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Monday, 10 February 2025 22:18

Divergent Opinions in External Articles - The opinions expressed in articles from external sources do not necessarily reflect the views of Renalco SA and are shared for informational purposes only.

Last week was intense for investors as Trump fired his first tariff salvo against Canada, Mexico, and China, while threatening Europe. Interestingly, a week later, equity markets have barely moved and US10Y rates ended slightly down for the week. Even more interestingly, the equity markets of potential trade losers, i.e. Canada, Mexico, Europe, and China have completely shrugged off the threats.

Several factors can explain this phenomenon:

• Tariffs against Canada and Mexico were quickly put on hold by Trump for a month “after great calls” with respective leaders, which raises questions about Trump’s reliability and real motivations.
• Other factors drove markets, such as the discussions of peace agreement in Ukraine, a weakening oil price with Trump looking for a new nuclear deal with Iran, the cooling ISM services in the US, and the on-going earnings season.
• In Europe, the major large-cap bank stocks, such as Santander and BNP Paribas, supported the stock market.

Still, looking at the returns of the last five days, sectors potentially threatened by tariffs, such as Automotive and Consumer Discretionary Goods (many companies rely on trade flows) have come down, while some sectors perceived as inflation hedges like Energy and Food Retail have done well. In the case of Energy, it is particularly noteworthy that the oil price fell during the week.

In today’s weekly note, we provide several interesting charts on the US trade situation with the rest of the world. It makes us even more skeptical about Trump’s policy and its ability to dramatically change the trading picture with its partners, except maybe with China where a re-appreciation of the yuan would be the best outcome for both countries.

The fact that Trump’s policy could be inflationary is well-documented by many researchers, with a lot of scenario analyses available (see here and there for example). It is all the more credible as we have seen the effects of 2018 tariffs: importers tend to pass through the tariffs and local competition – which could be a substitute for foreign products – also tend to raise their own prices.

Moreover, we also find that the US’s trade situation hasn’t worsened particularly in recent years, as opposed to the eurozone’s, clearly making Trump’s claim that the US has a bad deal with the world not very credible. Europe has lost a lot of market share in global exports, while the US has maintained its own. Furthermore, despite booming consumer demand relative to its big trading partners like Europe or China, the US hasn’t seen its deficit widen as a percentage of GDP.

When it comes to its relationship with Europe, we have noted many times that the EU’s trade surplus should be considered with services as Europe imports almost all of its technology from the US. In fact, we note that the FT reported this week that the EU might consider hitting US Big Techs if Trump goes after its trade surplus on goods. That is a smart move since any big hit on Big Techs could weaken the S&P and influence Trump’s perception of the situation.

What is our concrete assessment of the trade war risk?

• It sounds obvious, but we re-emphasise that investors need to consider hedging equity portfolios with derivatives. The overall investment backdrop favors stocks over bonds, but a significant pullback, similar to the scenario in 2018, is plausible if Trump goes beyond what is rational. By the way, we would note that his attack on Canada and Mexico is incredibly more brutal than the threats he made in 2018/19.
• Bonds are where the risk is. However, at 4.5% on US treasuries, we think the risk is fairly remunerated. Very aggressive tariffs could have counterproductive effects on the US economy, with a fall in business and consumer sentiment. The market illustrated that risk last Monday. While inflationary, this policy could push the yield curve back to inverted territory. We’re not there yet, but that’s a possibility.
• In terms of geography, tough tariffs would favor the US equity market over the rest of the world. However, this is partly what drove the boom of inflows into the US in November and December last year, with this extreme positioning backfiring this year. On the other hand, a reasonable outcome on tariffs would actually favour diversification towards the RoW, notably Europe and China, which are way cheaper and have plans to offset pressures from tariffs.
• We tend to have a balanced approach between Defensives and Cyclicals in our European sectors allocation. A lot of sectors at risk from tariffs are very attractive from a valuation point of view if moderate tariffs are set (we upgraded Autos to Neutral, and Beverages is another example). In fact, the cyclical compartment overall (Basic Resources, Chemicals) remains attractive after several quarters of manufacturing production pressures. Many inflation hedges such as Real Estate are very cheap too. Finally, rebuilding Ukraine would be very favourable for a number of cyclical European sectors.

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