Markets Moving On From Tariffs
It’s fascinating to see the S&P 500 pressing up against 6,400 at the close of last week, a level that I don’t think anyone could have imagined we’d be at less than four months removed from the chaos and uncertainty that was unleashed on Liberation Day back in early April. The S&P 500 has surged +28% since its low for the year and is in the midst of riding an impressive five-day winning streak, while the Tech-heavy Nasdaq Composite has ripped +38%. It really is humbling to observe how markets have adapted their viewpoint, where a 15% base tariff rate is being treated as if it is a nothing burger. Levels of tariffs that had investors freaking out in April are now celebrated. Sounds strange, to be sure, but this is the nature of setting expectations at an extreme level and then walking back from there while at the same time transforming uncertainty into certainty. The thing is, investors now believe a 15%-20% range across all or most trading partners is going to be the norm, and nobody seems to have problems with that new and higher blanket tariff rate.
However, there will be real-world impacts that we will all see play out in real time: Steel Dynamics and Cleveland-Cliffs sharply boosted their prices in the second quarter, and GM announced last week that the tariffs cost the automaking giant more than $1 billion in its bottom line. Investors are focused on the fact that we are getting greater clarity on the trade file, but there is a cost to this degree of protectionist trade policies.
The big news over the weekend was another trade agreement being announced by the administration, this time between the U.S. and the EU. This came less than a week after a deal was announced between the U.S. and Japan. The EU will now face a 15% tariff on most of its exports to the U.S. (half the 30% level that was threatened) while the U.S. receives greater penetration into the continent's energy market (EU to import $750 billion) and a commitment of $600 billion in foreign direct investment. As with the announced $550 billion investment commitment from Japan, the details are thin on where the money is coming from and in what form, but how dare anyone get caught up in the minutiae or fine print? Although that didn’t stop the FT from raising some questions: Cracks widen in Japan and US’s interpretation of tariff trade deal
“The US will secure 90 per cent of profits from joint investments with Japan only if it takes on a proportional amount of risk and financing, Tokyo said yesterday, as cracks widened in the two allies’ interpretation of their hastily agreed trade deal.”
“The Japanese will finance the project. We will give it to an operator, and the profits will be split 90 per cent to the taxpayers and 10 per cent to the Japanese. They basically bought down their tariff rate by this commitment,” said Lutnick. […] But a slideshow issued by Japan’s Cabinet Office yesterday appeared to contradict Lutnick by saying the ratio of profit distribution would be “based on the degree of contribution and risk taken by each party.”
“Officials familiar with the US-Japan talks said the deal was pulled together during a 70-minute meeting between Japan’s chief negotiator, Ryosei Akazawa, and Trump on Tuesday.”
“Japanese officials said there was no written agreement with Washington — and no legally binding one would be drawn up — after Trump administration officials claimed Tokyo would back investments in the US from which American taxpayers would reap nine-tenths of the profits. Japan secured a reduction in reciprocal and automotive tariffs from US President Donald Trump’s threatened 25 per cent to 15 per cent in the deal announced this week, but different perceptions of what was agreed have become apparent.”
“There is nothing inspiring about the deal,” said Mireya Solís, senior fellow at the Brookings Institution, a US think tank. “Both sides made promises that we can’t be sure will be kept… There are no guarantees on what the actual level of investments from Japan will be.”
Details aside, you have to give credit where credit is due. We are a long way off from understanding the full implications of the collection of trade agreements that have been and will be made, but this administration is taking a swing at restructuring global trade—a very heavy lift—and so far, it is pulling it off. What is really incredible is how these deals are so quickly coming to the fore – we are seeing them being signed in a matter of weeks or months, which is laser-speed when you consider that it took more than two years to negotiate and implement the Canada-U.S. free trade agreement from 1986 to 1989. Then again, it is still unclear whether these are more “frameworks” than real iron-clad “deals” and just how much of this is really “smoke and mirrors.” Complex trade agreements between regions like these tend to take a lot longer to complete than what we are seeing unfold.
