The End of an Era?

Chip Wrappers

Back in the days before Health & Safety regulators decreed that wrapping chips in old newspaper was unsafe, it provided a good metaphor for the ephemeral nature of news. Policymaking and markets are moving with indecent speed at the moment, and so there is always a risk that some of this commentary will have a very short shelf life. To illustrate just how fast things can change, there was a moment on Monday when the S&P 500 Index rose 8.5% in just half an hour as comments on a news channel were misinterpreted to suggest that President Trump was going to pause the application of tariffs to allow time for negotiations. Fifteen minutes later, following some backtracking, the market had fallen 5.5% from that intraday peak.

We are talking about moves generally seen over a year happening in less than an hour. I have commented regularly that the current structure of markets, featuring leverage, the increased use of derivatives such as options, and the procyclical nature of market liquidity (it has a habit of evaporating just when you most need it) means that higher short-term volatility is a ‘feature’, not a ‘bug’. There is no possible way we could implement short-term trading views in this environment, and we are not going to try. Our investment horizon remains a distant one and is relatively fixed. It’s only the choppy seas that obscure it from view at times.
 

Tariff Man

There are several aspects of Donald Trump’s presidency that raise red flags for investors. The results of some of his actions, such as the nature of his appointments to a number of important roles and his plans to eviscerate large chunks of central government, might not become apparent immediately, but the imposition of tariffs is something that investors feel they can and should react to. Our opinion has been consistent that tariffs, badly reasoned and applied, are a poor policy tool - and these are dreadful. I will concede that tariffs can be used with some justification in certain circumstances. There can be legitimate grounds of national security, for example, or the protection of certain industries from predatory behaviour. Nascent sectors with strong growth prospects can be shielded from competition, although even that’s pushing the limit.

The calculation of the tariff levels in this case has been variously described as “what astrology is to astronomy” and a school project conceived, created, and delivered at the last minute with the help of ChatGPT. Inconsistency is rife. For example, there is a blanket 20% tariff on the EU despite the fact that some member countries, such as the Netherlands, have trade deficits with the US. Madagascar has a tariff rate of 47% (half of its net trade surplus with the US, which is how they were calculated) owing to the unique product that it exports, vanilla pods, which require a specific climate and to be pollenated by hand. Does the US really intend to become self-sufficient in such a ‘strategically important’ commodity?

Whatever the methodology, Trump’s tariff theory is misguided on at least two major fronts. First of all, he believes, wrongly, that trade deficits are the result of the United States having been "looted, pillaged, raped and plundered by nations near and far, both friend and foe alike”. He fails totally to acknowledge the benefits derived by US companies, who have taken advantage of being able to outsource to cheaper labour markets, or by consumers, who can buy goods that are either much cheaper or otherwise unavailable in the US. This has been a key factor in the rise of corporate profit margins in the US and, as a result, higher valuations for equities. All other things being equal, removing this benefit will result in lower profitability, which is something that investors are pricing in. If he continues on his current path, we suspect that he will not be able to ignore the corporate backlash forever.

Second, he thinks that tariffs are a wonderful source of income for the government, Even more incredibly, he seems to believe that it is the exporters to the US who will pay them, even though the burden will more probably fall on US consumers and companies. So far, at least, his plan for some of the costs to be mitigated by a stronger dollar is not working either, as investors retreat from the US. The $600-800bn figure being touted as the income from tariffs sounds impressive but is dependent upon current levels of imports being maintained. Is that plausible? It’s not exactly what he is trying to achieve. And there are other taps of growth that are turning towards ‘off’. These include household consumption coming under pressure from higher prices, falling real wages, a weaker wealth effect and rising unemployment; a weaker fiscal impulse if Trump is serious about getting the deficit down; lower capex than currently planned (how do you make decisions in this environment? ‘Reshoring’ does not happen overnight, and many of the recent big investment announcements, such as Apple’s $500bn, were reheated leftovers); weaker external demand (there is a soft boycott of US goods and reduced travel plans to the US, not to mention the fact that global growth forecasts are being cut).
 

