Markets in turmoil - now what?
Commenting on the status quo and daring a few predictions.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
TLDR Summary
Markets are waking up to the fact that the US administration is determined to meaningfully reduce the US trade deficit. They are doing so by implementing the most draconian tariffs in more than a century. This will reshape the global economy with downside risks for everyone involved.
Retaliation makes no sense for any country. The US are pretty much the only large scale trade deficit nation on earth. That makes them a monopolist in global trade. A monopolist that sets the terms. Play by their rules or don’t play at all. Those countries embracing that first will come out of this in the best possible shape.
Succeeding in reshaping global trade will however be a pyrrhic victory for the US because they are currently destroying a key competitive advantage. Economic growth will come down. Input costs will rise because sourcing them from abroad will be more expensive. I doubt that this will move up inflation sustainably because sustained inflation requires income growth. Instead, I expect that US corporate profit margins will get under pressure.
All of this should rerate the US stock market much lower, probably much more than the 10% correction level we are currently at. It’s ironic that the US bull case is falling apart precisely at the moment where it became a no brainer. Trump was supposed to launch the next leg of the bull market. Instead, he’s burying it.
The outcome of Liberation Day
As expected, Trump has announced big ‘reciprocal’ tariffs against most countries. The estimated average tariff on all imports is now 22%, the highest in more than a century.
There will certainly be negotiations which may change these tariffs back to a lower level. But it seems clear that the US administration is very serious about their large scale surgery of the global economy. The primary purpose of these tariffs is to reduce trade imbalances and to lower the US trade deficit. Conservative economists (or at least those that influence current policy) loathe this deficit as a matter of national pride.
Domestic manufacturing is deemed a virtue in itself, irrespective of financial calculations. Some go even as far as arguing that the current trade deficit destabilizes American families by reducing the labor market for less-educated men (check out for example this 2019 interview with Oren Cass). This is a highly ideological topic that is deeply engrained in the collective psyche of the political movement currently in charge. There is very little bluffing here.
Irrespective of where tariffs will ultimately settle, a base case for the near to medium term should be that the almost $1tn US trade deficit will come down a lot. Markets are waking up to that fact. As of this writing, the S&P 500 is down 3.5% today to below 5,500. In total, it has lost 11% from its ATH in February. The 10-Year Treasury yield has dropped to 4.07% after peaking at 4.8% in January.
Let’s think through some of the ramifications of all of this.
How will the rest of the world react? And how should they react?
The 2018-2020 trade war between the US and China offers insight into who is likely in a stronger position in a trade conflict. It started in January 2018 with Trump’s first tariffs. And it ended when both administrations entered into a trade deal in January 2020. During that time, the S&P 500 outperformed the Shanghai Stock Exchange by about 30%.
There were obviously other factors at play as well, most importantly Trump’s tax cuts that increased the fiscal deficit substantially which boosted the US economy. But even considering that, it seems obvious that the US came out of this conflict stronger than China.
The US are pretty much the only large scale trade deficit nation on earth. That makes them effectively a monopolist in global trade. It’s difficult to source imports elsewhere, but not impossible. In contrast, China had no alternative buyer to absorb the $300bn trade surplus they had with the US.
The rational choice for any nation is therefore to play by US rules. Drop all trade barriers, hope to negotiate some tariffs down and adjust to the new normal as quickly as possible. I can imagine that many countries will choose that path, especially those in Asia and Latin America. I expect that the European Union will fight back most passionately. It’s the most ideological jurisdiction on earth. Its leaders want to be proven right more than they want to actually achieve a bearable outcome. Europe will likely be the biggest loser a few years down the road.
What will the consequences be for the US?
Contrary to the dominating opinion in the White House, there are very strong arguments that the US have been a winner in international trade for many years. Their trade deficits have poured capital into the country and the US have been able to leverage this capital into strong economic growth. As a result they have outgrown the other G7 countries by a factor of two on a GDP/capita basis over the last 30 years.
This outcome was not inevitable. There are many examples of countries where trade deficits have caused unemployment and have put pressure on the currency which caused inflation and impoverished the population. The US however have had an appreciating currency for the last two decades and unemployment is close to the lowest level ever. Foreigners have been very eager to sell goods and services to America reinvest the proceeds in the US economy where the proliferation of its technology and energy industries provided huge returns.
It seems obvious to me that the new US trade policy will impair this mechanism. The US economy will grow slower because less capital is pouring into the country. Input costs will rise because sourcing them from abroad will be more expensive. I doubt that this will move up inflation sustainably because sustained inflation requires income growth. Instead, I expect that US corporate profit margins will get under pressure.
For reference, before the Global Financial Crisis, the US trade deficit stopped expanding for several years and then it contracted from $60bn per month to $30bn per month. This analogy is far from ideal because the trade deficit contracted back then as a response to a weakening of the US consumer. Very different from the policy-induced deficit contraction we are about to see.
