What the Trade Détente Means for Investors

Treasury Secretary Scott Bessent didn’t return from Switzerland and proclaim “Trade peace in our time” while waving a piece of paper. Instead, the interim deal represented a signal toward a trade détente and the acknowledgement that China is an equal in global trade with the U.S.

The agreement. lowered the U.S. tariff on Chinese imports from 145% to 30% for 90 days. China reciprocated by lowering its tariffs on U.S. imports to 10%. Shipping bookings skyrocketed in response and the deal took the tail-risk of a recession off the table.

It’s no surprise that the stock market rallied.

Before you become overly excited, analysis from the Budget Lab at Yale found that the average effective tariff rate is now 17.8% pre-substitution for high-priced imports and 16.4% post-substitution, which are still very high by historical standards.
 

 

Here’s what the trade détente means for investors.
 

 

Economic Effects

The Budget Lab also modeled a number of other effects of the revised trade deal.

• PCE rises 1.7% pre-substitution and 1.4% post-substitution, assuming no Fed response.
• GDP real growth in 2025 is 0.7% lower.
• Long-run GDP growth is 0.4% lower, with differing sector effects. Manufacturing output grows by 1.5%, but that’s offset by losses in output in agriculture at -1.1% and construction at -3.1%.

 

 

In other words, higher inflation and slower growth.
 

 

Questions for Policy Makers

While receding recession risk is a welcome development, I have many questions for policy makers, for the economy and for investors.

The most important question is for the policy makers in the Trump Administration. The trade détente is a tacit acknowledgement of China’s importance in global trade. Trump’s retreat was partly attributable in response to the pressures brought about by U.S. small business owners who are mostly Trump supporters that were pushed to the edge of bankruptcy by the sudden imposition of the steep tariffs (see the WSJ article “How Tariffs Are Crushing Small Businesses: ‘Nobody in Power Seems to Care’”). The latest NFIB Optimism Index, which includes the post “Liberation Day” announcement period in its survey window, shows a drops in both the soft survey-based and hard data components.

 

We’ve gone from “trade deficits are bad”, which has been a core Trump belief since the 1980s, and “let’s bring manufacturing jobs back to America” to “let’s make a deal with China” over a single weekend. Is this a tactical or a strategic shift in thinking?

If the intent of Trump’s trade policy is to reshore manufacturing by reversing the effects of globalization, and the trade détente acknowledges that China is here to stay as a trading partner, how does Trump achieve his objectives (chart annotations are ours)? Equally important is how will Trump approach trade negotiations with all the other countries?
 

 

Treasury Secretary Scott Bessent has outlined one of the objectives that the Trump Administration of success is to lower the 10-year Treasury yield. Bessent faces considerable challenges. Inflation expectations have risen in the wake of the trade deal; $9 trillion of U.S. debt will mature in 2025. The initial version of the Republican tax plan would extend TCJA cuts while adding $4.9 trillion in debt over 10 years, though the objective is to reduce that figure a $4.0–$4.5-trillion range.
 

China found Trump’s Achilles Heel by leveraging the supply chain sensitivities of the U.S. economy to Chinese exports. Other trading partners have also discovered negotiating leverage through the use of the bond market vigilantes. There had been a rumour floating around that Canadian Prime Minister and former central banker Mark Carney had instructed Canada’s finance department to accumulate Treasuries in order to create a war chest of Treasury paper, and he had co-ordinated a synchronized sell-off of U.S. debt with other G-7 partners. When a reporter questioned him about the rumour, he deflected the question and just smiled enigmatically.

What happens next? How have Trump’s trade and economic policies changed, if at all?

 

I believe one of the biggest risks to risk appetite is a rising concern over the fiscal deficit as the Treasury’s estimate X-date, or the date the government runs out of money, approaches in August. The Trump and Republican wish list to extend the TCJA tax cuts and other pro-growth measures faces a large fiscal shortfall that has to be resolved. Cuts to Medicaid have the potential to doom the GOP in the mid-term elections, and fiscal fixes like raising taxes on millionaires has the potential to split the Republican Party.
 

 

From a big picture perspective, upward pressure on Treasury yields is a symptom of growing stress of Treasury issuance absorption in the absence of traditional buyers. Foreign official demand is weak, especially if Trump reduces the trade deficit which leaves fewer USD for foreigners to recycle back into the Treasury market. Domestic balance sheet capacity is limited. As the Fed continues its quantitative tightening program, there is no buyer of last resort. If the 10-year yield continues to rise, investors could see negative side effects, such as wider junk bond, rising mortgage spreads, which increases housing stress, lower Treasury market liquidity0 and rising pressure on high-duration (high interest-rate sensitivity) growth stocks.
 

 

Questions About the Economy

From an economic perspective, investors also need to ask how individuals and corporations are likely to react to the news of the trade détente.

How will individual Americans view the tariff headlines within the context of their own income and job stability? Individual Americans likely breathed a sigh of relief. Expectations of empty shelves, which may still occur sporadically this summer, are mostly gone. As long as the economic outlook holds up, they can continue to spend. That’s the good news.

