After a week of turmoil markets have rebounded, as the Trump administration announced a surprising backflip on its Reciprocal Tariff Policy.
The S&P500 jumped 9.5% on the news, while the ASX200 rose 4.5%. The A$ has rebounded to just over 62c, after dropping to 59.5c the day before the surprise policy backflip.
The market’s initial bullish reaction was tempered the following day, as the reality of a deteriorating US-China relationship saw US equities give back 3.5%. The A$ has managed to marginally extend its gains as the US dollar saw broad selling.
The catalyst for Trump’s partial but significant policy reversal appears to be the pressure of rising turmoil in equity markets, credit markets, and ultimately even the US government bond market, combined with staunch criticism from respected corporate leaders in the US.
While it is a pause - not a cancellation - investors appear to be leaning towards the view that the reciprocal tariff policy that was set to impact over 70 countries will be significantly walked back before the 90 day pause ends.
We see this as an incremental positive for both the global and US economy, as well as key asset markets, relative to the situation facing the world in the middle of last week.
While investors were hopeful for some form of negotiation/walk-back outcome, consensus had been building that it would be a drawn-out process with no guarantee of significant progress.
A Positive Development Yet Plenty of Uncertainty Remains
While Trump’s rapid backflip is an incremental positive, significant uncertainties remain.
A significant walk-back of the disastrous reciprocal tariff plan appears likely, but is not certain.
The 10% baseline tariff that affects just about all trading partners remains.
Sector tariffs also remain in place on “strategic” goods - namely steel, aluminium and autos.
At the same time, the China tariff was escalated again to 125% (it appears to have been escalated yet further to 145% as at 11 April).
Relieved but still dazed and confused
The market’s positive yet volatile reaction is justified in our view. Trump’s about-face may be a positive, but significant uncertainties remain. Most important is the parlous state of the US-China relationship, given China is the USA’s second largest trading partner after Mexico.
Even if the now 145% US tariff imposed on China is negotiated down (to say 50-60% as per Trump’s election campaign pledge) and the global tariff remains at 10% with some additional sector tariffs, then the inflation pulse for the US is significant (¬2%).
Apart from the straight mathematical impact of higher tariffs, investor, business, and consumer confidence has been hit hard by Trump’s nonsensical and haphazard trade policy, and some scarring is likely.
Despite the market bounce and the “better than mid-week” outlook, some additional risk premium for US assets is likely permanent or could take years to unwind.
US Equities Still Priced Optimistically?
From this perspective, even though the US equity market is now down (as at 11 April) 13% from its mid-February highs, it is not screening as particularly cheap. We estimate the price-earnings ratio for the US - based on the usual methodology of one year forward consensus earnings - is in the 19 to 20x area. This is better than the recent high of 22x (which was close to a record high) but is still expensive versus anything more than a five year average. The US is still being priced at a big premium to the rest of the world. While we have long argued that the quality and growth potential of US corporations demands a significant premium, the US now faces the reality of a relative de-rating, given its recent policy missteps.
Cyclically, the US also faces the prospect of a significant economic slowdown, due to damaged confidence and a spike in the cost of living (from tariffs). Even if the US can avoid a recession over the coming 6 to 12 months, the embedded 11% earnings growth that is in the current market valuation is carrying above average downside risk. Our base case is that low single-digit earnings growth is more likely, with significantly more risk if the US does indeed fall into recession (not our base case but a close call).
The US Bond Market. Bad News Is Good News. For Now
While the US equity market has been incredibly volatile, it is arguably the US bond market that forced Trump’s hand in reversing much of his tariff policy. After an initial sizeable drop in long-term interest rates post the Liberation Day announcement on April 2, bond yields started to sharply reverse course in the middle of last week to move above pre-Liberation Day levels.
While there have been a number of reasons put forward, all with some degree of merit, it appears that leveraged hedge fund positions in the bond market were being forcibly unwound, causing significant stress in the system. This appears to have tipped Trump into his embarrassing backflip. Long-term bond yields have seemingly stabilised, and the most recent bond auction demand has been strong.
However, even the US bond market faces the tail risk of a buyers strike if some policy sanity fails to prevail. Our base case is that US yields are to track lower, as the market absorbs the reality of an economic slowdown and the likelihood of a significant fall in the Fed-driven front-end of the curve. Australian ten-year yields have been swung around with US trading and look good value at 4.3%, versus expectations for the RBA to lower the cash rate to at least 3% over the coming year.
Pausing for Breath
In summary, we see Trump’s rapid-fire trade backflip as an incremental positive for the US and global economy and for equities compared to the dangerous position last week. However, significant uncertainties and risks remain.
Policy volatility has been unprecedented over the past week, and this will undoubtedly hurt market, business and consumer confidence.
Our recent tactical shifts to lower global equities and increase domestic bonds remain in place for now. We believe the most likely (rational) outcome is for a successful winding back of the reciprocal tariffs and a walk back of the punitive China tariffs, but this could now take time. We need to wait for some additional better news on these fronts before upgrading our tactical equities outlook.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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