In the past six weeks, the world has been focused entirely on the trade war between the U.S. and everyone else. This is understandable given that there has been no greater market catalyst than Liberation Day since the pandemic.
While many people sympathize with the America First philosophy, as most voters globally would choose that for their own country, President Trump seems to be on a quest for America to go it alone. He seems to be taking on the whole world at the same time, allies and geopolitical competitors alike. This approach did not go down well with traditional allies like Canada, Europe, and Australia, arguably influencing recent elections in Canada and Australia.
The trade war might also catalyze positive change, as Europe is suddenly much more focused on internal cooperation and fiscal stimulus, which could provide a positive economic impulse. This is also happening in Canada, Australia, and China.
However, the big picture for macro investors is the market rotation out of the U.S., which is a trend that started well before April. Why? For the U.S. stock market, the main problem is that fiscal policy is exhausted, and it cannot return to the ultra-stimulative levels seen in recent years.
Meanwhile, the rest of the world has the ability and now, thanks to Trump, the willingness to increase fiscal spending. This is particularly true since President Trump’s trade war is seen as an exogenous threat, similar to the pandemic.
- A Policy-Induced Recession?
- Does the U.S. Have a Trade Deficit?
- The Fiscal Gravy Train is Ending
- Bullish on Europe
- Overweight the European Stock Market
- Inflation Risks
- The End of the Dollar Cycle
- China’s Economy
- Our Portfolio Positioning
A Policy-Induced Recession?
That brings us to the question; will the trade war lead to a recession in the U.S.? First-quarter GDP data missed estimates and showed that the U.S. economy shrank by 0.3% annually, led by a sharp slowdown in net exports. Consumption slid to 1.8% from 4.0%, reflecting falling consumer confidence. Business investment rose modestly, likely due to tariff-driven frontloading, evidenced by a spike in inventories and falling capital expenditure intentions. Frontloaded demand and inventory accumulation will weigh on Q2 growth as new orders fade.
April’s stronger-than-expected U.S. jobs report eased recession concerns. Nonfarm payrolls rose 177k, but downward revisions to prior months leave the three-month average at 155k. The unemployment rate held at 4.2%, underemployment ticked down to 7.8%, and wage growth remained steady at 3.8% y/y.
Beneath the surface, low hiring and low firing continue to define the labor market. Leading indicators are weakening. With inventories high and new orders contracting, employment remains vulnerable. Tariff-related uncertainty has so far created a freeze in decision-making rather than outright retrenchment, but growth is softening.
Given the uncertainty for businesses and consumers, it is likely that Q2 economic growth will be weak as well. A recession is defined as two consecutive quarters of negative growth. It is quite likely that we could experience a shallow recession. The question is how much might already be priced into markets.
Moreover, a policy-induced recession could be reversed by changing the policy. In a policy-induced recession, the second derivative of policy leads markets. During a pandemic-induced recession, fiscal stimulus and easing of lockdowns mattered more than macroeconomics. In a tariff-induced recession, no big fiscal stimulus will be needed. Instead, it will be the delta on tariffs and negotiations that will allow markets to look ahead of the curve of quarterly earnings revisions.
The U.S. equity market surged close to 10% on April 9th when President Trump announced a pause on some of the Liberation Day tariffs, underscoring that an underweight risky asset stance is vulnerable to quick policy reversals.
We still believe that many of Trump’s trade tariffs are part of his negotiation style to extract certain concessions from trading partners. President Trump keeps walking back his tariffs as part of his negotiation strategy. Investors should expect a lot of back-and-forth over the next two months.
Investors should not become overly bearish as trade negotiations evolve. Clearly, he is negotiating. Can President Trump conclude 90 trade deals in 90 days? Obviously not, as trade deals are complex, but that makes the deals more likely to happen, not less. They will not be comprehensive deals that truly change global trade.
We had previously thought that the stock market would constrain the administration’s trade policy, but it appears that the bond market has been more impactful in that regard. We think the sharp rise in Treasury yields in April has greatly alarmed Treasury Secretary Bessent. We agree that the administration is attempting to climb down from its current position, particularly with China. We also think that negotiations between the U.S. and China will begin soon, which will be at least a positive short-term development.