It’s a different matter for corporate management. I pointed out last week that equity volatility remained elevated in the 2018–2019 trade war era of Trump 1.0. The trade war isn’t over yet. The U.S. has yet to reach trade agreements with other major trading partners. It’s difficult to envisage any board approving long-term capital investment commitments with 5–10 year time frames under such conditions of uncertainty. While recession risk has receded, growth is likely to be sluggish for the foreseeable future.
 

 

 

Questions for Investors

Lastly, how will investors alter their long-term allocations in reaction to the increased uncertainty?
In the long run, the valuation of stocks depends on how earnings evolve and the multiple the market puts on forecasted earnings. Prior to the trade détente announcement, the S&P 500 bottom-up estimate revisions were stalling. The top-down forecast from the Budget Lab is calling for a -0.7% hit to 2025 GDP growth. Management is unlikely to undergo significant expansion plans under the current conditions of uncertainty, which will create drags on employment growth.

The wobble in the earnings outlook isn’t over. The April CPI and PPI reports told the story of higher goods prices from tariff increases was offset by softer services. Investor saw increasing pass-through of tariff increases and signs of margin compression, which will start to appear in Q2. Keep in mind that the average tariff rate in April was only 4.4%, compared to a full rate of 17.8% based on the latest developments announced on May 12. It is therefore no surprise that Walmart warned about price increases in the coming months.
 

 

As for the question about earnings multiples, the market P/E depends on two factors: the level of interest rates and the risk premium investors put on stocks, or the equity risk premium. I have documented how inflation expectations staged an upside breakout even before the trade announcement, and continues to rise, which puts upward pressure on the 10-year Treasury yield. Notwithstanding the evolution in trade policy, I would watch for how the Republican tax bill progresses through Congress, and how anxiety over the $9 trillion in Treasury debt rollover in 2025 and additional financing needs puts pressure on bond yields.

The S&P 500 is already trading at a forward P/E of 21.4. If it were to test its recent all-time highs, the P/E would rise to a nosebleed level of over 22, which rivals the recent high. Does the market deserve such a multiple in the current environment of uncertainty and in the absence of fiscal and monetary stimulus?
 

 

Under the circumstances, the natural reaction is to diversify away from U.S. assets. U.S. stocks have been a one-way bet since the GFC and the NASDAQ has outperformed the global equities since the 2008 market bottom. If Trump continues to try and de-couple from the rest of the world, the diversification trend should continue. The latest BoA Global Fund Manager Survey shows that global managers are already underweight U.S. stocks (annotations in red are mine). Is this the start of a trend or just a hiccup?
 

 

 

A Wide Trading Range

Where does this leave us?

An analysis of the Trump factors shows a number of cross-currents. The Trade War factor is understandably in retreat. Inflation expectations are rising, which will put upward pressure on the 10-year Treasury yield and heighten anxiety over the tax bill this summer. The Sell America trade is showing mixed results. On one hand, non-U.S. sovereign bonds pulled back against 10-year Treasuries but they are recovering in USD. On the other hand, the S&P 500 is gaining against developed market equities, though the outperformance is likely attributable to a short-term stampede into Magnificent Seven names.
 

The news out of the meeting in Geneva underlines an important point about the latest market tantrum and recovery. It was all attributable to U.S. policy that depends on the whims of one man, whose opinions can be unpredictable.

Investors have also seen how the Trump Put is struck. China found Trump’s vulnerability by leveraging the integration of Chinese manufacturing to U.S. supply chains. Developed economies such as the EU with current account surpluses can leverage the U.S. vulnerability to rising bond yields. The Trump Put will put a floor on risk appetite.

On the other hand, the man directing U.S. policy has shown himself to be unpredictable and operate with few constraints if he believes he has the leverage in a negotiation. Bloomberg reported that Trump signaled that he doesn’t have to sign any deals, just charge access to other countries for access to the U.S. market.

When markets are riding high and the Trump Put isn’t activated, he will be tempted to try and assert his perceived bargaining leverage and sideswipe markets. That’s why I believe volatility will remain elevated. Businesses will find it difficult to make expansion plans in such an environment, which will retard economic growth potential and put downward pressure on employment.

In the absence of meaningful fiscal or monetary stimulus, which seems to be case today, my base-case scenario calls for a wide trading range for the S&P 500. Downside risk will be defined by the Trump Put in the form of the April lows and pressure on Treasury yields. The upside ceiling will be defined by the all-time highs.

In the meantime, investors are diversifying away from USD assets. A divergence is growing between the USD and the 10-year Treasury yield, which is an indication of a rising “Sell America” premium.
 

 

Even more worrisome is the strength of the 30-year Treasury yield, which exceeds the strength of the 10-year. Moody’s announced Friday that it is downgrading U.S. debt from Aaa to Aa1. Is the Fed losing control of the bond market at the long end of the yield curve?
 

Despite its recent pullback, gold remains in uptrends in all major currencies and it has staged relative breakouts against the S&P 500 and the 60/40 balanced portfolio. I interpret this as a sign of a secular trend of USD weakness.
 

 

In conclusion, the prospect of a Sino-American trade détente has taken recession risk off the table. The S&P 500 is on course to recover from a bear market, but faces headwinds from policy unpredictability. Investors should position in a diversified portfolio of global assets and gradually diversify away from USD exposure.