Navigating through the fog of the trade war

Well, no one said navigating the Straits of the Sirens successfully was going to be easy, or worry free. Quite to the contrary, we anticipated volatility as President Trump initiated his multi-pronged agenda, though not to the degree we just experienced! Still, as regular readers know, as we entered stormier waters in early January, we set upon the Ulysses strategy of “strapping ourselves to the mast” to avoid doing something like selling in a panic near the lows (which the record volume on the big down days of the last two weeks suggests that many did). And we even added modestly to our equities right on schedule, the day the market first hit our new money entry point of 5,400—a level we have been bouncing up and down around ever since. For now, we are sticking with our now-moderate equity overweight (50% of max in our balanced portfolios), waiting for a sign that the fog of uncertainty hanging over the market is beginning to lift, or at least get less dense. Good news: we may be getting closer.

There are two big buoys in the water that we’d point to from last week that suggest we may have reached the point of peak uncertainty:

1. Emphasis shift within the Administration from Peter Navarro to Scott Bessent. Prior to last week’s market meltdown, trade hawk Peter Navarro seemed to be the most influential advisor on trade to the President. His speech on the White House lawn on April 3, “explaining” the logic and arithmetic behind the Administration’s new reciprocal tariffs, was, frankly, scary. It appeared to market participants that the President was directing the US economic ship directly into the reefs on the back of some very dubious mathematics. The market meltdown that ensued, followed by a timely interview on Maria Bartiromo’s morning news show, was halted when the President announced (1) a rollback (for 90 days) in the giant tariff levels implemented on April 2 and (2) that Treasury Secretary Scott Bessent would be running the negotiations with the first trade partner on the list, Japan. This move increased our, and others’, comfort that the delicate intricacies and interplay of world trade and financial markets, which Bessent knows well, would be carefully folded into the forthcoming tariff discussions. Everyone can agree that achieving fair trade practices across countries is a worthy objective, and one that if implemented well could lower tariffs and prices worldwide. More indications on this front would be welcome, and we expect, could be coming. (Friday night’s announcement of an exemption of electronics goods in the China trade war was another positive indicator, by the way.)
2. Clarification of tariff war objectives. Early on, it was unclear what the balance of objectives for the tariff war actually was. The announcements last week helped clarify. For one, the fall back to a 10% base level tariff for all but China clarified that this level is likely permanent and will satisfy the President’s “efficient fund raiser” objective; our calculations suggest it could raise nearly half a trillion to fund other tax cuts, with perhaps half of that amount paid by foreign suppliers, not US consumers. It also clarified that the 20% base tariff on China was the stick in the negotiations to incent them to clamp down on the fentanyl trade, another tariff war objective and one that Administration officials have been highlighting as a likely path for the Chinese to begin to step down tensions. Third, the announcement of a pause on all trade partner tariffs except China clarified that beyond China, the key objective is “fair trade,” not “no trade,” an objective that the markets can believe is both reasonable and achievable without economic Armageddon. The fourth objective, encouraging more in-bound investment to the US of key manufacturing activities that would be needed in a shooting war (or more importantly, would be needed to avert one), is by the subtraction method “everything else,” i.e., the very substantial and prohibitive 100%+ tariffs on all China imports excepting electronics. This alone is enough to cause some economic dislocation as manufacturers shift their supply chains out of China and back into the US and/or US-allied countries, but at least it is a risk that can be sized: on our estimates, this impacts about 1% of GDP and is part of the reason why we’ve cut our GDP forecasts for 2025. (And of course, it is not necessary to shift 100% of US-bound manufacturing out of China, just enough to make us self-sustainable without them.) All of this suggests that the tariff discussion is shifting from a complete overhaul of the world trade order to a more reasonable goal of making the world trade system fairer and more stable over time.

Going forward, there are several more areas where we think we are likely to see uncertainty decline, mostly in a good way.

