We have profited in recent years by keeping our investment focus on economic reality rather than political headlines. And on this front, the news remains good. Economic and earnings growth remains solid, and while we did see a 'soft patch' in economic data outside of the US, this appears to be drawing to a close. But rhetoric is translating into reality, and the Trump administration is moving forward with tariffs on multiple fronts. Given the uncertainty surrounding trade frictions – which markets appear to be underestimating – we choose to reduce the size of our global equity overweight and move to a broadly neutral tactical allocation.
Why markets may be underestimating the tariff threat
Direct impact: While the extent of tariffs ultimately enacted still remains to be seen, the risk of ongoing retaliations leading to a full blown trade war has risen. There is therefore now a plausible scenario in which the US could impose tariffs on USD 450 billion of goods from China, as well as raise tariffs on USD 350 billion of auto and auto parts imports. Even in this adverse scenario, we do not believe the direct impact of tariffs on corporate profits would be particularly large across regions in the context of more than 20% and 10% earnings growth in the US and Eurozone respectively. Recent market moves seem to reflect this sentiment since President Trump's initial announcement of the first USD 50 billion on Chinese goods on 28 May.
- Market reaction so far: US equities are up around 5% since the first tariff announcement.
- Estimated impact of adverse scenario: We estimate the negative impact on S&P 500 earnings growth would be less than 5%.
- Market reaction so far: Eurozone stocks are roughly flat since the first tariff announcement.
- Estimated impact of adverse scenario: The impact on Eurozone earnings would likely be similar to the US and concentrated to autos and materials.
- Market reaction so far: Chinese stocks have been hit the hardest, falling around 7% since the first tariff announcement.
- Estimated impact of adverse scenario: Impact on company earnings would be minimal as banking, technology, and consumer sectors would be largely unaffected.
Second-order impact: However, this relative strength in stocks suggests that markets do not appear to be pricing in the increased risk of second-order effects from tariffs. These effects could prove to be much more meaningful in terms of their negative impact on economic and corporate profit growth, particularly if they limit China's ability to manage its necessary structure reforms and deleveraging. Therefore potential risks, such as the ones listed below, have caused us to reduce the size of our overweight in global equities.
Investment and hiring
The Federal Reserve has noted that the uncertainty alone is already affecting US investment and hiring.
US consumer confidence has already shown signs of taking a hit.
If tariffs are sufficiently widespread they will inevitably disrupt supply chains, and reduce the ability to substitute taxed goods.
China could potentially turn to non-tariff measures in its retaliation, such as slowing the delivery of goods to the US, imposing additional bureaucracy on US companies, or depreciating its currency.
What we will be watching
The challenge with trying to time changes in positioning is not just about protecting the downside, but also what should trigger a return to more risk in the portfolio. This is a particularly important consideration today given that we do not believe the cycle is ending, and we know that policy can change course with a single Tweet. We will be watching the following developments closely:
Trade: We will be looking for signs that indicate if threats are part of a genuine desire to tax imports to the US, or are part of an Art of the Deal style negotiations: issuing maximal demands to extract concessions before rowing back to a more conciliatory positon.
Fundamentals: Upcoming earnings season will be key. We expect strong year-on-year growth of 23-25%, but the comments on the outlook will be just as important to help us judge if second-order impacts on tariff uncertainty are beginning to affect investment and hiring decisions.