Nevertheless, the broadly accepted view is that the U.S. economy needed some tweaking – less reliant on consumption and a bump in industrial investment, and that’s what we’re getting. In its simplest form, the U.S. is levying a consumption tax on the rest of the world and incentivizing investment to revitalize American industry. All eyes now shift to China, where representatives from the U.S. and China are meeting in Stockholm today, with reports suggesting that a tariff truce will be extended for another three months. Furthermore, chatter is growing that a meeting between Trump and Xi is being coordinated for as early as October. This will surely keep investors on their toes and keep the bid alive in the equity markets. Any weakness and Trump can revert to what worked so well in his first term, signaling “trade talks are going well” to prop up equities.
All that said, it does seem incredible as to the extent to which an environment of escaping Armageddon on the tariff file could elicit such a dramatic market reaction. Even with the deals cobbled together thus far, we have tariff rates established at 15% on Japan, 19% on both the Philippines and Indonesia, and the EU at 15%. All in all, it now looks like the effective tariff rate will end up settling in as low as 16% or as high as 20%. Either way, far above the 2.5% effective rate at the start of the year and the highest since the 1930s. Worst-case scenarios from a global trade war were priced out of the market months ago, but investors continue to react to every piece of news without realizing the tariff rate being set represents a huge tax increase on the $3.3 trillion market for U.S. goods imports. The math maps out to an approximate $500 billion tax bite which swamps the $100 billion annualized benefit to the business sector from the tax benefits contained in the Big Beautiful Bill (call it a $400 billion drain on the U.S. private sector, seeing as foreign exporters have so far been shouldering an estimated 20% of the burden).
The laws of unintended consequences still lie ahead and are not being appreciated.
Still, the point is that somebody pays for the tariff increases and the spillovers, and it must be stated yet again that in the United States, it is not the foreign exporter, but rather the importer of record that sends the checks to the government. This has yet to fully play out, and for whatever reason, is being ignored by the marginal investor, or maybe it's me that’s missing the mark in thinking that this represents a drain on global liquidity that will matter at some point.
Speaking of earnings, we’ve had roughly 40% of S&P 500 companies (168) report results, where second-quarter earnings are on track for around a +6% YoY increase, which has predictably topped the beaten-down ~4% consensus estimate back at the start of July. Alphabet set a bullish tone for AI capex growth last week (raised 2025 capex guidance $10bn to $85bn on data centers) and reiterated the theme that the price tag to compete with the big boys in AI is extremely high.
Another theme we’re seeing continue on the course it’s been on for years (notwithstanding the intermittent spasm) is the pace of price appreciation outstripping the pace of earnings growth. Since the end of March, the S&P 500 has risen nearly 14% vs. earnings growth tracking a gain of +6%, so price is outstripping the pace of earnings by roughly +800 basis points. This has the S&P 500 currently trading at a nosebleed 22.6x multiple on year-ahead earnings estimates, more than 40% above its long-term average P/E ratio of 15.8x – despite operating in an environment of elevated real-interest rates. It’s not just on earnings that stocks look expensive; on a price-to-sales basis, the S&P 500 is now valued by investors at more than 3.3 times (according to Bloomberg data), an all-time high.
Look, I’ve learned through experience that it's more lucrative and better for your returns to try to understand why markets are doing what they are doing rather than telling them what they should be doing. There are factors at play that help in explaining why valuations are rich relative to history (passive flows, global capital flows, profit margins, quality factors, momentum…), with market concentration among the world’s most profitable and dominant companies being a major driver. Speaking of which, just 10 stocks comprise almost 40% of the S&P’s market cap today, versus around 20% near the peak of the dot-com bubble back in 2000. And, while I consider this a risk for the markets at some point, it’s not a risk I’m much worried about at the moment.
