So far, April has indeed been the cruelest month in a long time for global markets. Yesterday, as the Trump administration prepared to levy even higher tariffs on Chinese imports, LNW CIO Ron Albahary, CFA sent a follow-up note to clients with our last thinking. Below is an excerpt:
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The Trump tariffs, while pitched as economic rebalancing, to us seem akin to a blunt-force shock to global trade, business confidence, and inflation dynamics based on a dubious methodology.
The instrument of force is a new U.S. effective tariff rate not seen since the early 1900s: 10% tariff on all imports, plus “reciprocal” tariffs of 20% to 64% based on a country’s trade surpluses, with escalation already underway. U.S. tariffs imposed on China doubled yesterday, and both China and the European Union raised their tariffs in response.
Here are what we see as the likely baseline consequences based on what we know so far and IF the tariffs and counter-tariffs remain in place for the next 6-12 months:
- GDP hit: U.S. GDP for fourth quarter 2024 (latest available) was 2.3%. If tariffs remain in place, economist estimates are coalescing around a drop in U.S. GDP of 1% – 2%. Regardless of the exact level of impact, global GDP and trade volume contractions are likely. A sustained market decline would likely reduce U.S. consumption, the strongest pillar of this expansion, given the sizable negative wealth effect.
- Recession & stagflation risk: Estimates for the odds of a U.S. recession have risen to as high as 60% – 75% should tariffs persist. At the least, we are likely to see slower growth with higher inflation (i.e. stagflation), with cascading effects on consumer sentiment, hiring and capital investment.
- Supply chain disruption: Retaliatory measures from China, the European Union and others could unravel complex global supply chains. Eventually, once the rules of engagement stabilize, companies will adjust; they demonstrated their ability to do so during the Covid-era supply shock.
- Lower commodity prices and U.S. interest rates: The U.S. dollar had already been weakening and the yield curve has shifted downward, indicating the market may be seeing tariff implementation as a deflationary shock (rather than inflationary). If that is correct, the resulting drop in demand would likely cause oil, metals and broad commodity prices to fall. The shift downward in the yield curve, driven by heightened recession fears, should provide some financial relief for companies and households struggling with higher interest rates. That said, volatility in interest rates has been high (yields unexpectedly shifted upward yesterday) so what rates are indicating can change quickly. We will be closely watching the movement in the U.S. Treasury yield curve and credit spreads (which have also widened recently) for signs of additional market stress.
- Capital flight risk: Foreign investors, especially from Europe and Asia, may reduce or liquidate their U.S. equities and/or shift capital investment to other countries (both in the short and long term) to start reducing their reliance on the U.S. economy, regardless of the incentives that may be offered by the Trump administration. This is a real risk for the U.S. and an unintended consequence of erratic tariff policy, but this would support an internationally diversified portfolio not only because non-U.S. companies and economies would benefit from higher investment; a weaker dollar would also generally benefit assets denominated in foreign currencies as their pricing is converted into dollars.
- MEEGA “Making Everyone Else Great Again”: U.S. isolationist policies may have the opposite effect by driving trade partners to strike up relationships with other countries and invest more in themselves, reducing dependency on the U.S.
- U.S. bear market: U.S. equities have clearly stumbled as investors have questioned the administration’s strategy. With the S&P 500 on the verge of entering a bear market, stock valuations may compress further as earnings expectations are revised downward.
What’s the Aim of Trump Tariffs?
We think the Trump administration has a political sequencing issue, and it wouldn’t surprise us if their actions are akin to a company expecting a bad quarter and throwing out the kitchen sink to get all the bad stuff out of the way upfront. (As an aside, companies this quarter may take the opportunity to do just that by reducing forward guidance thereby putting additional pressure on equities.)
Trump 2.0, we think, knew they had a sequencing problem vs. Trump 1.0. They had to tackle what they considered to be the economic detractors first (illegal immigration and trade/tariffs) before introducing what they believed to be growth catalysts – tax cuts and deregulation (as well as driving interest rates lower through their tariff policies).
Treasury Secretary Scott Bessent has continued to say we are still in the “Biden economy,” and that the “Trump economy” wouldn’t manifest itself for another 12-18 months. He isn’t necessarily wrong. Today’s economy is a reflection of what transpired over the past few years, and it does take time for new policies to have an impact. With that said, we think the administration is plausibly banking on some or all of the following:
- Deregulation and tax cuts in mid-2025 boosting economic activity
- A weaker dollar, despite the flight to safety, boosting U.S. exports and capital investment in the U.S.
