The Risk-Reward Remains Challenged

14 May 2025

The trade discussion over the weekend in Geneva between the United States and China appeared to yield “substantial progress.” At 3pm Singapore time on Monday, the US announced that they will reduce tariffs on imports, for 90 days, to allow for further negotiations. Both sides agreed to lower the tariff rate by 115%, to 30% for China and 10% for the US. UBS estimates that the weighted average tariff rate for US imports from China is now ~35%. We also note the Treasury Secretary emphasis on the United States and China not de-coupling and the importance of the “mechanism” is now in place for future negotiations.  This was a positive surprise relative to expectations. However, we would note that the level of the tariffs remains high compared to Pre-Liberation Day levels.

As we noted last week, markets are no longer pricing the worst-case outcome. Equities have mostly recovered from the post-April 2nd collapse. However, we are now around one month away from finished and intermediate goods depletion. While there has been progress on trade negotiations, the central case continues to be more uncertainty and disruptions. Even if tariffs on China are dialed back to 30% that would still represent the largest tax increase since the 1960s (tariffs are effectively a tax). That might subtract ~1% from GDP and 10-15% from corporate earnings in a growth shock or recession scenario.

The second challenge is that the Federal Reserve is unlikely to ease the policy rate in the near term. While the short-term interest rate markets have a lower path for the Fed funds rate, inflation expectations surveys (Atlanta and Michigan) are at the highest level in 40 years. The driving principle of Fed policy revolves around whether inflation expectations remain well anchored. Although there has been a sharp deterioration in confidence and leading indicators, the hard data remain resilient for now. That suggests the Fed will likely be late in responding to deterioration in growth.

We hope that the outcome of negotiations will be a return to pre-Liberation Day tariff levels. We also hope that the Federal Reserve will be able to ease policy rates over the coming months. However, we fear that both have unfavorable odds. We also note that the US Administration has a challenging path on the passage of tax cuts and fiscal policy. In that context, the S&P500 (global risk proxy) at 22 times earnings and 7.5% consensus EPS growth remains heroic. The risk-reward outlook for equities is challenged.  

We’ve included on the following pages the note from the 7th of May “Walk the Hawk”.

07 May 2025

One of our favourite expressions in the post-2008 regime was, never underestimate the Fed’s ability to out-dove the market. The implication is that there was an asymmetry in the Fed’s policy bias to defending the left tail or downside risk for the economy (and markets). Although we would argue that the Fed’s desire for “stability” (to smooth the business cycle) paradoxically contributed to instability via a build-up in leverage, positioning (in all forms) and the inevitable unwind. In the current episode we fear that the Fed has a hawkish bias. The implication is that the Fed will cut policy too late to prevent a sharp growth shock.

Short term interest rate markets anticipate only a 2% probability of a rate cut at the May FOMC. Odds are around 33% for a cut in June and 68% in July. The recent trend has been toward fewer, not more, cuts. The probable reason for the shift in short rate expectations is inflation. The good news is that core inflation is in the 0.2% monthly range. However, inflation expectations as measured by the Michigan survey has increased to the highest level (6.2% over the near year) in 40 years. As we noted last week, the prices paid sub index in the ISM surveys is also consistent with a re-acceleration in headline consumer price inflation. The driving principle of Fed policy revolves around whether inflation expectations remain “well anchored.”

The controversial aspect of the Fed’s stance is that there has also been a sharp deterioration in confidence and the best leading indicators of activity. To be fair, the hard data remains resilient (for now). The time series below is the ISM manufacturing and service sector indices relative to private final domestic demand which remains around 3%. Note, the weakness in first quarter GDP was a function of the surge in imports (and the detraction from net exports). However, there was a notable moderation in consumption.

Of course, the Fed’s stance on inflation expectations is anchored on “tariff uncertainty.” From our vantage point, the key issue is that markets are no longer pricing a worst-case outcome. Equities have mostly recovered from the post April 2nd collapse; credit risk premiums and implied volatility remain narrow. However, we are now around one month away from finished and intermediate goods depletion and not a single tariff deal has been announced (yet). While deals might be announced soon, the more important counterparts are China, Japan, India, and the European Union. The central case is more uncertainty and disruptions. China tariffs will likely be de-escalated to around 60% although that is still likely to be very damaging. As we noted above, there is unlikely to be an offset from the Fed or from potential tax cuts.

The labour market is cooling very quickly under the surface. Job openings are now at a maximum convexity point for unemployment (chart 1). The risk for the Fed is that employment starts to deteriorate rapidly with negative revisions to non-farm payrolls over the coming months. While companies might be holding on to labour in the near term, odds are that capital spending (investment) and hiring get slashed. In that context, the S&P500 at 21.1 times forward earnings and +7% consensus EPS growth over the next 12 months feels heroic. The risk-reward on the global risk proxy feels unattractive at current levels. We remain defensively positioned.

Chart 1

Source: Bloomberg

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