Breathing space

Taking stock 

Market participants have rarely had to deal with the level of uncertainty that has emerged since Trump returned to office. It has created volatility in markets, caused investors to question ‘US exceptionalism,’ and led to downward revisions of the growth outlook and upward revisions for inflation. The uncertainty creates paralysis amongst investors and businesses and is perpetuated by Washington’s constantly changing messages. As such, it is hard to produce a consistent and credible narrative to guide investment strategy. However, it is always worth trying to take stock of where we are.

Higher tariffs, even with deals 

At the macro level, despite the delay in implementing the reciprocal tariffs announced on 2 April, it is likely the US will have a significantly higher tariff regime going forward than was the case before the so-called Liberation Day. I do not need to go over the macro case again as to why this is bad for growth and inflation. Most forecasters have marked down their US and global growth numbers, including the International Monetary Fund this week. As we have argued for a while, the risk of a recession has increased. Recessions typically see profit margins decline (there have been suggestions from the corporate reporting season that companies are absorbing some of the tariff costs in margins), and net income is hit. I would suggest until the economic outlook is clearer (and better) it will be hard for US equity indices to return to their previous highs or for US credit spreads to return to the tight levels we saw in January and February of this year. Negative returns from US assets remain a significant possibility.

Backing off 

We suspect a higher level of tariffs will be in place going forward. That impacts growth and inflation. However, we also know Trump will back off from more extreme positions when markets move against him. The 90-day delay came after a huge stock market sell-off and the bond market has caused him to pledge that he has no plans to fire Powell, despite attacking him on social media and calling for interest rate cuts. There is perhaps a wiser council around Trump. Even he might be able to see the potential economic and financial market damage done by large-scale selling of US financial assets and the dollar. For now, extreme tail-risk policies and market reactions are less likely. One lesson, for the nimbler investor, is to buy those aggressive sell-offs for a short-lived bounce when the White House backtracks. But the words “nimble” and “short-lived” should be stressed here. The backdrop is worse than it was when the S&P 500 generated a 20%-plus total returns in 2023 and 2024. It is hard to see Trump politically backing off everything – tariffs, DOGE, and attacking the Fed – as this would negate his “Make America Great Again” agenda and leave him politically damaged ahead of mid-term elections later this year.

Hitting the mandate 

The Fed Chair’s position is safe for now. There are arguments for and against whether Powell has been a good Chair, but the markets are dead against political interference in monetary policy. The Fed might not be perfect, but investors tend to understand it, have a good handle on its reaction function and the price of risk is based on all of that. Interfering with the Fed risks destabilising interest rate and inflation expectations, which is not good. Today, the Fed is close to achieving its dual mandate objectives – unemployment is just below the non-accelerating inflation rate of employment (NAIRU) – the lowest rate that can be sustained before causing inflation to rise - and core Personal Consumption Expenditures (PCE) inflation is just above 2.0%. Under normal circumstances, the Fed would maintain its current slightly restrictive stance until inflation falls further. Looking forward - and keeping in mind that it is deviations from the unemployment objective that have historically caused greater changes in the Fed Funds rates - slower growth and a higher jobless rate should push the Fed into cutting. For bonds this should sustain the trend of a steeper yield curve and deliver decent returns across the curve.

Treasuries are super-important 

Despite increased volatility, Treasury yields remain well within the range of the last year or so. The total returns from the ICE US Treasury index are 3% year-to-date. The catastrophe of the rest of the world exiting their US Treasury holdings has not happened. Much has been written about the rarity of bond yields going higher and the dollar going lower, but of the two, the weakening of the dollar has been more significant. All other major currencies have benefitted from the weaker greenback which suggests some repatriation of capital to creditor nations. With the eventual tariff level being significant enough to contribute to a higher recession risk in the US, with business and consumer confidence having fallen sharply and with US equities and credit still not cheap, there could be further downside to the dollar. I would also note that 30-year Treasury yields have been in an upward trend for more than three years and that the long end of the Treasury curve continues to cheapen relative to swaps. There is a risk premium in Treasury securities that reflects a range of policy and economic uncertainties.

In the week after Liberation Day, the Treasury market volatility reminded us how important this market is in terms of setting the global price of risk but also in providing the venue for all kinds of hedging, funding and leveraged investing. When there is volatility, there is huge collateral damage. So far, few major victims have emerged. But if Trump plays fast and loose with the dollar, with the Fed or with the budget, another bond market tantrum could have bigger repercussions. For now, assuming policy shocks subside, a long duration position in Treasuries should reflect growing evidence of slower growth. Combining this with a position in short-dated inflation-linked bonds captures both sides of the stagflation impact of tariffs.

Inefficient equities 

On equities, the consensus is for S&P 500 average earnings to be $265 per share in 2025. That puts the index on a price-earnings multiple of above 20 still. This is high by international standards and by its own history. Analysts are revising down forecasts though, which might mean the market will struggle to hold on to current price levels. Earnings announcements so far have included many references to the uncertainty caused by tariffs and how they are impacting supply chains, orders, and capital spending.

However, history has shown that when the market corrects by 10%, the following one-year returns have tended to be positive. If the worst-case scenario of an “America First” policy-driven slump is avoided, then the kind of equity bear markets seen in the early 2000s and in the wake of the global financial crisis might also not develop. For the check list, we have had a meaningful correction in equity index levels (small tick), but US equities are not cheap yet and the economic outlook is worse than it was. Too early to go roaring back to the “buy America” trade. The long-term impact of Trump’s agenda and the need for higher risk premiums is not in the price of stocks yet.

High yield at more attractive levels 

Credit spreads have also retreated in the last week and excess returns from investment grade and high yield corporate bonds have been mostly positive since the announcement of the tariff postponement. High yield index spreads are just below 400 basis points (bp), and the index yield is around 7.8%. Default risk has risen but this looks like comfortable compensation for higher yield investors. Historically, spreads between 400bp and 450bp have, on average (since 2000), delivered modest positive excess (above government bonds) returns over most holding periods. In total return terms, yields of between 8.0% and 8.5% have been associated with one-year returns averaging around 11%. Another modest correction in high yield would improve expected forward returns.

Just as equities can go lower, however, spreads can widen further. Another 10% correction in the S&P 500 would push high yield spreads wider by as much as 100bp-150bp from today’s levels. At a 500bp-550bp spread, average historical excess returns have been around 5% over a one-year period and a yield of 9.0% or more is likely to be a very good entry point for high yield investors. It is worth pointing out though, higher yields bring a higher risk of credit problems, so exposure to high yield is best achieved through diversification and flexibility.

More than a tantrum 

Three weeks on from Liberation Day and most charts of financial asset prices look like the reaction was a well-contained tantrum. The S&P 500 is 10% above its 8 April low, 10-year yields are 20bp lower than the 11 April high, and credit spreads are 15bp narrower in investment grade and 88bp narrower in high yield (as of the close on 24 April). On paper then, the drawdowns in markets are less than they could have been, largely because President Trump blinked in the face of a market meltdown. But the damage done should not be underestimated. Recent events have made a mockery of US policymaking and ongoing uncertainty requires higher risk premiums, especially for foreign investors in US assets. More than anything, companies are voicing real concerns about the impact of all of this on demand and the outlook for earnings. The Trump shock is not over. The probability of macro, valuation, sentiment, and technical factors all flashing red on US assets remains a significant one.

Performance data/data sources: LSEG Workspace DataStream, ICE Data Services, Bloomberg, AXA IM, as of 24 April 2025, unless otherwise stated). Past performance should not be seen as a guide to future returns.