Haven’t we heard enough?

Price and volume 

Despite tariffs being about price (inflation), the market is focused on volume (growth). The so-called ‘Liberation Day’ liberated the bears – global stocks have been in free-fall; bond yields have dropped sharply, and the dollar has retreated against other major currencies. There is an unequivocal belief that President Donald Trump’s tariffs have significantly raised the risk of a US recession, and perhaps, elsewhere. Over the last few weeks, US surveys have been highlighting the consumer and corporate confidence collapse. More forecasters are explicitly predicting a US recession. If that is the case, we should expect corporate profit margins to plummet, net income to fall and price-to-earnings multiples in the equity market shrink. The Federal Reserve (Fed) has historically cut interest rates aggressively in recessionary periods. This is probably the road map ahead and more portfolio reallocations are likely to be necessary as a result. Market moves so far have been brutal. From its mid-February peak, the MSCI World Equity index had fallen 9.7% at the time of writing. In the US, indices are down much more; the S&P 500 fell 4.84% on 4 April; the Nasdaq dropped almost 6%. Market pricing is now for four Fed rate cuts this year.

Since 1980, US Treasuries have outperformed US equities for more than two consecutive quarters in 1982, 1992, 2001 and 2008-2009. These were all recessionary periods. If we are heading to a recession, the odds are that it will not just have been Q1 2025 that saw US bonds outperform US stocks. And if that is the case, the pattern is likely to be seen in other markets too.

Stagflation 

In my first ever economics class I was introduced to the supply and demand graph. It shows us that, all else being equal, if the price of something goes up, demand for it will go down. The extent to which demand changes depends on the “elasticity of demand” for that good or service. If it is for example, an essential or low priced good – like bread, oil or a box of matches – demand won’t fall much. If it is non-essential, or there are credible substitutes, demand might fall by a lot more. How US companies and consumers react to the inevitable price and cost increases that will result from the tariffs depends on the good and whether there are realistic (American made) substitutes. The reaction will be complex but there will not be like-for-like substitutes for everything subject to tariffs. So, prices up, volumes down. That will show up in reduced real consumption in the US and reduced exports from the rest of the world. And universal tariffs means that the entire cost of imports goes up, including components and intermediate goods which feed into the sales cost for (mostly) American-made products. That raises the general price level – prices up, volume down. I hate the term, but it’s going to look like what a lot of people will call stagflation.

Doom loop 

For Asian and European based exporters, the tariffs mean reduced demand (because of higher prices their US customers will face) and reduced revenue if they choose to cut selling prices to offset the tariffs. Lower sales and revenues from the US are unlikely to be compensated for by dumping output to third party economies that are also being hit by tariffs. Globally, a trade war might mean the demand curve arguably shifts to the left – meaning volumes down and prices down, eventually. In other words, a disinflationary shock once the full implications of protectionism are seen. It will be made worse by the fact that the dollar is weakening.

Bleak for stocks 

At the beginning of the year, the IBES (International Brokers Estimate System) consensus for aggregate earnings-per-share (EPS) growth in 2025 for the S&P 500 was 14%, with a 2025 EPS estimate of $270. Now that growth rate has been cut to 12.2% with a $266 target. The momentum on expectations is downwards. Readers would not expect otherwise, surely? The global trade system is being upended, price and volume trends point to reduced earnings, and in the technology sector, which drove profits growth in the last couple of years, the exorbitant rents of the early pioneers of generative artificial intelligence are coming down because of increased competition. Growth stories might re-emerge but not when policy is slamming down on free markets.

It's hard to estimate the equity risk premium. But it is generally agreed that it has been very low in the US market in recent years. The gap between the earnings yield on stocks and the 10-year yield on US Treasuries (a proxy for the equity risk premium) has been less than 1% over the past year, compared to a 3.3% gap on average this century. A higher risk premium and lower earnings will mean lower equity prices. Bond yields coming down might help – and they should – but a decline in yields significant enough to offset the other two factors will require the Fed to more than validate current market expectations of another 100 basis points (bp) of easing. Of course, if that happened and equity prices had already responded to the lower growth outlook, stocks will again be a ‘buy’. But we are getting ahead of things here considering that global investors are probably still overweight US equities. Just to frame the risks, if the equity risk premium rose to 3%, bond yields dropped to 3.5% and the 12-month forward earnings target came down another 10%, the calculated value for the S&P 500 would be around 30% lower than where it closed on 3 April. That sounds a lot. It would take the market back to its low, following the onset of the Fed’s tightening cycle in 2022.

US vs. us  

I don’t enjoy contemplating a global recession and equity bear market – my pension pot is in reach, and I don’t want it to be diminished (boomers buy bonds!). Yet I can’t conclude a happier outcome when the US administration has no empathy with the rest-of-the-world and is prepared to use strong-arm and barely believable tactics to get what it appears to think will be good for Americans. There is an incentive for the rest of the world to realign away from the US, but that is not going to be easy (the UK government won’t even speak of reversing Brexit; more broadly there is suspicion of China; and so on). So, the response to what is going on is likely to be insular and nationalistic - the danger is more protectionism everywhere. Trump wants other countries to respond to his policies with “phenomenal” offers. Whether they will or not remains to be seen but the genie has been long out of the bottle regarding the US’s singularity ambitions. Monetary and fiscal easing everywhere seems likely now. Europe may have to become very creative in accelerating its spending stimulus. If it does, then the case for European stocks is relatively better still.

Bond bulls 

Bond yields below 4% in the US and UK, and below 2% in Europe are likely in this deteriorating environment – indeed, the US Treasury 10-year cracked 4% on the morning of 4 April. Central banks have plenty of tools to deal with recession and disinflation if they become material risks. At some point, investors would be wise to think about the best protection against longer-term inflation (equities and high yield bonds become the go to asset classes at some point, but again, that is ahead of us). Another cost of any response to a global slump will be more government borrowing and steeper yield curves in time. Low (or zero) duration, high quality cash-flow based assets that deliver a meaningful premium to cash will be preferred to an asset class that runs long-term debasement risk. The appeal of short-duration inflation linked bonds is clear.

Self-harm 

The early take on the tariffs is that the effective rate for the US will rise to between 20% and 25%, the highest since the 1920s. (It’s not the Trumpian view but mainstream economists argue that the Smoot-Hawley tariff act of 1930 worsened the great depression). Consumers will end up paying a lot of the tariff cost and that will impact consumer income and spending. The stock market is telling us that there are great concerns – everything is down but consumer discretionary stocks had a particularly bad day on 3 April.

There may be some relief from negotiations between the US and other countries, meaning concessions on currency and other non-tariff impediments to US exports. But demand for US goods is likely to be severely damaged in response to Trump’s tariffs. Despite the theatrical statements of victimhood, a relatively valid argument is that the US has not made things that the rest of the world wants to buy, or it can’t make them cheaply enough or of good enough quality (American cheese anyone?) Add to that the fact that Americans spend too much and save too little goes a long way to explaining the trade deficit. Causing a recession is not going to change that except impoverished American consumers will demand less imports. Neither will the tariff policy change the fact that robots are cheaper and better at making cars. Hordes of newly trained assembly line workers in Michigan and Louisiana is not one of the results of tariff policy we are likely to see. And if car makers move a plant from Mexico to the US, it does not guarantee more sales either. It’s a mess.

(Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 3 April 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.