for 2026 have also been revised upward, likely reflecting anticipated Fed rate cuts and the impact of the One Big Beautiful Bill Act. In contrast, European 2026 forecasts have edged lower, weighed down by the delayed effects of U.S. tariffs, while China’s outlook remains broadly stable.

“Still, early-2025 policy disruptions have left lasting marks. Tariffs are reshaping global trade dynamics, likely keeping inflation elevated and persistent. Meanwhile, lingering concerns around U.S. institutional stability and its geopolitical posture may have structurally weakened the U.S. dollar.

“These pressures are compounded by already rising global fiscal concerns, which threaten to keep long-term government borrowing costs elevated, limiting the scope for future fiscal stimulus, and potentially undermining the effectiveness of monetary policy. The near-term picture is robust, but underlying vulnerabilities are forming.

“Despite dire post-Liberation Day fears, the U.S. economy has proven broadly resilient. Robust consumer spending and capital expenditures have been key drivers of economic activity, with AI-related investment emerging as a significant growth engine. Technology investment alone is estimated to have contributed roughly one-third of real GDP growth in the first half of the year.

“Sentiment across both households and small businesses has also picked up since April, likely reflecting growing optimism around the policy stimulus, as well as greater tariff certainty.

“Yet not all measures of economic activity have improved. Labor market data, including non-farm payrolls, have underwhelmed as companies remain cautious on hiring amid policy uncertainty. Still, broad U.S. economic data confirms a gentle moderating trend. The trajectory ahead likely hinges on a few key developments:

• Fed rate cuts succeed in supporting economic activity as the Fed’s careful policy approach avoids missteps.
• OBBBA drives higher capex and expanded hiring plans.

“Ultimately, monetary and fiscal policy tailwinds could enhance an already constructive 2026 outlook.”

US equities have also enjoyed a recently “surprising” rally in the wake of dimming tariff concerns, fueled by increased artificial intelligence spend and the expectation of further rate cuts. Fixed income opportunities have also presented a mixed bag for investors, Shah said.

“U.S. equity markets continued their upward momentum through the third quarter, buoyed by expectations of multiple Fed rate cuts and a surge in AI-related capex. While tech remained central to the rally, more cyclical areas of the market, particularly small-caps, also began to recover after a prolonged period of underperformance. Global equities joined in the strength, with Asia and emerging markets delivering exceptionally robust returns.

“Given earlier concerns about elevated tariffs, the rally’s resilience has come as a surprise to many. Yet, the combination of a deregulatory policy agenda, enhanced tax incentives, and sustained AI investment suggests a strong earnings outlook for 2026. Historically, equity markets have performed well in the two years following the start of a non-recessionary Fed easing cycle. With recession risks currently low, policy remains a tailwind.

“Risks, however, persist. A sharper-than-expected deterioration in the labor market or renewed fiscal stress could push bond yields higher, offsetting the benefits of easier policy. While an AI spending slowdown would undoubtedly disrupt risk assets, the broader investment theme appears durable, making any volatility in near-term AI capex unlikely to derail its long-term trajectory.

“Bond markets have faced a complex mix of forces this year, including negative growth surprises, persistent inflation concerns, heightened fiscal scrutiny, and even questions around the Federal Reserve’s independence.

“While renewed optimism around Fed easing recently pushed nominal yields lower—bringing 10-year U.S. Treasury yields just above 4% after the September FOMC—underlying risk premiums have continued to rise. This increase, reflected in a higher term premium, points to growing unease over fiscal sustainability, heavy Treasury issuance, and broader institutional challenges. Foreign investors, in particular, have shifted away from longer-duration Treasurys in favor of shorter-term debt.

“This trend appears to be global, with long-end yield curve steepening evident across other advanced economies, suggesting that rising risk premiums may be driven by common factors such as mounting public debt.

“Ultimately, while central bank easing provides some support, persistent concerns around fiscal and institutional stability may limit the potential for a sustained decline in long-term yields.”

The commentary also identified a “constructive” outlook for diversified risk assets driven by resilient growth, AI investment and policy easing, despite relatively unfavourable conditions amid stretched valuations.

“Risk assets have delivered strong returns year-to-date, driven by resilient growth, AI enthusiasm, and expectations of global monetary easing. While equities have surged and credit spreads remain tight, stretched valuations underscore the importance of balance and diversification.

“In the U.S., although the scale of AI-related capital expenditure warrants some caution, the theme remains a key market driver. Second-order beneficiaries, including utilities and semiconductors, still offer compelling opportunities. Small-caps are trading at historically attractive valuations, offering discounted entry points and greater sensitivity to domestic growth, reshoring, and innovation trends.

“International equities can provide diversification, especially in Europe and emerging markets, where valuations are more attractive and structural drivers such as AI adoption, digitalisation, and consumer growth, remain supportive.

“Core fixed income is becoming increasingly relevant, with higher yields offering both income and downside mitigation. Real estate remains a valuable diversifier, with public REITs trading below asset values and private real estate delivering stable cash flows and inflation mitigation—particularly in sectors like logistics, healthcare, and data infrastructure.”