US Recession Risk

Our subjective probability of a recession developing in the US is 45% (from 25% a month ago). The Polymarket betting probability (which was quite good at predicting the outcome of the US election) has risen from 40% pre-tariff announcements to 61%. But it’s fair to say that everything is dependent upon Trump’s whim, and that, to a great degree, will be dependent upon the reaction of other countries to the tariffs. The equity market, being a discounting machine, has already priced in some of this probability, and this can be seen in the lower valuations given to equities. China’s retaliatory 34% tariff was the first escalation on Friday, and that was followed by Trump threatening another 50% on China on Monday (which has now been enacted).  Price screens turned immediately red on both occasions. Ultimately, we believe that a lot of the current tariffs will be bargained away, although not necessarily returning us to the status quo ante. The stickiest ones could be on China, the US’s only rival as the global hegemon. Finding an ‘off ramp’ to de-escalation that saves the face of both Presidents could be a challenge.

The peak-to-trough fall in the S&P 500 Index of 17.6% (to the close on 7/4/25) comes on barely a sniff of lower earnings estimates, at least based on an aggregation of bottom-up forecasts. Analysts have had no time to react and there is also a wide range of possible outcomes depending upon the eventual tariff levels and who pays them – exporters (lower prices), companies (lower margins) or consumers (higher prices – which they did not vote for!). What we are witnessing here is a front-running of earnings downgrades combined with a higher equity risk premium, which makes a lot of sense. But what happens next, and what might tempt us to be more positive on equities?
 

Navigating The Trough

We are of the opinion that anyone who says they have ‘called the turn’ or ‘got in at the bottom’ will have done so purely by chance. Market lows are usually defined by a high degree of uncertainty and not conducive to exact science in terms of, say, valuations or earnings projections. And if there is some sort of defining event (such as a favourable tariff announcement or central bank intervention) then the market will be marked higher before you can even decide what you wanted to buy.

And so, we need some sort of roadmap. Barring a specific market-turning news event, we can look at estimated earnings in the context of bond yields, credit spreads, the equity risk premium and historic valuations, as well as observe more technical factors ranging from market sentiment and positioning to chart analysis. On our current analysis, the aiming point is around 10% below current market levels. This might sound worrisome, but, in reality, is well within the boundary of potential drawdowns modelled in portfolio risk projections. And it’s also worth bearing in mind that this is just for equities. There are other elements of balanced portfolios that are able to provide stability and even gain in value while equities are falling – but it’s usually only stock markets that you hear about in the media.

You might well ask, then, if we see further potential downside risk, why are we not taking an even more defensive stance? First, we are seeking some sort of preferred level for buying which optimises the risk/reward balance, not making a forecast that this is where it’s going. Second, we are acutely aware that selling well (assuming it is a good decision) also requires one to buy well on the other side of the trade. As we saw on Monday, when only the slightest hint of better news was enough to add $2.5 trillion to the S&P 500’s market capitalisation, timing one’s re-entry is fraught with danger.
 

Interest Rates

One potential silver lining of the current episode is that interest rate projections have shifted, with futures markets now pricing in four quarter-point cuts in the US Fed Funds rate by December, and three-and-a-half in the UK. Maybe that is not so attractive to deposit holders, but it would help on other fronts. There is plenty of debt scheduled for refinancing this year, from countries, companies, and mortgage holders (especially in the UK, where 5-year deals agreed in 2020 are expiring). Lower rates would be welcome.

Whether lower bank rates feed into equally lower longer-term bond yields is more open to question. On Monday, we saw a sharp move higher in bond yields following recent falls. We have had a couple of warning shots in the past about how investors view persistently high fiscal deficits negatively, and if weak growth means lower tax receipts and higher benefits payments, that will add more pressure. This was not a problem when debt-to-GDP ratios were low (say under 70%), but most developed economies now have debt-to-GDP ratios of 100% or more and, as bond yields have risen this decade, are having to pay more of their tax receipts away in interest payments. Bearing this in mind, we continue to recommend holding government bonds below benchmark duration.
 

Taking The Long View

It gives me no pleasure to keep having to remind readers of this, but risk (as defined by market volatility) is the price we pay for better returns… in the long run. Our portfolios are not leveraged, and so not in danger of being wiped out by unexpectedly large falls, and we have an enduring preference for investing in sound companies with limited risk of failure. Sometimes it’s enough just to be around to fight another day and then be able to enjoy again the positively compounding nature of financial returns. There is no doubt that we are in challenging times, but the promise of innovation and progress is, perhaps, greater than ever as we contemplate the potential for new technologies to increase productivity.