UK spending review and US inflation to set the tone

It is shaping up to be another risk-friendly week. The S&P 500 is just over 100 points away from reaching the record high set back in February, Tesla shares were up another 5% on Tuesday and have now recouped nearly two thirds of the losses from last week. When Tesla is rallying, you know that risk appetite is strong.

Incremental good news on the US/ China trade agreement tests market’s patience

However, this could be buy the rumour and sell of the fact. The big news on Wednesday is that the US/ China trade talks have come to an end. The talks concluded with a pledge to enforce the Geneva protocol on trade between the two nations, albeit with a renewed focus on some sensitive areas. China has pledged to speed up shipments of rare earth minerals to the US, while the US side has agreed to curb some export controls. This agreement still needs to be signed off by President Trump and President Xi, which may be why stocks are pointing to a lower open early this morning.

US stock market futures are pointing to a slightly lower open on Wednesday as the US/ China trade talks come to an end. UK stock market futures are also pointing to a modest decline at the open. Overall, the US/ China trade agreement is taking its time, and it could test the market’s patience. Optimism about a deal has propped up stocks this week, so it will need to continue to move in a positive direction to help the S&P 500 reach February’s record high.

Trade news could still feed risk sentiment

Trade news is still positive for risk sentiment in our view. There are also reports that the US and Mexico are close to reaching a deal to reduce steel tariffs and to cap Mexican imports to the US. This good news on trade is giving the market hope that the US will be able to reach agreements to set tariffs at reasonable levels with its main trading partners before the end of the reciprocal tariff reprieve next month. The EU is conspicuous by its absence, once the US reaches an agreement with China, we expect the EU to be next in line.

Although the trade news is positive for stocks, without a concrete agreement between the US and China, this means that we could see stocks rally alongside gold for some time.

Drop in bond yields also positive for stocks

The second reason why this is a risk friendly environment is the recent recalibration in interest rate expectations, and a drop in bond yields. The UK Gilt market was the top performer on Tuesday, with yields dropping sharply across the curve. The 10-year Gilt yield fell 9bps, after a weak labour market report that saw a sharp drop in payrolled employees in the past 12 months, a rising unemployment rate and slowing wage growth. This has boosted expectations that the BOE will speed up their rate cutting cycle to protect the economy from the twin effects the rise in employer national insurance, and US tariffs.

The UK interest rate swaps market is now expecting 2 rate cuts over the rest of this year, up from 1.5 rate cuts expected on Monday. The decline in yields weighed on the pound, and GBP/USD is lower by 0.3%. Cable did manage to bounce off Tuesday’s lows and it is currently below  $1.35 early on Wednesday.

In focus: UK spending review

The rally in UK bonds may be auspicious for the announcement of Chancellor Rachel Reeves’ spending review later Wednesday. This much-hyped event will see the chancellor allocate £600bn of public funding later today, which is one quarter of the UK economy. No pressure then, Rachel! One wrong move and the Chancellor’s hopes for growth could be dashed. Much of the spending review has already been flagged. There will be more money for defense and the NHS, pensioners will get their winter fuel allowance back and hopes for a bigger policing budget look like they have been dashed. The chancellor has already pledged to invest in Northern transport links; some may wonder if London and the South will get any pledges from the Chancellor later today.

While we know where the vast amount of money will be allocated ahead of this speech, what we don’t know is where the savings will come from? The spending review has been touted as one of the biggest ever Treasury exercises, going line by line through government departments budgets to look for inefficiencies and elimination of waste. If the Chancellor cannot convince the market that she is serious about getting the UK’s finances on a good footing, then the UK Gilt market may give back some of Tuesday’s gains, and bond yields could rise, which may weigh on sterling.

Since the Chancellor has been in office, debt levels have risen, and cracks are starting to appear in the economy. Thus, she needs to convince the bond market that she is willing to cut bloated public sector spending levels. The reaction in the bond market later today will tell us if she has been successful. If the spending review suggests that 1, there will be a much larger debt issuance in the future or 2, that taxes may need to rise to fund public spending, which could weigh on growth, then the bond vigilantes could come knocking on the UK’s door once more.

UK bonds have had a good month, and yields have fallen across the curve. The 30-year yield has backed away from the 5.58% high, the highest level since 1998, and is trading around 5.25%. No doubt the chancellor will be acutely aware that everything she says will be scrutinized by bond investors. While she will want to ensure her spending decisions are voter-friendly, if bond yields spike as a result of this ‘review’ her time as Chancellor could be short lived, just ask Kwasi Kwarteng.

The market impact from the spending review

From a stock market perspective, we think that this spending review will reinforce defense firms, which have been the top performers in the FTSE 100 so far this year. BAE Systems and Rolls Royce are higher by 60% and more than 50% YTD, respectively. A lot of the news about defense spending is already known and baked into the price of these firms. However, they may continue to do well due to momentum.

The FTSE 250 has been driven by banks and home builders so far this year. The government is expected to release more funds for homebuilding. This could also keep the homebuilders buoyant, while the short-term outcome for banks could depend on how bond markets react to the review. Considering the Chancellor has left little room for surprises, the UK bond market could absorb the spending review well, in our view.

US CPI review

The other main event today is the US CPI report for May. So far, growth data has held up well in the US, which means that inflation data could determine the Fed’s next move. Expectations are for headline and core inflation to edge higher to 2.4% and 2.9% respectively. The big question is whether tariffs will start to impact US CPI. We think it is too early for two reasons: 1, reciprocal tariffs are paused until July. Although there are higher tariff rates, for example, on steel and aluminum, it could be too early for these to feed through to consumer prices. 2, the economy slowed sharply in Q1, so fears about weak demand could keep the lid on goods and service inflation for now.

Overall, we do not expect the CPI data to be too market moving. The interest rate futures market is still expecting only 1.7 rate cuts from the Fed for the rest of this year, with the rate cutting cycle ending in September 2026, when US interest rates are expected to be 3.33%, they are currently between 4.25% and 4.5%.

The dollar has not been able to capitalize on relatively elevated interest rate expectations, and the dollar index is trading in a consolidation pattern at a low level around the 99.00 level, although it is higher this morning. For now, US stocks are still impacted by the better than expected labor market report for May and hopes that the US and China will reach a trade agreement. So far this week, value stocks, dividend yields and share buybacks, along with liquidity, are driving gains in the S&P 500. This is healthy: the stock market rally may be broadening out, after it looked like tech would once again dominate US stocks. This has helped the Russell 2000 to outperform the S&P 500 in recent sessions. A moderate inflation reading, that opens the door to two Fed rate cuts this year could see small cap and value stocks continue to outperform.