The VIX is a commonly noted index that measures fear and anxiety. It is based on option premiums, the thought being that higher premiums denote greater expected volatility. In this century, there have been only five instances where the VIX was over 45, the level it closed at on Friday. In each case, equities were higher six months later. One might assume hedge funds and algorithmic traders feed off of volatility. However, they aren’t hired to take risks; they are hired to make money. The equity markets aren’t a casino (with a few meme-stock related exceptions!), they are platforms that allow investors to take appropriate risks consistent with their own level of tolerance. As the name hedge fund implies, these pools of money try to manage risk using strategies that limit the downside using a wide combination of long and short positions of both stocks and options. But when volatility gets too extreme, managers do what any prudent person does in a storm. They seek shelter until the brunt of the storm passes. They minimize risk, sell positions and head for the bunkers. Some, maybe much, of last week’s selling was seeing the pros run for cover seeking protection in cash and Treasuries until signs appear that the worst of the storm is over.
Before addressing when and how the storm might end, I want to discuss why the storm turned so virulent last week. Obviously, the size of the announced tariff package was larger than most anyone expected. While many were surprised, any understanding of Trump’s logic suggests that the initial tariffs may be more than the economy can bare. But they are a starting point. Note that most of last week’s announced tariffs don’t go into effect until Wednesday. There is still room for some negotiation.
Beyond the size of the tariff package, however, how they were computed is puzzling. That’s a polite way of putting it. For weeks, the administration has been talking about reciprocal tariffs whereby our tariffs would key off of tariffs already in place by our trading partners. The centerpiece of Wednesday’s announcement was a poster board stating the tariffs to be implemented on imports from dozens of trading partners. The minimum was 10%. During the early part of the Wednesday announcement, stock futures actually rose on the misunderstanding that 10% across-the-board tariffs would be the whole package. While the administration tried to posture the tariffs for individual nations as a response to their tariffs on us, the formula used for each country was simple math; imports minus exports divided by imports and then applied at 50% of the result. When investors saw tariffs might exceed 30% or more, they ran for the exits. Note, however, that the formula doesn’t mention reciprocity anywhere. The tariffs scheduled to begin this week don’t relate to any tariffs against U.S. goods already in place. Thus, if a poor African nation imports almost nothing from us but sells coffee or cocoa beans to the U.S., they end up getting hit with an enormous tariff of 30% or more regardless of the fact that America isn’t going to start growing coffee or cocoa beans. Some of the tariffs announced are almost comical including those imposed on an island inhabited by penguins but no humans.
Most of our trading partners were as surprised by the tariff announcements as investors. The Wall Street Journal reports, for instance, that Chinese efforts to engage in dialogue with the Trump administration have fallen on deaf ears. The subsequent Chinese reaction was to raise tariffs on U.S. imports to China by the same 34% that we added to existing Chinese tariffs last week. Most other countries haven’t reacted yet, hoping that negotiations might ensue. Everyone is asking for a discussion. Now the ball is back in Trump’s lap.
Markets hate surprise and uncertainty. They got both in megadoses last week. The reaction was predictable. And we don’t see an end, at least not yet.
Were those peak tariffs? How much negotiation will the Trump administration be willing to undertake? Over the weekend, they haven’t budged much. But just as Congress never seems to pass anything meaningful until the clock reaches 11:59 pm, it is still quite possible that there will be some movement before Wednesday. A week ago, a general thought was that Wednesday’s announcement would reduce uncertainty. Wrong! But we all know that can change on a dime.
With all this said, let’s look at some of the actual implications that we are able to discuss. The flight to safety has lowered Treasury bond yields and, by extension, reduced the cost of mortgages. That’s one silver lining. Conversely, the value of the dollar has fallen. While that makes imports more expensive and exports more enticing, goals of the Trump administration, it also would reduce capital flows into the U.S. Capital chases strength. Mercedes isn’t going to be enticed to build another auto assembly plant in the U.S. if the dollar were to be in steady decline or U.S. demand for luxury cars weakens. As for manufacturing reshoring by U.S. companies, recognize that building large plants can take years. In addition, while onshore manufacturing could escape some tariffs (which would still be in place on imported components), there would be offsets related to higher labor costs, and elevated regulatory expenses. Indeed, the tariffs would increase the costs to build a new plant in the U.S. President Trump will trumpet any isolated news that an overseas company will manufacture widgets in the U.S. but that would be a P.R. blitz more than a change in world economics.
To most economists and investors, tariffs are a tax. They could be paid in part by the company selling goods to the U.S., in part by the importer, and in part by the end user. So far, Trump’s tariff policies focus solely on goods. Excluding food and energy, the sale of goods represents about 20% of GDP. Thus, the headlines may sound worse than reality. By the same token, tariffs on goods, adjusted for last Wednesday’s announcement, would be equivalent to a tax hike relative to goods imported of well over 20%, the highest in more than a century. Even accepting that goods are a small part of GDP, that still equates to a material inflationary impact.
After 9/11 and at the peak of the Covid pandemic, America seemed to freeze in place. It took months for some semblance of normality to return. So far, the initial reaction this time is one of outrage by many, but given an unemployment rate barely over 4%, life has gone on. What we will be watching in the weeks ahead will be changes in behavior. Are we going let fear stop us from spending? Will new home purchases pick up? Lower mortgage rates suggest they will. Economic uncertainty may yield an opposite impact for a short period. Auto dealers will see a rush of buyers seeking cars already on the lot that are tariff-free. The same will go for appliances like washing machines, computers and iPhones. Once tariff-free inventory is depleted, however, sales may stop. New car buyers will seek out tariff-free used cars rather than pay thousands more for a new car.