- Lower U.S. interest rates, as the Fed tries to combat a slowing economy or recession. Trump et al. can then characterize this as a “rescue” from the “Biden economy,” just in time for mid-term elections Nov. 2026.
- Sign high-profile bilateral trade deals with major trading partners. The shock-and-awe tariff strategy lowers the bar to such an extent that the ground is set for the President to then announce “wins” on a regular basis, providing catalysts to turn negative sentiment back to positive over the next few months.
I think it is hubristic for any Presidential administration to believe they can manipulate the U.S. and global economy to such an extent and time their desired outcomes just right. But, who knows, perhaps it is possible to “stick the landing.”
What Now
A risk we identified in a note to clients the day after the 2024 Presidential election bears revisiting:
“The unknown unknowns. An unexpected shock to the system is always possible but it is perceived as more likely during periods of higher instability, where we find ourselves today. The state of homeostasis that we’ve all become used to can quickly evaporate as an exogenous shock changes stability to instability. Some of our diversifying portfolio exposures are likely to hold up a bit better than others if we experience equity and/or bond market volatility as the composition of the new administration unfolds.”
The state of homeostasis has evaporated and the rules of engagement for making decisions are changing with little clarity regarding where they will settle. We have shifted from geopolitical decision making grounded in economic fundamentals to “game theory”: The outcomes of the current environment, perhaps more than any time in recent memory, rely on the decision making of others, like China, Canada, Mexico and the European Union. To some degree, it almost feels like President Trump is not playing four-dimensional chess but Russian roulette.
Regular readers of our Commentaries know that we do not fancy ourselves as economic or market forecasters. That remains especially true today in light of extremely high equity market volatility, which yesterday saw the S&P 500 whipsaw from a 4% loss to 3% gain within a few hours to finish very slightly down.
What we do know at this point is that investors do not have enough clarity to gauge the probability of the negative vs. positive scenarios. The markets could selloff further from here as U.S. equity valuations are still not cheap from a historical perspective. In considering the more pessimistic scenarios, a further drawdown of 10%-20% (or even more) for the equity portion of portfolios is not out of the question.
We are not trying to be alarmists but realistic. Uncertainty weighs heavily on corporate decision-making (i.e. hiring and investing) as well as equity multiples. With that said, equity downside risk is normal and what you sign up for as an equity investor. Thus the importance of having a well-diversified, properly calibrated asset allocation aligned with your risk tolerance and goals.
What We Are We Doing
In my April 3 note in our Flash Report, I stated that this is not the time to abandon long-term strategic allocations. This is a time to be deliberate, recognizing that volatility can provide opportunities for our managers and that the potential scenarios to play out demand a fine balance between offense and defense. Our investment philosophy and portfolio construction process are designed to navigate both bull and bear market cycles in the following ways:
Potential Risk Mitigators
- Cash allocations. Over the last several months, we have been topping up cash allocations where appropriate and rebalancing portfolios as part of ongoing risk management.
- High-quality fixed income and diversifiers (especially core hedge fund exposures). Both have performed relatively well in the equity market selloff, and we expect they will continue to do so should investors grow increasingly more risk-averse, and the selloff continues.
- Real assets. We also continue to recommend core positions in real assets, which are specifically included in portfolios as inflation-risk mitigators as well as potential contributors to risk-adjusted returns. Given the potential for accelerated inflation, these exposures have also provided ballast to portfolios and remain attractive.
Potential Risk-Adjusted Return Enhancers
- Foreign asset allocations. We maintain globally diversified equity portfolios, and that potentially makes even more sense today with the tariff framework providing a near-term catalyst for stronger performance by non-U.S. stocks. However, we are not recommending major shifts into overseas assets as the recent intra-day market volatility underscores a high level of uncertainty regarding tariff policy.
- Diversifiers. Private credit and select hedge fund exposures can take advantage of dislocations as we have now by providing liquidity at attractive terms to those who need it in the private markets. In private equity, middle-market domestic firms may be in a stronger position to navigate the changes in trade policy and may benefit from deregulation and tax reform in the second half of 2025.
- Special opportunities. Back in January 2022, we noted that reshoring would be an important secular trend. Going forward, there are likely to be additional opportunities for our managers to invest in public and private markets that are supported by a shift to a more nationalistic, multi-polar global trade regime.
- Portfolio management. Building portfolios with an objective of achieving long-term goals means something different for each client. For some, heavier allocations to risk-oriented assets (e.g. public and private equity) are necessary to achieve those goals, while for others, a more conservative approach relying on fixed income investments is more suitable.
