Short story:

The US doubled tariffs on China to over 104% and China retaliated by going to 84%. These levels break the export/import model. They’ll either moderate or we’ll see a wholesale economic decoupling. With the news well priced in, it looks like equity investors are being tempted back into stocks. That’ll work well if we have a resolution within a month or so. If we don’t it’ll just be a “bull-trap”. Bond yields have been rising in the last couple days which is concerning from a portfolio construction perspective, but could reflect a positive view that we’re approaching max uncertainty, after which things can only improve.

 

Long story:

There are a lot of amusing movie analogies floating around out there. One analyst I follow likened this to the movie Unstoppable, where Denzel Washington has to stop a runaway freight train. Maybe it’s more like Chicken Run in Rebel Without a Cause? Who’ll jump first? Others, feeling overwhelmed liken the situation to Everything Everywhere All at Once – a mind-bending run through parallel universes.

 

There is a perception in the US that tariffs hurt China more than they do the US. I think that assessment is correct. It tells us Xi will probably blink first. On the other hand, it’s also true that China has the political will and ability to endure extreme privation, if needed. It’s not like people can protest on the streets of Beijing. Also, groveling may be politically dangerous for Xi, and I think they see this conflict as inevitable and part of a larger strategic struggle, rather than an isolated situation that can be solved permanently.

 

On the other side, the Chinese believe Trump will relent when the impact of tariffs hurts his constituents enough. That might be the case, but we’re not going to see that for a while. Well over 90% of self-described MAGA Republicans support or strongly support the tariffs. Congress could reassert control over the situation with legislation, but there isn’t enough support for a veto-proof majority. The courts don’t normally intervene in tariff issues. And Trump’s approval ratings, while dipping, remain quite high. If there is a brakeman in the American locomotive, he’s clearly on a coffee break.

 

When does the pain actually start transitioning from Wall Street to Main Street in a very noticeable way? Probably a month or two. Online retailers have already started raising prices, but only a bit. Ships that left port before the tariffs took place will be exempt, meaning near tariff-free goods will keep arriving in US ports for a couple weeks. Even when the tariffs start showing up in retail prices, it will take a little while for shoppers to notice and a little longer to filter into CPI numbers. In the meantime, most of the impact will be in markets, corporate board rooms and newspapers. Unless the rates on China come down quickly, we’ll probably soon read about a hedge fund or two blowing up, and some extremely exposed businesses shuttering. But those will have more headline impact and sentiment impact than real-economy impact.

 

Markets are broadcasting the implications of tariffs loud and clear. It seems to me that stocks are pricing in a medium-bad scenario, where these tariffs stick around, but ultimately moderate. To me, this looks like “upside risk” for stocks now outweighs “downside risk” at least in the very short run. Commodities are reflecting a clear recession risk, particularly oil. Crude prices have dipped below average break-even levels for most of US shale. “Dr. Copper” one of the most cyclical commodities, is down. But we’re also starting to see some weird action in bond markets. In the last few days, bond yields have been rising, when they should be falling. This is a little concerning. Theories abound.

 

Some are asking whether Beijing is stealthily selling treasuries to move the market. If so, it would signal that the trade war is spreading into a “capital war”. A less conspiratorial take is that investors are sniffing out a deterioration in the US debt situation or stagflation. A tariff-driven recession plus tax cuts could worsen the debt load in the short to medium term, and central banks may be reluctant to cut much if inflation kicks off. I think they’ll cut anyways, but that’s just my take. Another possibility is a big unwind of what they call the “basis trade”, where small differences between prices for cash-treasuries and treasury futures are arbitraged with tons of leverage. Extreme volatility tends to break arbitrage strategies. Of course, it could be a combination of these things.

 

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual.