DeepSeek shows us that 2025 won't just be about Donald Trump

The week the tech world turned upside down…

Treasury yields declined over the past week, after the release of the latest AI model, from Chinese firm DeepSeek, led to upheaval across the broader tech sector. It came as a surprise to learn that this model has achieved comparable performance to market leaders Meta and Open AI.

However, it has managed to achieve these results at vastly lower levels of cost and research spend. US restrictions on Chinese imports of the latest chips are likely to prevent a competitor, such as DeepSeek, from overtaking established leaders in AI.

Yet, DeepSeek’s progress has come as a shock, with some in the tech space even suggesting that this could be a moment similar to when Russia launched Sputnik in the Space Race, shaking US complacency with respect to its position of dominance.

US tech has traded at elevated levels, on the assumption of aggressive growth forecasts linked to booming investment in AI technologies over the coming number of years. Indeed, the announcement of the $500bn Stargate project was announced by the US administration only as recently as last week. Earnings projections were also supported by assumptions around high barriers to entry in this space.

Yet, if results in AI can be achieved much more cheaply than previously assumed, by a hitherto little known player, then this could upend some of these investment assumptions.

This may inject some reality back into a market which, at times, has been at risk of believing too much in its own hype and allowing valuations to detach from reality. Yet for now, tech earnings have shown strong momentum.

Additionally, an alternative interpretation of the DeepSeek news could be that this leads to additional determination to invest more rapidly in the short term, in order for US firms to demonstrate their renewed leadership in the AI sector.

Indeed, this was the case if one looks at the example of the US Apollo programme, which followed in the 1960s, after the country received a bloody nose from early Russian success. Either way, what plays out in tech, and AI specifically, will be important for the global economy over the years to come and in the near term, and a source of potential market volatility.

This week’s Fed meeting contained no big surprises, and we see the FOMC on hold in H1, having cut interest rates by 100bps in the second half of 2024. That said, were the US stock market to correct more than 15% from its peak, we could see how this would make it more likely for the Fed to continue cutting rates at upcoming meetings.

Aside from this, we don’t see much change in the economic backdrop. Consequently, we continue to see 2-year yields trading close to cash rates at 4.3% as around fair value. In this context, we have maintained a flat position on duration, though may consider returning towards a short stance should front end yields test 4.0%, absent material new news on the economy.

Meanwhile in the US, it was interesting this week, to observe how the threat of a 25% tariff was enough to force Colombia’s hand with respect to accepting repatriation flights of migrants the US is seeking to deport.

This shows how trade policy can be utilised to support the broader Trump agenda and a reason why utilising Executive Orders, rather than legislation, allows the incoming President the greatest freedom to leverage and negotiate the outcomes he is eager to deliver. A broader global tariff may ultimately be legislated, as per comments from Treasury Secretary Bessent. This would allow the administration to utilise tariff revenues in order to part pay for lower taxes.

However, the legislative path is likely to take 6-9 months or more, given the narrow majority in Congress, and will be worked as part of a potential series of reconciliation bills that get moved across the floor later this year. However, the focus in the near term may be on targeted tariffs at a country and sector level, utilising Executive Orders.

In this context, the Colombian example also show how US tariffs can create a very uneven playing field, as Colombia will always need access to the US, whereas the US is not remotely dependent on Colombia in the same way. Here, it is seen how the world’s significant superpower, which is food, energy and security independent, has the power to win and dominate bilateral trade disputes to its advantage.

Some may worry that there is a risk in this that the US is able to abuse its position to the detriment of others in this way. Yet, many in the US will cry foul at this claim, noting that any relative shift in favour of the US is only restoring order and balance into trading relationships, which have benefited other countries at the expense of the US itself. This goes to the heart of the ‘Make America Great Again’ message and is why tariffs will surely be delivered. The question confronting markets is where and when.

From this point of view, looking at countries that maintain large bilateral trade surpluses with the US may well be instructive. The US administration may seek to highlight these bilateral imbalances as examples of where the US is unfairly losing out, though it should be noted that many economists would conclude that these are more a function of US over-consumption, relative to other countries.

