Capitulation Day

30 April 2025

Earlier this month in the immediate aftermath of “liberation day” “liquidation day” we argued that US-China relations is in the ultimate game of chicken, 1) either something breaks, and we plunge a lot lower in risk assets, or 2) shorts get steamrolled by the US Administration (and China) capitulating. Arguably, last Tuesday (April 22nd) was “capitulation day” with incrementally positive news on a potential tariff deal with China and hope for a more dovish Fed lifting equities. The Donald also backed away from the hyperbolic language toward Powell and the Fed. From our vantage point, the rally was also a function of reflexive (self-reinforcing) collapse in volatility and short covering (unwind of hedging programs). The big picture question looking forward is whether the rally from the April low is sustainable. There are a few points to note.

First, a durable rally is likely dependent on a tariff deal with China that brings down the effective rate immediately. While there has been more conciliatory language on both sides, the gap between the two countries on key issues remains large and Chinese state media outlet the “Beijing Daily” published an opinion piece widely viewed as representing the Chinese leadership’s official stance on the ongoing trade war, it is “Necessary to Revisit on Protracted War.”

The title was based on a classic essay by Chairman Mao Zedong in 1938, in which he laid out China’s strategic approach to winning the war against Japan – namely preparing for a long and arduous struggle. The key observation from the “Beijing Daily” is that the Trump Administration, wielding tariffs as a weapon, is attempting to extort and strangle China with unprecedented aggression and ruthlessness. This represents an extreme provocation against China’s national sovereignty and dignity, leaving NO ROOM for compromise and no justification for submission. From our perch, China’s pledge to fight to the end” might not be mere rhetoric. However, our sense is that both sides (and the global economy) would benefit from a de-escalation and deal resolution.

Second, macro risk has deteriorated over the past few weeks. Shipping data suggest that there has been a clear collapse in trade between China and the United States. There has also been a clear collapse in consumer and business confidence surveys. For example, new orders in the regional manufacturing indices have plunged to the worst levels since 2020. While not quite a “sudden stop” the odds of a non-trivial decline in activity, investment, hiring and corporate earnings has increased. Overnight the Dallas Fed Manufacturing new orders is consistent with a national ISM New orders index of around 40 and a material decline in S&P500 earnings (chart 1). While interest rates have priced a more dovish Fed, recent communication by Jay Powell suggests that the Fed is in “wait and see” mode.

Chart 1

Third, the internals of the stock market suggest enthusiasm for a durable rally is misplaced. Cyclical sectors of the stock market remain soft relative to defensives. In particular, the transportation index (sensitive to the business cycle and central to this episode) remains particularly soft relative to the industrials index (chart 2). There is no confirmation signal for the rally from transports or cyclicals which suggests that it is something to fade.

Chart 2

As we have noted previously, the key in this episode was the poor risk-reward starting point. The S&P500 commenced the year at 23 times forward earnings, the prevailing bias was American Exceptionalism, and indices were concentrated in US mega-cap technology. Following the recent correction, the S&P500 is 20.8 times 12-month forward earnings. Moreover, consensus EPS is still +8% over the next year. That feels heroic given the deterioration in new orders and confidence. Even if a de-escalation and deal between the United States and China is achieved quickly, considerable damage has likely been done to corporate profits. In that context, US equity and credit risk compensation remains poor. On the positive side, our exposure in this region remains inexpensive at around 10 times (already pessimistic) earnings.

20250429_Capitulation Day.pdf

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