Right here, right now it’s the return of speculative activity and FOMO that has me cautious over the near-term with specific reference to the boom we are seeing in zero-day-to-expiration options trading (options expiring within 24 hours) having soared off the charts. Not to mention the daily swings in speculative penny stocks becoming absolutely wild. Last week, we had some days where, within hours, the likes of Opendoor and Krispy Kreme soared as much as +40%, GoPro by over +70%, Kohl’s by +50% and Beyond Meat by nearly +20%. The stock market has morphed back into a casino of sorts – akin to what we experienced during the SPAC mania back in the spring of 2021. The most shorted stocks have soared +60% in aggregate from the early April lows in what is turning out to be nothing short of a retail-driven speculative investment boom.
The complete lack of fear is underscored by the VIX, which closed south of 15 last week for just the third time this year. The long-run mean back to 1990 is close to 20. Remember that the best buying opportunity of the year was back on April 7th, when the VIX was at 60 and the S&P 500 closed at 5,062 (that was on April 7th), the lows were turned in the very next day. High yield spreads, at 260 basis points, are where they were in the winter of 2000 and the fall of 2007 — nearly half the long-run norm of 500 basis points. Not to mention that vol-control and CTA funds are nearing max equity exposure in their respective models. ‘Everyone back in the boat’ is the phrase that comes to mind. This doesn’t mean a crash is around the corner, but rather that caution and patience at the current moment is your friend, not your enemy.
Don’t get me wrong, I’m not bearish nor negative over the balance of the year (though willing to change my mind at any moment), but rather tactically cautious and seeing a decent opportunity to de-risk portfolio exposure where appropriate. Another factor playing into my thinking is the modest roll-over starting to materialize in global liquidity (follow the money – both up and down). It’s difficult to see in the long-term chart below, but the passage of the debt ceiling will bring the Treasury back to the market with a more aggressive issuance schedule. Combine this with tariffs, immigration set to negatively filter through the labor market, and a Fed on hold – it all adds up to a marginally negative drain on global liquidity.
Speaking of the Fed, perhaps President Trump’s visit to the Federal Reserve building last week will placate his harassment of Chair Powell for a little while (doubt it). The latest complaint is a $2.6bn cost overrun on a renovation to the Federal Reserve building, no doubt a big number to you and me, but for context, Uncle Sam will spend $2.6bn in the next 3 hours and 12 minutes (data according to Michael Hartnett at BofA ML). Puts into perspective how out of control government spending in general has become.
Nevertheless, the President has been clear that he wants rates lower and while I don’t disagree, it’s a hard sell to economists at the Fed with data coming in as it is. Last week we had initial jobless claims come in at a three-month low of 217k, and the unemployment rate hovering near 4.0%. Not to mention that 10-year market-based inflation expectations from the TIPS market is sitting at a five-month high of 2.45%, +45 basis points above the Fed’s target. At a time of record highs in the S&P 500 and Nasdaq, uber-tight credit spreads, sky-high crypto prices, CRB raw industrials near a three-year high, the speculative resurgence in meme stocks, and a weak dollar – none of this supports cutting rates in the near-term. Liquidity is abundant and capital markets are wide open, so there is no case to be cutting rates now outside of support for the housing market and a bailout of fiscal irresponsibility at the political level to rein in runaway debt-service costs.
Remember one other thing — whoever becomes the next Fed Chairman has one vote. Interest rates are set by the Committee. The Fed is not one person — it is an institution, and one that will always defend its independence. We could be facing a mutiny, and what comes after that is a decision the President may have to make in terms of finding a way to fire the entire FOMC. Which is one reason we won’t likely part with our exposure to gold as the best hedge against a further breakdown in trust and confidence, not to mention an asset that will retain its value in an environment that is structurally negative for the U.S. dollar, to be sure.
Investors have a very busy week ahead with a lot to digest. For starters, 40% of S&P 500 companies report this week (Amazon, Apple, Microsoft, and Meta will be the key companies to watch). The economic calendar is also jammed: JOLTS (June) and the Conference Board’s consumer confidence index (July) on Tuesday. Q2 real GDP is on Wednesday, which is the same day as the FOMC decision. The June core PCE deflator comes out on Thursday along with an important number for the Fed, the second-quarter Employment Cost Index. Then we round out the week with July nonfarm payrolls with estimates spanning a wide gap (0 to +170k) – glad I don’t have to forecast it.
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