If President Trump is willing to accept trivial deals like NAFTA/USMCA during his first administration this time around, then a recession may be avoided and an overweight stance toward risky assets may be justified. This is not yet clear, and the risk facing investors is that any near-term improvement in financial markets may embolden the President to seek even harsher deals that end up being rejected. Deals will likely be reached with certain countries, such as Canada and Mexico. Japan may also reach a deal relatively soon. Europe is probable, but may take longer, and time is not on the economy’s side. In the case of China, while negotiations are likely to begin shortly, a deal is very unlikely to happen soon, and economic damage is being done while tariffs remain in effect.
Does the U.S. Have a Trade Deficit?
Trump’s trade war is focused on the trade deficit in goods only. Global trade consists of three major pillars – goods, services, and energy. If we look at the total picture the story is quite different than the one President Trump is painting. America might be importing lots of its goods, but it exports a lot of its services and oil and gas.
Looking at the bigger picture, Europe actually has a trade deficit with the U.S. And China’s trade deficit is much smaller, as it does import services from the U.S.
Think of services like YouTube, Apple Music, Amazon Prime, Netflix, Microsoft Office 365, Salesforce CRM, and AWS cloud services that most companies globally use. There are many other corporate software solutions sold by U.S. companies all over the world. On top of that, Europe imports a lot of oil and gas from the U.S. If Europe reacts by imposing retaliatory tariffs on services and energy, U.S. corporations will be significantly worse off.
Just this weekend, Trump announced a 100% tariff on foreign-made movies. This is the first service tariff he introduced, and if he is not careful, he might open his own Pandora’s box. If Europe includes total trade into the trade negotiations things might not work out in America’s favor.
It makes sense that America imports goods and exports services, as it is a service-driven economy. Manufacturing is outsourced to the rest of the world not just because the rest of the world is cheaper but because U.S. services jobs pay better than U.S. manufacturing jobs. While Trump’s political base might like the rhetoric of bringing manufacturing back to the U.S., few people want to return to working in a factory.
The Fiscal Gravy Train is Ending
The problem for the Trump administration is that the fiscal gravy train, which Trump started way back in 2017, is at an end. Over the last eight years, the U.S. has run large fiscal deficits to provide massive fiscal stimulus to its economy, which is one reason why U.S. stocks and the U.S. dollar have outperformed the rest of the world.
Trump would like to continue spending, but with DOGE cuts broadly popular and the House of Representatives revolting, fiscal policy will not return to its maximum profligacy of 2020-2022. The gap between what Trump and the House want in his ‘big beautiful bill’ is significant.
Members of the House of Representatives are revolting. They have sniffed out that the deficit is hitting constraints, so they are struggling to pass the Senate agenda.
The U.S. has no more fiscal capacity to stimulate. Interest costs are higher than anywhere else in the developed world. Voters are also done with fiscal policy and inflation, which is why conservatives in the House are emboldened to not pursue profligate fiscal policy.
While the rest of the world can stimulate, the U.S. cannot. Europe has lots of fiscal room to ease and now seemingly the willingness to do so. And in China borrowing rates are low, allowing the government to increase borrowing.
Bullish on Europe
Despite America’s recent lackluster productivity performance, productivity growth in Europe has lagged far behind the U.S. The weakness in European growth reflects a variety of factors. The euro area crisis ushered in an extended period of fiscal austerity and corporate deleveraging in parts of the common-currency bloc, impairing investment spending. Brexit weakened trade ties between the UK and the EU. Immigration policy across much of Europe has been dysfunctional.
Spending on R&D is highly correlated with productivity growth. Whereas the U.S. and China have excelled, Europe has lagged. Most recently, the U.S. has led the way in AI development, with China once again offering the only serious competition. Europe lacks the deep capital markets that the U.S. possesses. Venture capital, in particular, has been sorely lacking outside the U.S., which has hampered entrepreneurship.
The rollout of AI services could benefit Europe, like what happened in the early 2000s when Europe went from being an internet laggard to being one of the first regions to offer mass broadband to its citizens. Increased infrastructure spending in Germany should also bolster productivity, although high government debt levels in other major European economies will limit their ability to loosen fiscal policy. On the flipside, if the tariffs remain in place, U.S. productivity will suffer as well.
