This week in the markets: Markets shaken by the start of Trump’s trade war
A week is a long time in financial markets. Just seven days ago, everyone was focused on the seismic shock posed by China’s DeepSeek to the AI narrative driving markets higher. After a market shock that lasted barely a couple of days, but included a 17% one day fall in AI poster-child Nvidia, investors quickly regained their mojo and markets ended the week pretty much where they had begun it. Then over the weekend the cycle started all over again.
Unlike the DeepSeek drama, this week’s reason to worry did not come out of the blue. Donald Trump has been threatening trade tariffs since long before the Presidential election. No-one can say they were not warned that he intended to slap substantial levies on America’s biggest trading partners. What has come as a surprise is the extent of the tariffs imposed on the US’s neighbours, Canada and Mexico - 25% in both cases with the exception of Canadian energy which faces a 10% levy - and their timing - they come into force at midnight tonight.
The market reaction has been substantial, especially when you consider that investors have had time to prepare for the shock. After the announcement on Saturday of the tariffs - which also include a 10% levy on US imports from China, and the threat of tariffs on the EU - Asian markets were the first to react. Japanese shares fell by more than 2%, as did South Korea’s Kospi index. Asian currencies were also significantly weaker against the dollar. Carmakers were hard hit, with Toyota, Nissan and Honda down more than 5%. Mazda was more than 7% lower.
Risk assets outside stock markets were also hit over the weekend, with crypto-currencies slammed. Nearly $600bn was wiped off the value of crypto markets, with Ethereum, the second biggest coin, down 27%. Bitcoin, the benchmark coin, was 4% off at $93,000, having recently hit a high of $108,000.
When stock market trading opened in Europe, the same themes continued with Volkswagen, BMW and Mercedes shares all off by more than 5%. The Stoxx Europe 600 and the FTSE 100 were both 1.3% lower at the open. At the time of writing, the US market has not yet opened but futures tracking the S&P 500 are down 1.7% and the Nasdaq is expected to open more than 2% lower.
The big unknown is the extent to which investors should take the tariff threat seriously, as a long-term hit to global trade, or view it as another - albeit high-risk - negotiating ploy by the Trump administration. The tariffs have clearly been linked to border issues - both immigration and the import of drugs, notably fentanyl - so the more optimistic view is that this framing creates a so-called ‘off-ramp’, a mechanism for the US to back off from its tariff threat while still being able to point to a policy win. This view sees the tariffs as being less about trade deficits and more about domestic political point scoring.
But the competing view doing the rounds is that Trump is deadly serious and the markets have so far been too complacent about the likely economic impact. Deutsche Bank’s view is that the market needs to reprice the trade war premium which it believes have been underpriced. It sees the tariffs as being at the worst end of the possible spectrum, especially the fact that they include energy imports from Canada. This runs counter to the market narrative that Trump would avoid measures that threatened to worsen the inflation and cost of living considerations that were so influential in his election victory last November.
Morgan Stanley thinks the impact on both growth and inflation will be meaningful, cutting growth by as much as 1.1 percentage points and pushing inflation up to 0.6 percentage points higher. This would limit the ability of the Federal Reserve to cut interest rates and would mean that last week’s decision to hold interest rates at between 4.25% and 4.5% would be the first of many no change decisions. The Fed would essentially be on hold until the growth impact forced it to loosen policy. The currency impact of a Fed on pause and big economic impacts in the rest of the world is already being reflected in a stronger dollar, which rose sharply over the weekend.
One possible escape route from the worst outcomes would be if the US courts issue a temporary injunction that pauses their implementation. The President has pursued a legal route designed to protect the US from serious security threats, essentially a war-time measure. Its use for tariffs is unprecedented and open to legal challenge. Specifically, the tariffs are not narrowly targeted to address the fentanyl threat, which has been given as their justification.
The view of most observers outside the administration is that tariffs are a damaging step both for the US economy and the rest of the world. And in many ways they are seen as a bad idea. For example, if fentanyl is really the problem that Trump is trying to address, then slapping tariffs on Canada, not a big source of the drug, is a strange way to address it. If immigration from Mexico is really the problem then causing a recession in Mexico and increasing the incentive for migrants to cross the border in search of a better life is likewise probably counter-productive. Picking on both Mexico and Canada seems odd given the ability of both countries to retaliate - they are the US’s two biggest sources of imports and so have leverage, even if they are very much the junior trade partners in the relationship with America.
From an investment perspective, the trade threat has come at a bad time, just as the AI narrative is reeling from the Deepseek blow a week ago. There is a danger that the combination of the two unnerves investors already starting to worry about the durability of a cyclical bull market that has been running for more than two years since October 2022 and a secular bull now coming up to its 16th anniversary.
That’s the bad news. There are offsetting positives that need to be borne in mind. The first is that momentum is very much intact. January closed out on Friday with a 2.8% gain for the S&P 500 and an even better 3.5% rise for the equal weighted version of the same index. The Russell 2000 index of smaller companies gained 2.6%, erasing the wobble at the end of December when the broadening out of the rally seemed to hit the buffers.
The MSCI all country world index was 3.4% up in January and emerging markets were 1.8% higher. Gold and bitcoin both rose substantially.
In part the market’s continuing strength has been driven by another strong earnings season. We are now about 40% through the fourth quarter reporting round and about 80% of companies have beaten expectations. The growth estimate for the quarter has risen by about 2 percentage points so far in the season. So far so typical, and a reason to think the fundamentals of the market remain in reasonable shape.
The question of valuations is still unanswered. Particularly the valuation of the US stock market, which currently stands at 1.7 times that of the valuation of all the markets outside the US. That is far and away the highest differential in at least 25 years. The extent to which this is justified by the better productivity and profitability of US companies is a debatable point. Higher earnings and higher payouts (dividends and share buybacks combined) lead to a higher return on equity which in turn justifies higher valuations. The question is how much is too much.
Looking beyond the tariffs story this week, attention will focus on Friday’s US jobs report. Last week, while keeping interest rates on hold, the Fed described the US labour market as ‘solid’ and said that unemployment had stabilised. The expectation is that 170,000 new jobs were created in January, in line with average over the past three months although less than the 250,000 reported in December. Unemployment is expected to be steady at 4.1%.
That makes it likely that the gap between US and UK interest rates will narrow this week as the Bank of England decides on Thursday whether to cut UK rates to 4.5%, the top end of the US rate range. Since last summer, the Bank has cut rates every other meeting and having left rates unchanged in December, the consensus is that they will come down this week. Thereafter it’s unclear where they will head next. The UK economy has stagnated in the past quarter and businesses are warning of job cuts following the increase in employers’ national insurance contributions, announced in October and due to come into force in April. However, inflation remains a worry, with wage growth higher than the Bank of England’s forecasts.
