The Trump tariff crisis is not over yet

Good morning. This week has felt about three weeks long. Is it too much to ask that not much happens today? Probably. Email us suggestions for relaxing weekend activities: [email protected] and [email protected]. 

What changed, and what did not

The market cheered when US President Donald Trump paused “reciprocal” tariffs on most countries on Wednesday; the S&P 500 rose by 9.5 per cent. Yesterday, the S&P gave back 3.5 per cent of that. 

It may need to give back some more. The ratcheting-up of tariffs on China leaves the US total effective tariff rate higher than it was before Trump flinched. According to Stephen Brown at Capital Economics, Trump’s promise of 125 per cent tariffs on China puts the US’s effective tariff rate at 27 per cent, the same level it would have been had yesterday’s 84 per cent tariffs on China and “reciprocal” tariffs on everyone else had been held steady. And Trump came out yesterday and clarified that the 125 per cent was new tariffs, not the total — putting the US tariff rate on China at 145 per cent (some have suggested it is a bit lower than that). So the US’s effective tariff rate is now hovering around 30 per cent. 

The US imports a lot of basic goods from China: 24 per cent of its textile and apparels imports ($45bn worth), 28 per cent of furniture imports ($19bn) and 21 per cent of electronics and machinery imports ($206bn) in 2024. A 100-percentage-point increase in tariffs seems certain to show up as higher prices for businesses and consumers. The only question is how much higher. 

Recession risk remains elevated. China accounts for 7 per cent of US goods exports, or 0.5 per cent of US GDP. According to Pantheon Macroeconomics, the hit to US exports from aggressive Chinese retaliation will outweigh any boost to GDP from the cancellation of “reciprocal” tariffs; it still expects a slowdown this year, as do most other analysts. And let us not forget that there are still 10 per cent tariffs on most other countries — a far cry from the effective tariff rate of about 2.5 per cent we had just three months ago.

The market, accordingly, remains extremely unstable. Not only are stocks and bonds highly volatile, the level of volatility is itself very volatile. Yesterday, the Vvix, which measures the volatility of implied equity volatility, hit its fourth-highest-ever reading, only below 2018’s “vol-maggedon”, August 2024’s tech spasm and the onset of the Covid-19 pandemic:

The Trump tariff crisis is not over yet.

(Reiter and Armstrong)

Mean reversion in a policy crisis

Earlier this week we argued that even after the tariff panic took a bite out of US stock prices, the prices didn’t look cheap at all. But, as yesterday’s trading demonstrated, the panic may not be through with us yet. Stocks may yet get cheap.

The situation feels a little tricky, though. Might a bear market driven by Trump be different than one driven by, say, a pandemic or the popping of a housing bubble? Erratic and aggressive tariff policy might make it hard to estimate the earnings power or intrinsic value of a company or index. And if Trump’s grand ambitions are realised, the damage to stock prices might be permanent, as de-globalisation establishes a new regime of lower profitability and higher risk premiums. It is a fundamental tenet of value investing that prices mean revert when they stretch to an extreme in either direction. What if Trump sets a new mean?

This time is absolutely not different, says the Financial Times’ Stuart Kirk in his column this week: 

All crises are the same. They stem from asset prices inflating to insane levels and then popping. There are always reasons why high valuations are justified. When they plunge, something else is blamed . . . the Orange Crash is merely the latest in a long history of investors becoming ever greedier as markets rise over a prolonged period, before fear moves in to replace the narrative.

Manish Gupta, a value fund manager at First Eagle Investment Management, agrees:

The implicit concept of value is buying something for less than it is worth. Does the value of a business change under these circumstances? It does, but at the end of the day you have to understand the fundamentals of the business — Is it well managed? Is there cash flow? Is management on the side of investors? You try to estimate intrinsic value — it’s always a moving target — and buy at a discount [to] that estimate, to give yourself a margin of safety. And at moments like this, the discount widens, so you still have that safety

I still wonder how investors seeking value can deal with the possibility that we may be in a new, more difficult valuation regime; does it not throw a wrench into the process of estimating value? I put this question to Rob Arnott, chair of Research Affiliates. He thinks Trump may change the valuation regime for the worse, but that even when that happens, investors can take advantage of valuation differentials: 

Any time you have a shock added to the system, it can be a catalyst for major market moves and in most cases cause a mean revision . . . [If the market multiple is permanently lower] we are still in a world where the US is the most expensive relative to the rest of the world, ever; where value vs growth is the most stretched ever . . . 

Remember what happened in 2008. What was expensive was hit hard, and rebounded gently. What was cheap was hit less, and rebounded more sharply. This can be true even if the whole market trades at a lower multiple. 

A change in valuation regime, in other words, does not change the fact that valuation matters. But Ben Inker of GMO points out that valuation bets are riskier when the price decline is driven by policy choices, because policy can change much more quickly and unexpectedly than most economic variables. “If you think about the financial crisis, the fear was maybe the government can’t fix it and we are doomed to go into a depression. In this case it was, we know the government can fix it, we just don’t know if they will,” he says.

Sarah Ketterer, founder of Causeway Capital, thinks that mean-reversion can still work in policy crises because very irrational policies themselves revert to the mean. She uses the example of the pharmaceutical stocks that have been sold off lately on news that the Trump administration wants the production of pharmaceutical active ingredients to be moved onshore, as well as health secretary Robert F Kennedy Jr’s vaccine scepticism. But domestic production of APIs would be “grossly inefficient” and “without vaccines we’re all in trouble”. 

If Ketterer is right that utterly irrational policy tends to be unstable and is likely to be softened or repealed in time, Trump’s trade policy is going to create a lot of investment opportunities. 

CPI inflation

Yesterday, we got some good news that the market ignored: the consumer price index came in cooler than anticipated. Headline and core CPI both came down substantially and are now both sitting below their October readings, when many pundits called time of death on US inflation:

Unhedged’s preferred measure, the annualised change in month-on-month core CPI, looks pretty darn good, too:

The specialised measures that we often use to undercut good headline inflation — the Atlanta Fed’s sticky price index, the Cleveland Fed’s trimmed median CPI and mean CPI, and shelter inflation — were all good, too. February’s cool reading was not a fluke. 

A shame no one seemed to care. Inflation readings — like all economic data — are backward looking. Trump’s murky tariff policy means good news from the recent past matters less. The two-year Treasury yield, which tracks monetary policy expectations, fell after the report, but rose again in the afternoon. Similarly, after the CPI report hit, the futures market increased its implicit estimate for the number of Fed cuts this year, only to reduce it again later in the day:

Policymakers and the investors know there will be some flow-through from tariffs to prices — they are just not sure how much and for how long. As Fed chair Jay Powell said at a conference last week, tariffs were “highly likely to generate at least a temporary rise in inflation, [and] it is also possible that the effects could be more persistent”. As Don Rissmiller of Strategas notes, it’s possible that tariffs will destroy enough consumer demand that inflation will recede quickly. It’s also easy to imagine a scenario where inflation stays around for longer.

Still, if one has to undergo a potentially inflationary policy shock, it is better to start from a relatively benign environment. 

(Reiter)

One good read

Let’s hope.