Overweight the European Stock Market
Turning to stock markets, a key argument for overweighting Europe versus the U.S. is that the AI bubble has further to deflate. AI-related stocks that have been dominating U.S. stock market performance in the last two years are based on two questionable assumptions. First, U.S. corporate profits will reap all the productivity gains from the generative AI revolution, just as they did from the Web 2.0 revolution. However, Web 2.0 was an anomaly because its ‘network effect’ created winner-takes-all natural monopoly firms. So, a small group of tech companies took most of the market share, resulting in the ‘Magnificent Seven’ concentration in the market.
In the case of generative AI, there is no network effect, so the productivity gains will be shared among a much broader group of companies.
The second assumption is that for the productivity gains from generative AI that do go into U.S. corporate profits, the market is assuming that the Web 2.0 superstar companies will all become the AI superstar companies. This is highly unlikely because the companies that are the big winners of one technology are rarely the big winners of the next technology.
For example, the superstars in early 2000 – Microsoft, Intel, IBM, and Oracle – were the big winners of the personal computer revolution. Additionally, Cisco, the company that made the ‘picks and shovels’ for the internet gold rush. Of these, Intel, IBM, Oracle, and Cisco have underperformed significantly since 2000, with only Microsoft transitioning to become a Web 2.0 success.
Today’s AI superstars are the Web 2.0 monopolies: Apple, Microsoft, Amazon, Alphabet, Meta, and Broadcom. Additionally, Nvidia, the company that makes the ‘picks and shovels’ for the AI gold rush. Of these, at most one or two will transition to become long-term winners of AI.
Europe’s huge and unprecedented valuation discount versus the U.S. is nothing more than the mirror image of the AI valuation bubble. As the AI bubble fully deflates, Europe’s discount versus the U.S. still has a lot further to narrow from its current 35% discount back to its long-term average of -20%. Meaning that Europe’s valuation versus the U.S. can rerate by about 25 percent.
Interestingly though, the U.S. overvaluation versus Europe is not just driven by the AI superstars. Even in an individual sector, like healthcare, Europe is trading at a record discount to the U.S. This is true despite the post-pandemic earnings growth of European healthcare and US healthcare being identical.
U.S. stocks also typically underperform their global peers when the U.S. dollar is weakening, and this time has been no different.
Inflation Risks
The danger of rising inflation expectations is clear, meaning that the Fed is unlikely to cut preemptively to prevent a recession.
Tariffs will certainly raise the price level for many goods, but whether the tariff-driven increase in the price level will lead to persistently higher rates of change in prices is a different story. Household inflation expectations point to that outcome, but there is strong evidence that the University of Michigan survey may be distorted by political affiliation, at least in terms of responses to questions on inflation.
The risk of higher inflation expectations will be much higher if a recession is avoided, and we could experience a period of stagflation if tariffs are imposed but unemployment does not rise. If the stagflationary outcome were to materialize, we would still take a more defensive stance toward stocks, but we would be more concerned about fixed income in that case.
The End of the Dollar Cycle
Despite weakening this year, the real trade weighted U.S. dollar index remains 16% above its 20-year average. The dollar trades at a similarly large premium to its Purchasing Power Parity (PPP) exchange rate, which is the exchange rate which equalizes the price of a basket of goods and services across countries.
If U.S. growth decelerates due to slower immigration inflows, and the Trump administration continues to pursue unfunded tax cuts and protectionist policies, the U.S. dollar could weaken significantly further over the next 12 months.
China’s Economy
The general perception is that China’s economy is very dependent on exports, which has made it very vulnerable to Trump’s tariff blitz. This is misleading, as China’s export dependency is actually not that high, at around 18% of GDP. It is lower than most European countries and much lower than most Southeast Asian economies. China’s exports to the U.S. account for 2.6% of GDP, and China’s trade surplus with the U.S. only takes up 1.5% of the Chinese economy. These factors explain why Xi has not yet called Trump for a trade deal.
Nevertheless, the proposed 145% tariffs will hurt China economically and China should do more to stimulate its own domestic consumption, which will be more effective than trying to find new export markets for its products.
Our Portfolio Positioning
In early March we diversified our portfolios away from the U.S. and increased defensive equity positions. This strategy has worked well in April’s volatile markets.
Our focus on quality and value in the equity market is paying off this year, especially as the AI-driven growth expectations are declining.
We remain slightly defensively positioned for the coming months as we expect markets to remain volatile and prone to swings based on new announcements by the Trump administration. However, despite the risk of a shallow recession we are not turning completely bearish either. Having a globally diversified portfolio is the right strategy in this type of market.
DISCLOSURES
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