We will get hints of real time changes over the next few weeks as companies report first quarter earnings. Actual results should be fine but what investors will focus on are changing trends. Managements will be cautious but they don’t want to breed panic either. “It’s too early to tell” will be a common response to questions.
I started this letter noting that markets recovered reasonably quickly to spikes in fear and uncertainty. Trump has his own way of doing things but he pays close attention to markets. He might tolerate a quick brief but sharp decline in the stock market. But if markets decline much further, he risks putting his entire agenda at risk. Remember that Republican majorities in both the House and Senate are miniscule. He can’t afford to lose many votes. The House goes into a two-week recess starting Friday. Members will get an earful when they go home. Telling voters to be patient and believe in the grand plan won’t be an ideal response. You are already starting to see efforts within Congress to regain some control over tariff and economic policies. Trump has a lot he wants to accomplish including a broad tax bill, better border security, and reducing the Federal bureaucracy, all of which appeal broadly to voters. To get to the finish line, he will need to keep unity within his party. Within a financial panic, he will lose unity, not solidify it.
Warren Buffett will tell you that the best time to buy is when everyone else is panicking. While I have no idea what compromises are forthcoming, or whether there will be short-term tit-for-tat tariff retaliation, clearly what was announced last week was a first step in a negotiation process, not a final edict to last for four years. There are also steps taken than need fixing. Taxing products that we cannot produce in the U.S. defies anyone’s logic. How about commercial aviation aircraft? Prior to last week, tariffs of commercial jets were zero. Now we are imposing a 10% tariff universally and a 20% tariff on anything coming from the European Union. Hint: if you are talking about balance of trade, Boeing commercial aircraft sales overseas are probably our nation’s largest non-commodity export. You won’t solve a trade imbalance by pushing Boeing jet buyers to Airbus.
All this suggests rationalization of tariffs announced last week is likely. What isn’t known is the extent of the tariffs that will remain in place and the economic harm those tariffs present in the months ahead. If one combines the impact of tariffs announced with the drop in key commodity prices, the inflation impact should be less than a percentage point. Tolerable. Growth is another question. Already predictions of GDP growth in the first quarter are close to 1% or even less. That’s before tariffs are taken into account. Leading economists now see a recession at close to a 50-50 proposition. While stocks could rally if last week’s pronouncements are moderated, don’t expect a full recovery from last week’s losses right away.
However, there are underlying strengths that will ultimately resurface as tailwinds for stock prices. AI is a growth engine that will be in place for years to come. A reduced Federal bureaucracy will improve efficiency. It will also shift the government’s percentage of GDP back toward historic norms. Given productivity in the private sector is greater than in the government sector, that’s a good thing. Once the one-time hit from tariffs flows through the economy, inflation can continue to move lower toward the Fed’s 2% target. And speaking of the Fed, markets now foresee 4 rate cuts this year versus 2-3 just a couple of weeks ago.
With that said, trying to reconfigure world trade in less than 90 days is gut wrenching. In the short run, such rapid change at best leads to dislocations. Once again supply chains need to be reconfigured. Reshoring, if it is to occur at all, will take years, not months. And even if every GM car or iPhone becomes assembled in America, many of the components will still come from overseas.
It’s scary times. I can’t predict what today will bring. Earnings season starts Friday and there won’t be a lot of cheer or optimism. I can’t tell you when the bottom will occur or how far lower stocks have to fall to set a bottom. Readers of my notes in the past know that I will wait for 2 back-to-back strong sessions before even thinking of sounding the all-clear alarm. For years, in our letters we have suggested that based on history, stocks were fairly valued, at times overvalued. Earnings estimates for 2025 are coming down. They are likely to come down further as corporate managements show muted near-term optimism. If I use $250 for S&P 500 earnings and apply a 16x multiple, close to the median for the last century, I derive a value of 4000 or 20% below where the S&P 500 closed on Friday. That’s not a prediction or a target. It is simply a derivative of math. If I use an 18x multiple, the number would be 4500, still 10% below Friday’s close. 4500 would be 27% below historic highs reached in February.
There is an old saying that stocks take the escalator up and the elevator down. In 1987, stocks fell 22% in one day and there was no ensuing recession. But stocks don’t stay down. Within a year, many stocks had recovered their 1987 losses. We should also note that not all stocks perform in line with the overall market. In 2008, one of the worst stock market years in memory, two Dow components, Wal-Mart and McDonald’s# finished the year higher. Thus, my advice is don’t panic. If you need to derisk further in order to sleep at night, do so but in moderation. If you are starting to bargain hunt, do so carefully buying a small position to start. Anyone who thinks he knows what tomorrow brings in this environment is foolish. Trump could announce a delay in implementing some tariffs this week and stocks will soar. Or he can double down if faced with massive retaliation. The only prediction I will make today is that volatility is going to remain high for a while at least until some clarity is achieved, hopefully sooner rather than later.
Today, Jackie Chan is 71. Former California Governor Jerry Brown turns 87.
James M. Meyer, CFA 610-260-2220