We referenced the uncertainty of tariff policy in our January Market Commentary. Little did we know that three months later, the level of uncertainty would be little reduced. Since tariff policy has dominated the headlines for weeks now, we felt that we needed to address tariffs in this month’s commentary, but the constant policy changes have made it a near-impossible task. Prior to “Liberation Day,” analysts went through the exercise of forecasting which countries, sectors, and companies would be hit hardest by the new tariff policy. What damage would be done to growth outlooks, and how would that translate into company earnings? Prior to April 2nd, market risk indicators had risen slightly but reflected expectations of a modest impact from the change in tariff policy. However, the April 2nd release was shockingly more extensive than expected and enormously impacted all global markets.
The key measures of the initially released tariff policy were a 10% universal duty on all goods and additional reciprocal tariffs. The calculation of the reciprocal tariffs was puzzling to many as they had nothing to do with tariffs but were calculated solely based on the bilateral trade imbalances, which can be large even if a country charges a 0% tariff on US imports. Regardless of the tariff calculation methodology, the market reacted violently with the S&P 500 selling off 10.5% and the Volatility Index (VIX) spiking more than 23 points to end the day at 45.31.
Despite President Trump’s insistence that the tariff policy was non-negotiable, much has changed in the less than two weeks since the initial announcement. On April 9th, a 90-day pause was announced on reciprocal tariffs, but the 10% universal tariff remained. China was the exception to this policy, and an increase to a 125% tariff rate was announced for Chinese imports. This announcement was met with a 9.52% rally in the S&P 500 as well as significant rallies in global equity markets. The VIX fell from an intraday high of 57.96 but closed at a still very elevated level of 33.43 which is not consistent with a one-off type risk event like we saw in August of last year when the VIX spiked on the unwind of the Japanese Yen carry trade and then fell below 15 a few days later. Finally, on April 11th, the Trump administration announced a temporary exemption of smartphones, laptops, and other electronics from the new reciprocal tariffs.
As of today’s date, April 14th, these are the inputs available for our investment outlook. Without reciprocal tariffs, the 10% universal tariff is significantly harsher than original expectations and will have a material impact. The unknowns include potential changes in the duration of the pause and magnitude of the reciprocal tariffs, announcement of further sectoral tariffs and other possible exemptions similar to the electronic exemptions made on April 11th. While we think it’s fruitless to speculate on the paths of the unknowns that we just described, we do see certain impacts of the tariff policies that will persist regardless of where policies eventually settle. First, the period of uncertainty that we are currently experiencing is becoming prolonged. Second, uncertainty is damaging global growth, and to date, it appears relatively more negative for the US. Third, global confidence in US asset markets is being eroded.
Figure 1 shows the Volatility Index from July 1, 2024, to April 10, 2025. In the past, we have used spikes in volatility as potential buying opportunities, such as last August when volatility spiked on the sharp rise in unemployment and the unwind of the Japanese Yen carry trade. Looking at August of last year, we see a significant spike in volatility, and only days later, the VIX moves down to below-average levels. What’s different today is that volatility has been elevated since early March. Even after the 9.52% rally in the S&P 500 on April 9th, the VIX only declined to a level of 33.43, which is just under two standard deviations above its long-term average. In this case, we see both the level and duration of heightened volatility as indicative of the uncertainty that markets are currently experiencing. We believe the current extended period of heightened risk and uncertainty will weigh on US as well as global growth and suggest a more defensive investment posture.
Figure 1
Source: Bloomberg, AAFMAA Wealth Management & Trust LLC
In terms of growth expectations, many analysts had a high probability of recession when including reciprocal tariffs. Even with the revision back to the current 10% universal tariffs, most analysts still have a significantly higher probability of recession and significantly lower forecast of 2025 real GDP growth relative to the beginning of the year. Figure 2 shows our current forecast for 2025 GDP growth. With tariffs, we now see real GDP growth 12 months forward coming in at 0.32%. This is a significant reduction to our above consensus outlook of 2.57% pre-tariff. Along with our downgrade to real GDP growth, we see a significant uptick in the probability of recession to 25%. Finally, we see Core PCE Inflation trending up to 3.29% over the next 12 months.
Figure 2
Source: Bloomberg, AAFMAA Wealth Management & Trust LLC
Although we haven’t seen any hard data yet, survey data in the US has been worrying, whereas survey data out of Europe has been more resilient. Growth expectations have been revised downward for most major economies, but we expect the US to be hit hardest in terms of downward revisions to real 2025 GDP growth. Exacerbating difficulties for the US is a more difficult inflationary environment, which will make it harder for the Fed to react with an easier monetary policy. Restrictive fiscal policy in the US relative to Europe (Germany) may also make it more difficult for the US to maintain its growth advantage. Thus, we expect a significant narrowing of the growth gap between the US and the rest of the world.
On April 9th, prior to President Trump announcing the 90-day pause on reciprocal tariffs, there was a significant sell-off in US Treasuries. This was unusual price action as treasuries generally rally during an equity market sell-off. There were multiple rumors as to the explanation for the price action. These included direction from China to cease buying USD assets as well as failing basis trades in the treasury market. A bond basis trade is a strategy that attempts to exploit mispricing between physical bonds and bond futures. These types of trades generally require significant leverage and liquidity.
Another interesting dynamic was that the US was experiencing an emerging market-type scenario where all asset markets were selling off: stocks, bonds, and the US Dollar. Figure 3 shows the relationship between the EUR/USD exchange rate and the spread between Euro 10-year yields and US 10-year yields. Usually, the exchange rate trades with interest rates; that is as US yields rise relative to Europe, the US Dollar strengthens versus the Euro. From the chart in Figure 3, you can see that this relationship completely broke down on April 9th. All of these market dislocations may have forced President Trump into the decision to delay the implementation of reciprocal tariffs.
Figure 3
Source: Bloomberg, AAFMAA Wealth Management & Trust LLC
An unnecessary trade war, extended period of uncertainty, persistently high volatility, and disorderly asset markets are all significant negatives for US asset markets and damage the safe-haven status of the US Dollar and treasuries. We expect this to manifest as a further reduction in the overweight US asset positions that foreign countries have built up over years. This will keep pressure on the US Dollar as well as US risk assets until we get some market stability and clarity on the steady state of US tariff policy.
Given the high level of uncertainty that currently exists in markets, we are reducing exposure to companies that are directly negatively impacted by tariffs, as well as reducing positions that are highly sensitive to the economic cycle in favor of more defensive names. This move includes a reduction in exposure to credit in our fixed-income portfolios. Additionally, based on expectations of a narrowing growth gap between the US and the rest of the world, further foreign selling of US assets, and expectations of further US Dollar weakness, we are adding unhedged exposure to foreign developed equity markets, which are inherently more defensive. We hope for a quick resolution to the current market uncertainty but feel that it’s prudent to make portfolio shifts to account for the immediate impact of the tariff policies as well as the possibility that the current environment will persist.
Yours in trust,
Parker
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