Calm analysis or hysteria?

The extraordinary volatility surrounding Donald Trump’s tariff policy has rapidly become the predominant factor influencing US investor sentiment in recent weeks and by implication has become the single most important factor driving global financial markets. Significant other macro-economic developments such as China’s additional stimulus measures announced at the week-long meeting of the legislature, or Germany’s reform of its strict borrowing rules that some have argued could unleash a trillion euros of fiscal stimulus or moves towards peace in Ukraine or indeed the fall in global energy prices have all been completely eclipsed by the on, off tariff saga.

Many commentators are now blaming the weakness of the US equity market, especially that of the Mag 7, directly on concerns that the tariffs (as yet indeterminant as to quantum, geographic application and timing) will be so economically damaging that they will tip the US economy into recession. At the margin, adding to those concerns are fears that public sector worker layoffs at the behest of DOGE will be sufficient to crater the labour market and broader consumer confidence. All of this negative narrative is of course not helped by Trump’s incoherent answers to journalists’ questions about the economy and about the equity market and some extraordinary and economically illiterate commentary on social media about the US administration’s desire to engineer a recession to lower the cost of refinancing US government debt.

I disagree with almost every aspect of these strange hypotheses and with the more bizarre conspiracy theories. Here are reasons why I think these explanations for what is going on are wrong.

1. Is the US economy going into a recession?

The short answer is no. On 27 February the Bureau of Economic Analysis announced that US GDP expanded by 2.3% in the fourth quarter of 2024. This was slightly below the 3.1% growth in the third quarter, with the slowdown attributable to lower growth in exports and investment, but consumer spending accelerated, and imports fell.

More recent, but much less reliable indicators of sentiment and survey data have indicated this very satisfactory level of growth may have slowed in Q1 2025, but, importantly, as recently as March 7th, the FED governor said that the economy was growing at “a solid pace”. He did highlight in his speech that survey data was less upbeat but added that “it remains to be seen how these developments might affect spending and investment.” He also said that sentiment readings have not been a good predictor of consumption growth in recent years. In terms of more detailed commentary, he highlighted the resilience of the labour market and the significant falls in inflation from its peak in the middle of 2022. Finally, and importantly, he finished by saying that if the labour market weakened unexpectedly or inflation fell unexpectedly, the FED will ease policy accordingly.

Recessions are not spontaneous events. They happen because economic events or policy errors trigger them. However, as much as I am concerned about the economic implications of the tariffs Trump has flagged but then delayed on numerous occasions, and the potential retaliatory measures. First of all, I still believe these are negotiating tactics and in my view are unlikely to be implemented and to endure even if they are. Secondly, the tariffs are, on their own, insufficiently significant to create the sort of economy-wide impact that would result in a recession.

In large part this is because the US economy is relatively self-sufficient compared to its peers as is shown in the chart below with total goods and services trade amounting to only 12.7% of GDP in 2023 which compares to 22.4% for the EU and 32.8% for the UK.

As the Fed governor highlighted in his most recent speech, if the economy weakens, interest rates will fall.

So, in summary, the growth momentum in the US economy is very healthy and exceeds that in nearly all of its developed economy peers, as disruptive as tariffs could be for specific industries, their economy wide impact is likely to be less worrying than consensus believes, energy prices are falling which will be helpful for growth and the FED will cut rates if the economy shows signs of weakening. For all these reasons, I am confident that there will not be a US recession in the foreseeable future. Finally, the other Trump policy priority of tax cuts, which has received little attention in recent weeks, will of course be a significant positive for US growth over the short and medium term.

2. Why is the US equity market weak?

As I write this (Tuesday evening), the NASDAQ is down again, and so is the S&P 500. Both indices are down year to date by nearly 11% and 6%, respectively, having both been up about 4% in late February. In the context of the last 5 years, these are quite significant corrections, but in the context of the gains in both indices over the last 5 to 10 years, not at all significant.

When it comes to diagnosing why equity markets go up and down, typically there are as many explanations as there are opinions. Sometimes, even with the benefit of hindsight, it is impossible to precisely diagnose why markets have moved. I will offer an opinion but there are likely to be many dissenters who would offer alternative theories.

As regular readers will know, I have been cautioning about the valuation of the US equity market for some time. In my experience, overvalued markets, for that is what the US market has been, need the support of a favourable and stable macroeconomic and political backdrop. In broad terms, that is what Wall Street has had since the pandemic. However, Trump has introduced a degree of economic and political mayhem into the mix that all investors worldwide are trying to quantify. Whether or not his radical policy agenda delivers for the economy is an open question. In my view it will, albeit that it will come with attendant risk, but on the way to that outcome we are going to have to contend with more volatility and uncertainty. That is manageable in most circumstances, but when a market or individual stocks are priced for perfection and they meet the economic equivalent of bipolar disorder, that can create the circumstances for investor risk aversion which is what I think we are seeing in the US market right now.

As I have already written, I think the US economy is in a good place, and I don’t see a recession as at all likely. Nevertheless, the US equity market is clearly not enjoying the policy uncertainty Trump is inflicting on it and for the time being I would not expect a dramatic bounce back. Having said that, I am beginning to see pockets of value emerge in parts of the market, which I would have avoided until very recently, so this correction is already starting to offer up some interesting opportunities.

I will keep you posted on what they are and when and if I see a value opportunity in them.

3. Conspiracy theory

Trump is engineering a recession to lower the cost of refinancing $9.2 trillion of US debt that will mature in 2025.

This rather strange theory runs along the lines that the refinancing cost of this debt could be lowered by engineering a recession (dubbed "Trumpcession"), which would result in FED interest rate cuts, lower bond yields and by implication lower refinancing costs, which would endure over the life of the refinanced debt until it matured (the NPV of this theoretical benefit would of course depend on the term of the debt that was issued).

This idea is in my opinion economically illiterate for a number of reasons.

1. Recessions are economically damaging and always increase government deficits relative to the size of the economy, which, by definition, shrinks. Any theoretical benefit from lower refinancing costs would be overwhelmed by increased welfare spending, lower tax revenues, and, consequently, higher borrowing.
2. The potential savings from this theoretical saving would be a rounding error in terms of current US government spending. In 2024, the US federal government spent US$ 6.9 trillion. If through engineering a recession, the US government could reduce the refinancing rate (10-year yields in the US are currently at 4.27%) by, say, a 100bps, then the saving, in theory, in an entire year, would amount to US$ 92 billion. That’s 1.3% of total federal government spending. But at what cost to the economy, tax revenues and welfare?
3. A recession also has all sorts of other costs and risks for the private sector. Recessions create economic stress for consumers (who lose their jobs), businesses that have to shrink to survive, lower investment in the economy, and sometimes, permanent damage to the productive capacity of the economy. It is not something any politician, civil servant, or central banker would wish for or deliberately engineer.
4. It would be far better for the economy to deliver lower refinancing costs by applying appropriate monetary policy and lower energy prices.

Summary

The US economy is not going into a recession. Much more likely is a continuation of the 2% growth or better that other western developed economies can only currently dream about.

The uncertainty of Trump’s economic policies has spooked the US equity market, but only because it was and still is largely priced for perfection. This uncertainty is likely to persist for the time being, and I don’t expect the market to snap back. However, I don't expect this correction to turn into something more worrying.

Conspiracy theories related to the Trump administration engineering a recession are economically illiterate and wrong.