Either way, it stands to reason that trade imbalances will be pushed lower. On this point, it would seem a better outcome for surplus countries (and regions such as the EU) to realise that it would be beneficial for this adjustment to come about through an increase in their own levels of consumption, which could boost growth, rather than the alternative of elevated tariffs, lower consumption and weaker investment.

Away from the topic of tariffs, economic data showed growth in the Euro area stagnating in Q4, compared to a projected 3% expansion in the US. This supported euro yields, though price action over the week tended to mirror moves in US Treasuries. We continue to maintain a modestly constructive view on European duration, given that we have much greater confidence in the ECB continuing to cut interest rates, against a weaker growth backdrop.

We are also focussing on the upcoming German election, where the far right AFD has been climbing in the polls. Indeed, we would not be surprised if this support is understated, given the reluctance some may feel in confessing their allegiance.

Although the AFD won’t be part of a governing coalition after the election, it strikes us that the coalition that will form is going to be weak from the outset. Notably, it would appear that the country wants to shift to the right, but with the FDP seemingly below the 5% vote threshold which is required, so the CDU will be forced to partner with the Greens and Socialists.

The significance here is that not much will get agreed and done in Germany, and so the current malaise will persist. Meanwhile, we see a trend in Germany and other EU countries towards a more nationalistic and less EU sentiment, which could end up challenging EU spreads again at some point, albeit there may not be a sufficient catalyst for this in the short term.

The UK has also followed developments overseas, pushing gilt yields lower. We can see the BoE pushing a dovish narrative at its upcoming policy meeting. However, we would continue to highlight ongoing evidence of inflationary pressure in the UK.

Ultimately, UK rate cuts may steepen the UK yield curve, but if the BoE makes a policy error in easing policy too far, then we see higher inflation becoming more embedded in expectations on a structural basis.

Last week’s BoJ rate hike has helped to support the value of the yen over the past week. However, in contrast to market developments last July, when the BoJ hike was a catalyst for dramatic volatility in markets linked to stop loss FX trades and significant losses in Japanese stocks, this time around the market reaction has been much more muted.

Ueda and colleagues will feel content that, having properly communicated to markets in advance of the January rate decision, the BoJ actions did not lead to any market surprise. We believe that further rate hikes will follow in the months ahead, with Japanese interest rates well below where the BoJ projects neutral interest rates to sit.

With the labour supply shrinking as a result of demographic factors, we see the ageing of Japan leading to higher wages in the coming years. Consequently, a 5% Shunto gain in 2025 is likely to be repeated again in coming years, in our view.

In this way, the ageing of Japan is making inflation more structural. Although the BoJ currently worries about how it raised rates prematurely in 2000 and 2006, only for the country to return to a deflationary state, we think the underpinning dynamics are now very different in the economy.

In this way, we think that with core inflation above 3%, there may be more scrutiny devoted to whether the BoJ is falling behind the curve, when normalising policy only at a very gradual pace. We continue to expect a rate hike to 0.75% on cash rates in July and a move to 1% to follow at the end of 2025, or at the start of 2026.

Looking ahead

If the past week teaches us anything, it’s that it can sometimes be the unknown-unknown events that have the biggest market impact. Indeed, it would seem that few investors would have heard much about DeepSeek until a couple of weeks ago, and it shows you how new catalysts can emerge and impact markets on a global scale.

In some ways it is ironic to think that five years ago, the world was just waking up to the threat of Covid, after it emerged in Wuhan and then ravaged the world beyond. That certainly is not to say that the latest release from a Chinese lab is necessarily something we should worry ourselves about.

Indeed, we would infer that if AI ends up cheaper and more widely accessible, then this will be good for productivity, good for inflation and good for economic growth. It just isn’t good for those investors who may have chased a move in some stocks, focussing on the thematic hype, without pausing to consider whether those valuations had become materially over-extended.

More broadly speaking, as we ponder claims of plagiarism by DeepSeek (and other Chinese firms) from rivals such as ChatGPT, we wonder what may lie ahead for us all in the Year of The Snake….