Tariff psychodrama creates opportunities

This article was originally published in FT Adviser on 12th June.

Since early April, equity market sentiment has switched from alarm at how big, broad and blunt US President Donald Trump’s tariff policy looked, to a more relaxed view about where key trading relationships might end up for the next three years.

The US government is in negotiations this week with both China and India, which represent a combined 20 per cent of world GDP and, more importantly, 25 per cent of the US trade deficit. Any resulting messaging will provide a useful indication as to whether the increasingly optimistic consensus should be seen as composed or complacent.

The signs so far look good.

Alongside signals that the administration’s commitment to the previously announced tariffs is less than complete, recent news of a trade court ruling against the legitimacy of some of the tariff policies has also helped to bolster sentiment. However, in our view, this does little to reduce uncertainty around the direction of the global economy.  Instead, it is a helpful reminder that markets are unlikely to see a long-term conclusion on trade relations in the near future.

US economy resilient

The worst fears of early April, which imagined the highest tariff rates since the Depression-era Smoot-Hawley Tariff Act in 1930, have been avoided for now, but estimates of an average current tariff rate of 15-20 per cent across the entire US import mix is still significantly higher than most investors’ starting expectations.

It is prudent to consider risks as two-sided from these levels, given how quickly the president changes direction. The good news is that the US economy still looks resilient, given everything that has been thrown at it.

Expectations for growth this year have already been marked down from a strong starting point, but the labour market in the US has only cooled, not collapsed. Discretionary spending patterns indicate a more positive outlook from individual consumers on their own prospects than the negative sentiment survey readings would suggest.

Inflation has moderated too, albeit with some stickiness in the pricing of services and before tariffs have had time to filter through. We expect a further bump up from today’s 2.4 per cent consumer price index rate (US) over the summer, as suppliers top up retail inventories with goods whose prices have tariffs baked in. But it is likely to remain far below the crisis levels of two years ago, even as US business surveys highlight their growing concerns.

Expensive valuations

Memories of US equity market weakness in the spring have faded fast, so investors are faced with a familiar conundrum. Corporate profit margins and earnings growth are still abnormally strong, and faith in the Magnificent Seven stocks is mostly restored.

This leaves expensive valuations as our primary concern: six out of the seven valuation metrics we use for stocks place the US in the top 20 per cent of its historic readings.  When priced for perfection, markets have fewer opportunities to positively surprise. But on the other hand, questioning the spending power of the US consumer and the dynamism of the US economy has rarely been rewarded.

There is also a good chance Trump will re-emphasise the aspects of his policy agenda that are likely to produce greater growth as his Republican colleagues focus on the midterm elections.

Other markets

Perhaps the best outcome this year from the trade tariff psychodrama is the reassessment of markets outside the US and what policymakers now see as feasible and even desirable. Chinese and German fiscal policy changes designed to ignite growth have been welcomed by market participants looking for alternatives to the US for their capital, but many investors are nervous about global debt levels.

Normalising energy costs here are helpful: European natural gas prices have fallen 75 per cent from their average levels in 2022, even if they are still double the levels of the prior 10 years. This should feed through to consumers eventually, but UK and European growth still looks unexciting. Unless you predict a structural uplift in profits, emerging markets could display more durable returns, supported by cheap oil and a soft US dollar.

Turbulent bond markets

Turbulence in global bond markets is less welcome. The market for longer-dated bonds will focus on the future supply of Treasuries, with buyers requiring a higher risk premium. Nevertheless, the real yields on offer are increasingly attractive, and we anticipate better performance across bond markets, if the current hiatus on Trump’s “reciprocal” tariff rates expire without resolution. 

The threat — and sometimes implementation — of tariffs as tools for US goals on trade, fiscal and foreign policy has been a fundamental driver of volatility and performance across global markets this year. Different assets have behaved differently, and not always as expected.

For investors it emphasises the importance of an investment process with the right blend of discipline and flexibility to adapt portfolios accordingly, and to ensure that true diversification of risks is kept as a primary focus.

Please note, the value of your investments can go down as well as up.