1. The bond market should begin to stabilize. Federated Hermes’ macro team is blessed with very close relationships with our company’s substantial fixed income and money market operations. So when the 10-year bond yield was rising precipitously last week, you can bet we were in active discussions with one another. As is often the case in times like this, we think there is no single explanation that fully fits what happened; rather, the backup in yields we experienced last week was likely due to a variety of factors, some of which should stabilize soon. First, concerns about the longer-term inflation impact of tariffs were in play, though the TIPS market, a discounter of forward inflation, did not corroborate this. Second, it is highly likely that the backup was exacerbated, or even caused, by one or more large leveraged players unwinding their positions in risk assets; Scott Bessent alluded to this in his TV interview on Fox Business. If so, this cause of bond volatility is likely to abate soon, as the unwind wraps up. Third, as Scott Bessent and others of President Trump’s advisors know (I can’t vouch for Navarro, by the way), the inverse of our trade deficits with other countries is their holdings of US Treasurys. So unwinding of trading activity due to the tariff uncertainty would certainly have put some near term pressure on bonds. However, assuming that the coming weeks bring more tariff deal announcements to the fore, and assuming that those announcements are beneficial to both parties and do not end trade but improve it, bond markets should stabilize. That would be equity market positive.
2. More trade deals should be announced with our key trade partners. The weekend’s news shows suggest that the US trade team has prioritized several key trading partners, including Japan, Vietnam, India, South Korea and the UK. All these countries are friendly to the US, and tariff deals here would be very welcome news for the market. Not only would these early deals support a substantial level of on-going trade by virtue of the volume we normally do with these countries, the deals would serve as a template for managing expectations of where we may be heading with our other trading partners.
3. Congress should reach agreement on the tax cut extension. A positive outcome of the present volatility in the markets is that it is surely increasing pressure on Congress to come to an agreement on the tax cut extension plan. With both houses having passed a bill, we are entering the next stage of negotiating differences to reach a final agreement. As we’ve pointed out before, congressional sausage-making is never pretty, but it now seems more likely than ever that the lawmakers will reach an agreement by the summer at least, and that the tax cut will be enlarged beyond a mere extension of the 2017 bill to include additional, growth-stimulative, tax cuts. Again, welcome news for the markets is forthcoming.
4. Deregulation announcements should begin. With the first 100 days focused largely on getting his Cabinet team in place, it was difficult for those Cabinet heads to begin making the changes to the over-bearing regulatory environment that the market has been anticipating. We expect the pace of announcements to increase from here. One, being discussed extensively within the bond market community, would remove the supplementary leverage ratio (SLR) requirement on banks put in place after the 2008-09 financial crisis and would address some of the liquidity issues in the Treasury market behind last week’s sell off. Good news if it happens.
5. The Fed should begin a new rate cutting cycle and take other liquidity measures. The Fed like the rest of us is unsure what impact the trade war will have on its two objectives, full employment and low inflation. To date, the impact has certainly been more deflationary than inflationary, with oil off 20%, the market down 12% and many retail investors down more on their favorite Magnificent Seven names. Going forward, though, the Fed worries about the impact of the final tariff levels passing through to the economy, though on our math what’s on the table at the moment is probably less than a one-off, 1% rise in the overall price level; much of this might be offset by lower oil. So net net, given the economic soft patch the tariff uncertainty is causing, the trailing numbers, which is what the Fed watches, should soon start signaling both the need for, and ability to, cut rates. We’ve continued to maintain that the overall impact of President Trump’s full agenda should allow the Fed to take short term rates down to the 3.0% area, implying the ability to cut 150 basis points out of Fed funds between now and then. A new rate-cutting cycle should begin in May or June, and that will be welcome news to markets. In addition, as noted above, the Fed is likely to loosen regulatory restrictions on the banks, including the SLR rule which has constrained liquidity in the long-term debt markets. Finally, they could and probably will end quantitative tightening (QT), providing further liquidity for bonds.

Given the trauma the markets have just come through, the still-rocky waters ahead, and the high likelihood of an economic soft patch as the key players await more clarity on the rules of the post-tariff-war global economy, a slowdown in earnings growth this year seems likely. However, on our numbers, that slowdown is already fully priced in following what’s amounted to be a 12% correction. Though we have downgraded our 2025 profits and market outlook accordingly, we have not changed our view that 2026 and 2027 promise to be much healthier, with improved growth, fairer trade, lower prices, and lower interest rates. Off of the present market level, that would make the upside to those levels that much greater for investors, and this is why we have shifted to a moderate equity overweight.

This said, with the near term voyage ahead still fraught with plenty of potential pitfalls and wrong turns, the probability of a retest of the recent market lows seems relatively high or at least possible. If so, we will re-evaluate and have cash at the ready to add to equities and assume a more aggressive stance. In the meantime, we are keeping our positions relatively defensive with an emphasis on value stocks, dividend payers and international equities.

Finally, as we enter the most holy of days in the Christian and Jewish calendars, it’s perhaps worth pointing out that it’s often darkest before the dawn, whether you were an enslaved people in pharaonic Egypt the night of the Passover, or a follower of Christ during his Last Supper in the upper room. In this spirit, we hope all of you have a happy and healthy Holy Week, Passover, or whatever spiritual journey you’ve embraced. And remember, a new dawn and calmer waters are coming. We’re almost through the Straits.