Answering Trump’s “nastiest question”
Stock market participants have dubbed Trump’s erratic trade policy “TACO” or Trump Always Chickens Out. While his rhetoric is bold and the threats often dramatic, they frequently end in watered-down policy or partial walk-backs. The latest incident with the EU is just the most recent example in a string of high-stakes bluffs reined in. After threatening the EU with a 50% tariff on the 23rd of May, President Trump backed off following a telephone call with the President of the European Commission.
While it is unclear if TACO-style brinkmanship can yield real strategic gains, or just create noise without substance, we expect that the Trump administration will ultimately settle on a 10% base tariff for most countries. The initial targets, Canada and Mexico, will likely see a reduction in the tariffs levied on them too. Partially protected by the United States-Mexico-Canada Agreement (“USMCA”). While most nations will experience a moderation in tariffs, we do still think that China will face higher tariffs than most.
From an industry point of view, higher tariffs on autos will likely remain in place. While sectors deemed important for national security, such as semiconductors and pharmaceuticals, could see additional tariffs unveiled in the coming months.
Altogether, the effective US tariffs will likely end up around 15%, slightly below the Yale Budget Lab’s estimate of the current tariff rate – see Figure 1. This level is close to where tariffs were set during the 1930s as part of the Smoot-Hawley Act. An act that is broadly attributed to having worsened the severity of the Great Depression. This time though, imports as a share of GDP is more than three times larger than it was nearly a century ago. Meaning that the impact could conceivably be materially worse.
Figure 1 – The highest set of tariffs since the 1930s
The weakening US labour market
Figure 2 – Correlations among R&D and labour productivity for various countries
As can be seen in Figure 2 above, the 12-month moving average of both initial and continuing jobless claims is still trending higher. In addition, real-time measures from job posting websites Linkup and Indeed report the continuation of declining job openings since the last JOLTS release in March. Meanwhile, an aggregate of 7 standardized survey-based labour market indicators, also known as “soft data”, illustrate that consumer confidence in the labour market has not noticeably recovered since it fell to dramatic new lows in the wake of Trump’s “Liberation Day” tariffs – see Figure 3.
Figure 3 – Labour market surveys (“soft data”) are pointing to a worsening job market
A weakening labour market typically begets decreasing consumption, as consumer spending can only exceed income growth if the savings rate declines. However, there does not appear to be much room for the savings rate to fall. As of March it was just 3.9%, well below the 2019 average of 7.3%. Consumers cannot turn to their existing savings either, as we have stated before and has now been confirmed by the San Francisco Fed, excess pandemic savings have been entirely depleted.
Of course, this leaves one final option for consumers to resort to in order to sustain consumption: Credit. However, here too the environment appears to be souring, as delinquency rates on credit and auto loans have returned to levels last seen in 2011 – an environment in which unemployment averaged nearly 9%. Interestingly, Figure 4 also depicts how student loan delinquencies have jumped right back to the levels last seen prior to the recently expired Covid-19 student loan relief programme. While student loan delinquencies at these levels are not necessarily a concern, the return of student loan payments does represent an additional burden on millions of Americans.
Figure 4 – Credit card delinquencies are now at levels last seen during the GFC
Where did all the housing demand go?
Figure 5 – Data points to a weakening housing market
Figure 5 illustrates that across the board, whether it be homebuilder confidence, or homebuilder share prices, the housing market appears to be weakening. This holds true for the hard data too, as measures such as existing home sales, starts, and permits issued have all deteriorated. Meanwhile the inventory of newly built unsold homes has climbed to the highest level since late 2009. The weakening housing market fundamentals and growing glut of supply are only being worsened by rising mortgage rates – Figure 6. Despite the US Federal Reserve (“Fed”) executing several interest rate cuts, the share of mortgages with a rate above 6% has increased from just 4% in mid-2022 to 20% of all mortgages today. A result of the lagged impact of changes to the Fed funds rate.
Figure 6 – More mortgage holders are paying higher rates now
Trump reports to the bond market
While the trade war has dominated headlines, it is the rising global bond yields (pushing borrowing costs higher) that pose the greater threat to economic growth – Figure 7. Of course, part of reason for the increase in yields is the lower recession concerns, tempering investor demand for bonds. However, the more material driver of rising bond yields is rising term premia, which mainly stems from the worrying prospect of ever higher government debt issuance.
Figure 7– Most of the rise in yields is due to increasing term premia
The Congressional Budget Office (“CBO”) estimates that US net government debt will rise from 98% of GDP in 2024 to 149% of GDP in 2040, assuming that the 2017 Tax Cuts and Jobs Act does not expire and instead is made permanent in line with Trump’s aspirations. As a result, interest expenses would rise to 5.3% of GDP, from the already near-record high of 3.1%.
We believe that the CBO’s deficit estimates may even be too conservative, as they do not account for any of the proposed House budget bill’s other tax cuts, such as no taxes on tips and overtime, or the expanded SALT deduction. Some may argue that these additional tax cuts could lead to stronger GDP growth, improving the fiscal picture. While others may point out that the benefits could be offset by other policy factors, such as tariffs, tighter immigration restrictions, or even budget cuts to scientific research. In truth, it is difficult to make high certainty predictions on the aggregate impact of Trump’s policies.
If bond yields do continue to rise, one can expect mortgage rates to rise too, placing additional pressure on an already weak housing market. While the Fed could step in and buy bonds to halt the upwards march of yields, we believe it is unlikely, as that would mean the Fed is condoning the Trump administration’s continued implementation of irresponsible fiscal policy. As a result, we believe it is unlikely that the Fed will intervene unless yields rise so high (e.g. 10-year yield reaches ~6%) that a recession becomes practically unavoidable.
Investment takeaway
At present, equity markets are pricing in very little economic risk. The S&P 500 currently trades at 21.6x forward earnings, at peak profit margins too. For context, during a mild recession the forward P/E ratio typically drops into the teens, and during a deep recession as low as single digits. Outside of the US, equity markets are cheaper, but the valuation gap has narrowed in recent months, with European shares now trading at 14.7x forward earnings, marginally above both their 10 and 20-year averages. With this in mind, we remain underweight equities.
On bonds, the risk of a recession would normally justify increasing one’s exposure. However, the risk of a fiscal crisis, as flagged by bond rising yields, caution us against going aggressively overweight especially with longer duration. In the near term, we remain neutral and will continue to monitor economic and fiscal developments closely.
If you are interested in finding out more about how cognisance of the macroeconomic backdrop impacts our investment decision making process, connect with Integrity Asset Management and let us help you navigate your investing journey.
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Source: Bloomberg, 30 May 2025