A Reset On The Trade Front Warrants A Reset In Investment View
The big news over the weekend was that the U.S. and China have reached an agreement to slash punishingly high tariff rates for 90 days as negotiators on each side work towards a more expansive deal. The U.S. will reduce tariffs on Chinese imports from 145% to 30%, and the Chinese will cut tariffs on U.S. imports from 125% to 10%. There are some other particulars for those interested in getting into the weeds, but the main takeaway for investors is that worst-case outcomes for markets and the economy have been dramatically curtailed. This goes far beyond any “détente” markets were expecting going into the weekend, hence the dramatic rally taking place in risk assets: high beta stocks surging, low beta plays flat to lower, gold selling off, bonds weaker, and the U.S. dollar well bid – the kind of price action you would expect with the left tail of the distribution curve narrowing dramatically.
It's important for investors to focus more on the outcome and what it means rather than getting down in the weeds on how we got here. It’s easy to play Monday morning quarterback and question the strategy, but at the end of the day, the global economy is in a better place when its two largest economies are not tied up in what amounted to an outright embargo, given where tariff levels were last week. If you were harsh in blaming this administration for their tactics and approach (myself included at times), you shouldn’t be shy about giving them credit for quickly figuring out that they were in a deep hole and needed to stop digging. They did, and now we all have a do-over on where we go from here, as you can see from the chart posted by Jim Bianco, showing most of the major indices from around the globe are now trading above where they were going into Liberation Day.
So, not only is policy getting a reset where negotiations will continue among all trading partners, but so do investors, which may be particularly helpful for those flexible enough to reassess the setup with an open mind.
As I type, we are a couple of hours into trading on Monday morning with the S&P up +2.5%, the Nasdaq Composite up +3.5%, the small-cap Russell 2000 index up +2.9%, and the U.S. dollar up +1.23%. Let me remind you that all of these indices are still down on the year between -1.4% (S&P 500) and -6.6% (Russell 2000). Sticking with the analogy from above, we’ve been able to climb out of a deep hole, which feels like a whole new lease on life. It’s the defensive areas of the market that are getting sold aggressively or lagging today: Gold -2.75% (+23% ytd), gold miners -6.75% (+38.5% ytd), Utilities -0.56% (+5.4% ytd), and the All-Country World Index ex-U.S. +0.74% (+11.83% ytd).
The bond market is trading down as the 10-year T-note yield is up +5 basis points to 4.43%, which makes sense given today’s news, but yields across the Treasury curve are up since Liberation Day: 2-year 3.97% today vs 3.90% on April 2nd, 10-year 4.43% today vs 4.20%, and the 30-year 4.87% vs 4.55%. This is something I’m going to hit on more below, but recall that it was the bond market (higher yields) that forced Trump and Bessant to pivot as trading in the world’s reserve asset (U.S. Treasuries) was becoming dysfunctional on April 8th and 9th.
While investor attention is rightly fixated on the latest Truth Social post coming out of this administration, there are other significant developments to keep your eye on. We learned last week that Jay Powell is in no rush to cut rates. Chair Powell went out of his way to express how uncertain he and the FOMC were about what the future holds, and as a result, a ‘watch and react’ stance is the approach they are taking on policy. Keep in mind, this almost guarantees they will be late to act if/when monetary action is needed, but that is how they are playing it. Doesn’t mean investors have to do the same, but it's important to understand where all the pieces are on the chessboard. Interest-rate futures show the Fed is still expected to cut rates this year, but is inching closer to two cuts from three. Additionally, the timing keeps getting pushed out: a June cut is down to just 8% odds, July is at 35% odds, and September is now priced as the next time we’ll get a rate cut at 66% odds (down from 100% 10 days ago). Then again, this is a headline-driven market, not a policy-driven market where a lot can change in a moment's notice.
We’ve heard comments from a host of Fed members since the FOMC that illustrate the complexity of the current environment for businesses, consumers, and policymakers. This is what Richmond Fed President Tom Barkin had to say on Friday regarding the economy: “What I’m hearing from retailers is that consumers are about tapped out,” adding (with implications for inflationary expectations), “that means it’s nice to say you’re going to pass it on, but it’s not as easy to pass it on as you might think.”
Additionally, New York Fed’s President, John Williams, weighed on the topic: “We are hearing more reports from businesses and others that consumers are starting to pare back some of that consumer spending.” Not the greatest news for profit margins or the stock market, but it is good news from an inflation stance.