But I think there are some similarities. Expanding deficits had been boosting economic growth in the 1990s and 2000s. When that trend stopped and reversed, economic growth slowed down and the stock market had to rerate to a lower growth profile.
After that had happened, it is my firm belief that the US shale revolution saved the US stock market. Lower energy costs made various US industries more competitive and boosted consumption. Could AI innovation repeat that this time? Imaginable, but challenging.
What will the consequences be for the rest of the world?
It is fairly easy to establish a trade policy that favors an export orientated economic model. You establish trade barriers in the form of tariffs and punitive regulation. If you have a functional economy, this should in theory put upward pressure on your currency which may counter your efforts. But an appreciating currency is easy to manipulate down (the opposite is quite a bit more difficult) which you can use to suppress labor costs. As a result, you will be able to penetrate foreign markets which will help you to manage unemployment and inflation. The better you handle those two metrics, the easier will it be to cement political power.
While it’s fairly easy to run an export orientated economic policy, it also comes with side effects. The potential growth in your economy will be lower than otherwise because a trade surplus is always also a capital deficit. Hence, you are draining your economy constantly of capital that is needed to generate future economic growth. Whether it’s Japan, Germany or China, trade surplus nations always hit growth limits eventually. And their stock markets are notorious underperformers.
The holy grail of trade policy is to establish a trade deficit that imports capital at a rate that is manageable for the economy. Manageable in the sense that it keeps inflation and employment risks at bay. Such an economic model is extremely difficult to establish because you need to keep convincing foreigners to invest in your country. This requires healthy demographics (ideally supported by a smart immigration strategy), innovation power, property rights and natural resources. And first and foremost, it requires a commitment to capitalist and liberal values. It means giving up centralized power, a scary thing to do for policymakers. The US have perfected this approach in the last 30 years which has granted them their enormous economic success.
If the US force their way towards trade surpluses, the rest of the world will naturally have to move the other way towards trade deficits. This means they will be forced to embrace the success factors listed above which is extremely difficult to accomplish. Rising unemployment is the biggest risk for them should they fail. I wouldn’t be surprised if that comes with political destabilization in some cases.
How are investors prepared for this?
You might be tempted to argue that all of this is obvious and on everyone’s mind right now. Once weak hands are flushed out, it should present a buyable dip for those with firepower. Nothing has worked better than buying dips in the US stock market for about 15 years. It always comes back quickly.
It’s possible of course, especially since this is a self-inflicted wound that can be healed more easily than an unforeseen external issue. But I want to draw your attention at the collective mindset we have had when this crisis hit. Bank of America titled the December 2024 edition of their global fund manager survey ‘Max Americana’. Investors heavily overweighted US assets and stocks and expected both (!) US stocks and the US Dollar to perform best in the new year.
By that time, all bears had folded and nobody questioned US exceptionalism anymore. Trump’s victory sealed the deal. Tax cuts and deregulation were supposed to launch the next leg of the bull market. The market was priced so much too perfection that it may have been ripe for a correction even if Trump had not launched his vendetta.
There has been a lot more pessimism lately, but even in the March 2025 edition of the fund manager survey, cash remain close to a record low. Institutional investors are still highly concerned about missing upside as they are about experiencing downside. The trade conflict is on the radar as a possible tail risk. But it seems that most view this as a temporary issue.
The violence of the bull market has trapped investors and made them bagholders. Even if the latest sell-off does get a technical bounce soon, I am afraid that very few portfolios are actually prepared for what’s coming. I continue to believe that this bear market will take a while. It will not unfold like a quick and healing carry crash that investors have become used to. I highly recommend to read the article below to manage expectations about bottom formation.
Sincerely,
Rene
As usual, a very thought provoking and well reasoned analysis. Keep writing - we need your help to try and understand these crazy times.
The GOP is clearly counting on massive tarrif income to fund their huge tax cuts. The Budget Lab at Yale projects that Trump's tariffs could raise 3.1 trillion in revenues if they remain in place and imports don't fall (A big if) Congress could use these estimates to get GOP members to vote for their very pricey tax cuts. So investors hoping to see these get reduced could be in for a nasty surprise.
Another thing that is not discussed enough. These tariffs give the executive extraordinary control over the economy where the President can pick winners and losers and companies have to come to him hat in hand to see if the can get exemptions. It's the most extreme govenerment interference in the free market possible - because it all comes down to the whims of one man. So it's a way of having corporate American be supplicant to Trump. The model here is Orban's Hungary. This has nothing to do with the classic free trade liberalism that conservatives used to care about.
Raising cash, sir! Too many 'ifs' for me... too much uncertainty. Only taking very specific single-stock risk. At the moment, I'm sitting on 25% cash, 50% stocks (cautiously rotating from RoW into US), and 25% long duration (30-year Treasuries).