'Cause you're hot, then you're cold
You're yes, then you're no
You're in, then you're out
You're up, then you're down
You're wrong when it's right
It's black, and it's white
We fight, we break up
We kiss, we make up
Hot N Cold, Katy Perry – 2008
This trade saga is starting to feel like a bad romcom. And the course changes are happening so rapidly that any strong view put on paper is a hostage to fortune; either useful guidance, or something to wrap the fish and chips in. Still, here goes. At the time of writing – midway through trading on 10 April, this observer would consider reducing risk exposure on strength.
The economic fallout
Let’s begin with the basics. The tariff pause still leaves us staring at a blended tariff rate of around 20%. That’s not as catastrophic as the 30% trajectory markets feared, but it’s still miles above the 3% average when Trump first took office. When Trump came into office there were two sources of optimism. We still had tech euphoria dreams of an AI-driven productivity miracle. That was reflected in a historically high multiple. We also had the hope of supply-side reform: tax cuts, deregulation, drill baby drill. That was reflected in healthy near-term earnings expectations. The potential cost increases and policy volatility of the present moment threaten both.
Valuations: is the rebound too optimistic?
Yesterday’s US equity market’s rebound pushed valuations close to the top of the range we’ve seen over the last decade; the S&P 12-month forward P/E multiple was back to 19.8x. This places valuations in the 83rd percentile of the last 10 years’ distribution.
For me the close-your-eyes-and-buy level would be around 15x, which was the trough in the 2022 sell-off. Assuming earnings expectations are fulfilled, this would equate to an S&P 500 level of 4,140, down 24% from last night's close.
The path to a significantly lower price level—or a similar one with less de-rating—hinges on downward earnings revisions, which have yet to fully materialise. Tariff-induced profit warnings remain rare for now, but as higher ‘costs of goods sold’ (COGS) begin to filter through business models, or as the uncertainty surrounding tariffs prompts cost-increasing contingency measures, we are likely to see more of them.
Moreover, there is a chance that less scrupulous CEOs might use the trade war excuse as cover to get other, unrelated bad news out the door. Currently, the three ‘live’ earnings-per-share calendar estimate years (2025, 2026 and 2027) are down on average 70 basis points (bps) from the start of the forecast period. There is potential for this to accelerate meaningfully.
To give some parameters, back to 1986, the average downward revision to any given calendar year is 14%. For a recession or recession-adjacent year the figure is 24%. Usually this happens gradually enough that future years come into the forecast horizon and the market keeps rising as it pins its hopes on longer-duration growth. In a recession, however, this can happen in a fast and disorderly fashion, immolating share prices.
Recession risk: a coin toss
On the subject of recession, we note that if you believe equity markets in aggregate are a forward indicator for economic growth, then you should surely have radically revised upward your recession probability, as many have. Historically, when stocks correct by 10% or more, 44% of the time a recession had either already begun, or started within 12 months. The correction last week exceeded 15%, implying recession odds may now be closer to a coin toss.
Are US Treasuries still a safe haven?
Apparently, it was the bond market not the stock market that intimidated President Trump. James Carville’s quip lives on. Structurally, and on a long-term view, we think the trend is toward higher yields. If you believe in the model of trend growth plus inflation expectation plus the term premium for a sovereign yield issued in its own currency, we think the theoretical fair value yield for 10-year US Treasury is between 4.6% and 6.8%.
It is worth reiterating the obvious point, however, that the 2022 playbook for bonds should be treated with some caution. This time the convexity and carry effects are on your side. From current levels, an 100 bps parallel shift upward in the curve would equate to -3% total return on a long 10-year US Treasury position. The equivalent move downward would work out at +11%. A garden variety, demand-led recession without inflationary concerns could well fulfil the latter scenario.
All data is sourced from Bloomberg, unless otherwise stated.
With contributions from Henry Neville, Director, Man Solutions.
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