I’ve spilled a fair amount of ink in prior missives about the transition from monetary dominance (where the Fed was the most important driver of economic outcomes) to fiscal dominance (where political leaders and their control of the purse strings are the most important drivers). It’s this thesis that causes the biggest doubt in my mind when I start to get negative on economic growth or the potential for an economic recession. Even over the last several weeks, where our work had me gravitating towards a recession outcome given the tariffs levied by the U.S. on the rest of the world post-Liberation Day, I still had significant doubt that U.S. economic growth could contract for a sustained period if the fiscal policy train continued to roll down the tracks. Nevertheless, given the reset on the trade file over the past month, that risk factor has been removed, and the latest developments on the fiscal front have me backing off the recession scenario quite dramatically. It’s not entirely out of the probability distribution, but its probability is substantially lower.
Beyond what has changed on the trade front, what we’re seeing coming out of Washington, D.C., on the budget process is a Republican commitment to blow out the deficit in the coming years. The bill coming out of the Ways and Means committee not only extends the TCJA tax cuts, which are estimated to add $5 trillion to the federal deficit over the next 10 years, but also adds an additional $3 - $4 trillion in deficits.
So far, this administration has been no different than the prior administration when it comes to fiscal responsibility despite all the attention garnered by DOGE. The current pace of federal expenditures are outstripping what they were under Biden’s last year in office with little indication, other than platitudes, that legislators are serious about reigning it in.
The details that are coming out of the sausage-making surrounding this “one big, beautiful bill” suggest that big deficits will remain the status quo:
The biggest question is where all the horse-trading in the House settles out with the cadre of fiscal hawks who don’t want to see the status quo maintained. The House's original budget targeted $2 trillion in cuts to offset the TCJA and increased revenue via tariffs. Well, tariff revenue is set to rise, but not nearly to the level penciled in a couple of weeks ago. When all is said and done, it is more likely that the fiscal hawks will have to accept small victories on some fronts, but acquiesce to the fiscal freight train continuing to roll down the tracks.
In a nutshell, the Senate, House, and President all seem to be rowing the boat in the same direction, where early in the administration, they talked about putting the U.S. on a more solid fiscal path as a priority. However, what we’re seeing coming out of each branch is a broader embrace of populist spending vs. prudence and pain. If the broad strokes of what we’re seeing becomes law, it puts the U.S. on a path to see >8% deficits to GDP with an economy operating at full employment and not having fully slain the inflation dragon.
The market implications are material in that it is bullish stocks, gold, and commodities while being bearish for bonds, yield-sensitive investments, and the U.S. dollar. However, inflation will be the wild card because if it remains stubborn to the upside, then that further handcuffs the Fed (might even put them back into a hiking bias) and will keep interest rates elevated. I admit to being pleasantly surprised at how well the economy and consumption have held up with interest rates 3- 4x higher than they were just five years ago, but this is a catch-22 situation. Retirees and savers, the boomer generation that controls nearly 2/3rds of the wealth in the U.S., are a beneficiary of this higher interest rate regime, while asset-light households or borrowers are penalized. The late 1960s through the 1970s was another populist era where inflation and interest rates remained high, which gradually compressed P/E multiples on stocks to single digits by the early 1980s. I’m not saying we’re going to see a repeat of the 1970s, but don’t be complacent to the rules of finance where the cost of capital, interest rates, and inflation are significant factors in calculating the intrinsic value of an asset. I know, I know, those prehistoric fundamental calculations don’t matter anymore (sarcasm intended), but what if they do (because they do in the long run)?
Another beneficiary of this evolving investment landscape is foreign equity and debt markets, where they have more fiscal and monetary room to support their economies. Not to mention cheaper relative valuations to the U.S., although not exactly cheap on an absolute basis.
Bottom line, with the constructive developments on the trade front and expected path of U.S. fiscal policy, stocks, gold, and commodities look favorable relative to intermediate-to-long duration treasuries and credit. High-yielding money markets and Treasury bills are the only areas I would feel comfortable allocating the majority of a portfolio’s defensive/safe capital. Don’t get me wrong, I’m more constructive on risk assets than I was last week, given the developments on the trade front between the U.S. and China, but I remain of the view that the margin of safety remains razor thin in U.S. equities for an ambitious policy agenda fraught with execution risk.
Make the best out of the reset on all fronts, including the equity markets, that is why they are trading back up near all-time highs in price and valuations, but understand that the bar is now reset higher for good outcomes. However, I caution against backing up on risk at current levels because you didn’t have the courage to do it at lower levels; don’t compound a mistake with a mistake. Additionally, watch interest rates, they are creeping higher. A move above 4.5% on the 10-year will start to weigh on equities, while a push up to the highs on the year around 4.80% will be trouble holding all else constant.
Be patient, be disciplined, and continue to adapt – there will be more opportunities to come.
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