Tariffs: Inflation, Recession, or Both?

Are tariffs inflationary or deflationary? That is the question. Or maybe they’re both.

Economic orthodoxy says tariffs are inflationary, but the prevailing characteristic of US President Donald Trump’s first 73 days in office has been his willingness to disregard all orthodoxies, economic or otherwise. And the initial reaction to his ‘Liberation Day’ tariffs last week was equities down, bonds up — in other words, markets see them as a growth shock rather than an inflation shock.

The inflation angle still matters, even if markets had already largely priced in higher prices and feel they now have the leisure to worry about growth instead. Inflation determines the amount of room central banks will have to ease policy to counteract the recessionary impact of the levies.

The current market narrative goes something like this: ‘The US consumer is becoming increasingly stretched (see the three terrible prints this year on the University of Michigan consumer sentiment index), and now imported goods are going to cost significantly more.’

Demand destruction

These goods tend to be, but are not exclusively, at the more luxury end of the market, and therefore consumers can be expected to simply stop spending, rather than pay more. This can be considered demand destruction rather than supply restriction and could exacerbate recessionary pressures.

At the same time as the tariff announcements, there are concerted efforts to reduce supply-side inflation on raw materials. Oil-producing nations are under pressure to increase output (such as the agreement by eight OPEC members on 3 April to raise production by over 400,000 barrels a day). There are also increasingly urgent demands on all parties to resolve the war in Ukraine to accelerate the flow of commodities out of the region. While these moves aim to ease inflationary pressures on essential goods, they do little to address the broader recessionary risks posed by demand destruction.

So what’s next? Markets are volatile. A useful data point is the three-month VIX contract, which reflects the ambient level of equity market uncertainty without the histrionics of the spot contract. After Trump doubled down on his trade policy over the weekend, the three-month VIX jumped to 29, compared to the just above 20 level after the ‘Liberation Day’ announcement last week. It then reflected heightened market uncertainty, but not yet alarm. It's worth noting that the contract hovered around 20 for three years following the COVID shock in March 2020.

The coming days and weeks should provide clarity on the scale of retaliatory tariffs from other countries and the specific impact on individual company supply chains. It shouldn’t surprise anyone if companies use this as an opportunity to bury all their bad news under the cover of tariff impacts, potentially paving the way for a disappointing upcoming earnings season. 

Risks and opportunities

From a hedge fund perspective, this environment brings both risk and opportunity. Risk, since market volatility can lead to losses, which in turn can trigger potentially systemic deleveraging across the more highly levered parts of the industry. There is some comfort in the challenges faced by some of the larger multi-strategy funds in the first quarter in that the worst of the crowding and excess leverage may have already been flushed out.

But there’s also opportunity. More volatile markets typically lead to dislocations that relative value specialists can capitalise on more easily.

And after a period of historically tight credit spreads, more dispersion in debt markets could create fertile ground for more nimble managers. Regardless of strategy, staying liquid, opportunistic and, above all, patient will be vital in these changeable times.

Key drivers of hedge funds' performance: An early March snapshot

Equity Long/Short (ELS):

• During March, US and European equities struggled, while Asian and emerging market equities outperformed. From a hedge fund perspective, it was another challenging month for the equity long/short (ELS) space, although there were some signs of recovery in equity-focused pods within the large multi-strategy funds
• Yet again, US-focused managers found themselves at the bottom of the pack, primarily due to beta exposure. Their weakness was evident early in the month, particularly on 6 and 7 March, and again during the last week of the month. Europe-focused ELS managers outperformed on a relative basis, driven by strong stock selection and favourable sector tilts. Asia-focused managers benefited from a tailwind provided by beta
• Risk appetite in equities continues to be driven by macro themes, particularly the artificial intelligence (AI)/tech supply chain and anticipation ahead of 'Liberation Day' last week. There were two reports of significant de-grossing in equities during March; however, this appears to have been driven by other strategies rather than ELS. Global ELS net leverage decreased in March, while gross leverage edged up slightly, reflecting an increase in single-name shorting and heightened hedging activity

Credit:

• Credit spreads finished wider on the month of March, with negative returns across loans, investment grade and US high yield
• Corporate credit hedge fund managers posted modest gains on average in March. Capital markets stayed active despite ongoing volatility, with continued issuance and exchanges as companies proactively managed upcoming liabilities. Certain reorganisation and stressed/distressed credits experienced modest mark-to-market losses, while government-sponsored enterprise (GSE) preferreds, such as Fannie Mae and Freddie Mac, remained well bid due to privatisation expectations. Portfolio-level hedges also delivered profits for some managers.
• Structured credit managers were flat to modestly positive with carry offset by mark-to-market losses in certain sectors

Event Driven:

• March was another positive month for Event Driven hedge funds, however with more dispersion in Special Situations strategies. North American deal activity remained steady in the mid-cap range, with several transactions valued between US$7 billion and US$10 billion
• There was a US$10 billion acquisition in the North American energy sector, and a further announcement of a deal in the healthcare sector for US$10 billion to take a drugstore chain private
• In Europe, there has been a slowdown in newly announced deals, though market participants report an increase in pre-announced situations, particularly in the UK, where deals are being speculated but have not yet been formally recommended by boards. Australian gold deals are emerging as a key theme
• Some Special Situations trades struggled amid hedge fund de-risking during the month, while Event Credit performed well, with steady contributions from both stressed names and post-restructuring situations

Discretionary Macro:

• March appears to have been a challenging month for Discretionary Macro strategies. Managers de-risked amid heightened policy uncertainty
• Performance in developed markets has been rather muted. Positive returns were seen in European bond markets following Germany’s fiscal pivot, with gains driven by short positions and trades benefiting from steepening yield curves. Weakness in US dollar (USD) crosses largely worked against macro positions, though smaller moves higher in Japanese yen (JPY) and Japanese government bond (JGB) yields supported performance. While risk levels across the space have generally declined, commodity risk has increased, with long positions in assets such as gold and copper on the Commodity Exchange (COMEX)
• Emerging market macro strategies struggled overall. The primary detractor was the Turkish lira, which came under pressure due to political unrest. Sovereign credit returns were also negative as spreads widened, with Argentina underperforming. However, select local market rates positions in Central and Eastern Europe (CEE) and Latin America (LatAm) delivered gains, driven by a more optimistic economic outlook in Europe and USD weakness in the region

Quant Strategies:

• Statistical arbitrage strategies performed well in March. Despite earlier deleveraging in equity markets, there were few signs of stress for these strategies; in fact, the volatility appeared to create opportunities for some managers to generate additional alpha. According to analysis from prime brokerage desks, quantitative managers were neither at the centre of the deleveraging activity nor significantly impacted by it
• Factor-based equity market neutral strategies also appeared relatively unaffected, with managers largely avoiding significant exposure to the momentum reversal. On a standalone basis, factors such as low volatility, quality, and value delivered positive performance, while growth and momentum lagged during March
• On an anecdotal basis, Europe appears to have slightly outperformed North America, though transparency remains limited at this stage. Long/short quantitative credit strategies seem to have faced a more challenging month, with some small losses being reported

On the radar:

• Looking too far ahead feels foolhardy in such uncertain times. The immediate focus remains on the fallout from the tariff announcements, potential retaliation by other countries, and the corporate impact revealed during the forthcoming quarterly earnings season
• If one does brave a glance down the track, the most important data in the coming months will centre on fundamental releases related to inflation, confidence and jobs. Any rise in expectations for faster rate cuts could help mitigate the economic impact of tariffs, but central banks must still carefully balance stimulating growth against the risk of waking the slumbering inflation beast