The Real Risk

How Will China and Mexico Respond?

With the market’s focus almost entirely on tariffs and Trump’s “liberation day” at the moment, it’s reasonable to expect that stocks & bonds will react pretty much only on trade war developments for the time being. Rumors of Trump’s plans to implement a 20% tariff on most imports beyond what’s already been announced has sent the VIX sharply higher and high yield credit spreads, save for the spike around last year’s reverse yen carry trade spike, to their highest level in 14 months. Risk is finally getting priced back into both the equity and bond markets, but it’s happening slowly and steadily.

Manufacturers are already saying they’re feeling the impact of tariffs with most acknowledging that their cost of goods is rising. The latest ISM manufacturing report confirmed what we already knew, which is that companies from front-running tariffs and building up inventories ahead of any Trump policy implementation. The sector is back in contraction now and could be a precursor to what is looking like could be an ugly Q1 GDP report. Inventory builds can be positive for GDP as they’re happening because they count as goods produced even if they’re not sold. On the back end, however, when they need to sell what they have before they ramp up production again is where the hit to GDP can happen. Currently, that lines up with the second half of Q1. The Atlanta Fed’s GDPNow Q1 forecast for GDP is at -3.7% with most of the negative impact coming from net exports.

Given the way that the trade war has played out thus far, perhaps we shouldn’t assume that what is said on Wednesday will actually stick. A lot of threatened tariffs have been walked back shortly thereafter. That’s what’s helped make the market so volatile in recent months and what’s left this cloud of uncertainty over the market and the economy. If the ultimate goal is to reshore manufacturing to the States, perhaps there’s a longer-term benefit to how this plays out. In the short-term, however, there could be a lot of pain and far-reaching ramifications beyond just the cost of goods.

Overall, we’re still seeing evidence that the flight to safety trade is taking place. Treasuries have been gaining relative to the S&P 500 for a month and a half. The negative correlation between stocks and bonds is returning. Spreads are widening. Gold is still rallying. A lot of what happens next will depend on what we hear this week on the trade front, but it’s unlikely to be good news. I still maintain that Japan is the larger risk to the global financial markets here, but there’s no question that the market is fixated on tariffs at the moment. That makes this market dangerous as the escalation continues.

As the markets remain almost entirely focused on tariffs at the moment, the real risk, in my opinion, is Japan. While GDP growth has looked fairly good over the past few quarters, the data that matters in this situation, namely inflation and interest rates, show a lot of risk currently building up. The annualized inflation rate is hovering around the 4% level for the third consecutive month and the BoJ has still only raised its benchmark rate to 0.5%. Japanese bond yields have, however, been pricing in this risk with the 2-year now at its highest level since the financial crisis.