Defending spending

• UK equities, which advanced +2.0%
• US government bonds, which rose +1.4%

• Asian and emerging market equities, which fell -3.7% and -3.9% respectively in sterling terms
• Gold, which fell back -2.7%

The UK government’s decision to ramp up defence spending was welcomed by the US government last week. Prime Minster, Sir Kier Starmer, pledged to increase defence spending to 2.5% of GDP from April 2027, up from the current rate of 2.3% – marking a £13.5bn annual increase. Furthermore, the inclusion of security and intelligence agencies in a wider definition of defence spending will mean the total spend ultimately amounts to 2.6% of GDP. The 0.2%-0.3% increase was derided by some opposition politicians as insufficient - and it falls well short of the 5% of GDP that US President Trump has at times suggested NATO members need to spend – although, Starmer also set out an ambition to reach a defence spending level of 3% in the next parliament. The announced increase will be funded by a 40% cut to the foreign aid budget, reducing it from 0.5% to 0.3% gross national income.

The expanded defence budget is intended to accelerate the adoption of a cutting-edge and high-tech military capability and will form part of the government’s Defence Industrial Strategy, which was a manifesto pledge to bring forward a defence strategy aligning security and economic priorities. It is hoped that the defence spending hike will help drive UK economic growth, creating skilled jobs and opportunities nationwide. Key UK defence contractors like BAE Systems, Thales, Leonardo and Babcock International are already seeing strong share price gains in 2025 reflecting the sector’s momentum.

President Trump has often pressed NATO allies, including the UK, to boost defence investment beyond the 2% guideline for member states. It is expected that Germany and France will follow the UK’s lead, though EU fiscal rules could pose hurdles. Following last Friday’s tense encounter in the White House between Volodymyr Zelensky and Donald Trump, a group of mostly European NATO allies met in London on Sunday to reiterate their commitment to increased defence spending. Ursula von der Leyen, the EU Commission president, spoke of the EU plan to “re-arm” Europe which is to be presented this week.

The US House of Representatives last week passed President Trump’s “big, beautiful budget bill” by a narrow 217-215 margin, setting in train a decade of lower federal spending, more tax cuts and potentially more debt. The bill now moves to the US Senate for reconciliation with 60/100 senators’ approval required for it to fly. The numbers are mind-boggling: net tax cuts of c.$4.5trn, Federal spending cuts of c.$1.5trn and raising the US debt ceiling by around $4trn. If enacted, the US may need to issue some $2trn more in Treasuries to cover the shortfall. Despite the US economy’s current relative strength, bond markets may already be fretting about the debt-to-GDP ratio surging from an already elevated 122% in 2025. Counterintuitively, investors insuring against the loss of cash-flows or default of more than fifty S&P 500 companies today pay less for so-called ‘credit-default swap’ contracts than investors hedging the same risks with Uncle Sam’s Treasuries. All that said, some economists believe it a stretch that the US Department for Government Efficiency will slice $1.5trn from federal spending. The numbers may not yet stack up.

Last week’s news that Ofgem will be increasing the energy price cap by an inflation beating 6.4% from April follows swiftly after the news that UK inflation had risen to a 10-month high. Although the rise in the energy price cap was expected – and analysts do predict that energy prices could fall come July – the news flow continues to raise the spectre of inflation ticking up further and remaining above the Bank of England’s 2% target for ever longer. The government warned that the road back to low inflation would be "bumpy", while opposition parties point to the Treasury’s planned tax hikes and spending increases as key contributors to near-term inflationary pressure. Such UK specific news flow coincides with the apparent wider global trends of protectionism and economic nationalism, and all adds to the perception that the disinflationary process has stalled across many developed markets. How central banks respond will clearly be key for financial markets, and while the Bank of England is expected to cut rates further as the year progresses, the US Federal Reserve (Fed) is firmly in “wait and see” mode.

Should rates fall at a slower pace than expected there is a possibility that continually higher bond yields will pressure the benign ‘soft landing’ narrative for the US and global economy. It is questionable whether the US economy can sustain current levels of activity and employment with persistently elevated borrowing costs. Evidence of a stalling global economy would likely be the catalyst which triggers dovish central bank action; however, it might also trigger an equity market correction at the same time. Market participants will be watching inflation indicators very closely, hoping that the prevailing upward pressures prove a temporary blip down to one off factors and uncertainty surrounding government policy. The Fed’s preferred gauge of inflation, the Personal Consumption Expenditures (PCE) price index, provided limited insight last week, with the index rising 0.3% month-on-month - in line with expectations and the prior month. However, on a year-on-year basis the print did offer small cause for optimism, with inflation easing to 2.5% from 2.6%.