Past the worst?

A period of reflection following the storm

A quieter week with respect to tariff news flow saw markets trade in a calmer fashion, with the VIX measure of market volatility dropping to 30 for the first time since ‘Liberation Day’ on 2nd April.

Although uncertainty around the elevated rates of tariffs remains, the 90-day pause means that there could be a somewhat quieter period ahead, which allows markets to consolidate somewhat.

In our opinion, we had looked at many of the elevated tariffs (away from China) as likely to be temporary anyway.

Ultimately, we have thought that tariffs would be legislated through Congress later this year in the context of the US Budget. Without legislating tariffs, the revenue from them won’t be admissible in the Budget and we have long held the view that these dollars are being earmarked to fund additional tax cuts.

Our thought has been to look for a universal tariff around 10% to be implemented later this year and that the present tariffs, implemented via Executive Order, would serve as more of a basis for negotiation. In this respect there may be a hope that overseas countries would actually lower their own tariffs on the US, in order for Trump to roll back.

However, the broad-based mishandling of the tariff rollout on April 2nd and in the days since have served to undermine US policy credibility and weaken Washington’s position to leverage its policy agenda.

With much of the rest of the world seeking to stand firm against Trump, we wonder what the Administration will carry through with once we get to the start of July.

However, with a legislated path to a more moderate tariff possibly coming into view, it may seem that the Trump team are more likely to push back the implementation of additional tariffs further if other nations refuse to blink.

Were this to transpire, markets could be cheered that tariffs only sit at 10%. Yet, even if this is the outcome, we should expect to see weaker growth and higher inflation as a result.

Meanwhile, sector-based tariffs designed to ensure re-shoring of critical industries that are crucial to make the US economy more self-sufficient, are also likely to have an impact. The number of carve-outs and exceptions make the impact difficult to analyse, though we would also assert that supply chain disruption is only likely to be compounded by tariff uncertainty.

In this respect, exporters may defer sending goods to the US under tariffs today if there is a hope they are reduced in the future. In this case, there could be shortages which lead to higher prices, in a manner not dissimilar to what we witnessed in the Covid supply shock, albeit to a lesser extent.

Uncertainty will also mean investors and consumers defer investments and big-ticket purchases, compounding the hit to growth.

However, for the time being we think that the underlying economy will still grow around 1% (ignoring the likely noise we will see as a result of gold and metals imports, in the upcoming GDP data).

Consumer and business balance sheets have been in healthy shape: there is not excess leverage and although unemployment will rise, this may be limited thanks to a labour market tightening in the wake of curbs on immigration.

A sharp tightening in financial conditions, were stocks to drop another 20% and credit spreads jump wider, would surely push the economy into recessionary territory, but we still see this as a risk scenario, rather than the most likely outcome.

Meanwhile, we expect US inflation to head to 4% as tariffs bite and the outlook for prices won’t be helped by a weaker US dollar.

The combination of rising prices and stalling growth will probably mean that the Fed feels that it can do nothing in terms of monetary policy, noting Powell has an eye on his legacy and doesn’t want to go down as the modern-day Arthur Burns, as a Fed Chair who lost control of inflation not once, but twice on his watch.

In this case we see fair value on 10-year yields around 4.5%, though we think the US yield curve will steepen over time, as investors demand an increased risk premium for owning US assets. In this way, Trump’s undermining of policy credibility risks weighing on the valuation of all US assets, as well as the dollar, for quite some time to come.

We also see global investors turning away from the US, as the country’s growth exceptionalism dries up. TINA (there is no alternative) was the justification for overseas investors to keep buying US stocks at inflated valuations, but this now appears to have fundamentally changed.

If less capital flows to the US than in the past, it may seem reasonable to expect the days of a stronger dollar to be behind us and it is conceivable that currencies which have undervalued, such as the Yen, have some way to rally in the weeks and months ahead.

We think it very unlikely that China, or other countries will sell Treasury holdings en-masse. However, it is very reasonable to expect forward-looking demand to diminish and this may thus limit the ability for US stock and bonds to rally very much, even if the next month or so are a bit quieter than has been the case in the past couple of weeks.

Away from the US, risk assets in overseas markets have also staged a recovery and this has seen sovereign and corporate credit spreads move tighter.

With Europe suspending its own tariffs on the US, this helps limit the inflationary shock in the region for the time being and from this standpoint it is understandable that the ECB will lower its benchmark rate to 2.25% later today, with a further cut to 2% discounted later this quarter.

However, we still think there are too many ECB cuts priced by markets, given prospective fiscal easing taking place at the same time. As for 10-year Bund yields, we see these as fair around 2.75% and expensive below 2.5%.

In Japan we have continued to see excessive volatility in longer-dated bonds and this highlights the relatively poor liquidity in JGBs, which has been compounded by recent developments in overseas markets.

30-year bonds have seen a dramatic underperformance this month on position capitulation. However, with the Japanese yield curve steepening (30-year bond yields are 200bp higher than cash), we see value in the long end of the curve above 2.5% and have added to positions we have held there.

This steepness is also seen in Australia, where we have also added long-end bonds on the basis that they look far too cheap, especially in contrast to curves elsewhere, such as the US, which appears too flat in our view.

Looking ahead

We are hopeful that the worst of the volatility may be behind us. However, meetings in Asia this week have underlined the impact Trump tariffs are having on trade.

Chinese exports have ground to a halt and goods are piling up at the ports. This is already leading to shortages in components required in products manufactured elsewhere and it is worth remembering that a supply chain of globally sourced components is only as strong as the weakest link in this chain.

At the same time, investor sentiment surveys have moved towards their bearish extremes and the deleveraging, which has already occurred in the past month, should mean that markets are on a sounder footing now than was the case, when we were citing investor complacency just a few weeks ago.

In this respect, we are more inclined to look for Trump to start to back down, rather than double down, in the days ahead on the view that his approach will be pragmatic, rather than dogmatic.

At the same time, it is hard to build much of a bullish view on US stocks, even if risk premia elsewhere begin to normalise.

However, credit looks okay as long as recession is avoided.

We would note that with Biden having gifted Trump an economy growing at 2.5-3.0%, it would go down as a monumental and historical act of self-harm were the US Administration to engineer a recession, entirely of its own making.

In this respect, Trump and team can’t afford markets to lose confidence in the US policy framework, as financial markets are based on confidence and trust and once lost, this can’t be easily restored – especially with the Fed ill equipped to come riding to the rescue.

Maybe it would be best from Trump to stop tweeting and spend a bit more time on his golf game instead?