Edward Lim, CFA
In “The Art of the Deal,” President Trump famously advocated for negotiating from strength and employing leverage, suggesting that projecting an image of power is indispensable. One of the key quotes earlier in the book was “The worst thing you can possibly do in a deal seems desperate to make it. That makes the other guy smell blood, and then you’re dead. The best thing you can do is deal from strength, and leverage is the biggest strength you can have. Leverage is having something the other guy wants. Or better yet, needs. Or best of all, simply can’t do without. Unfortunately, that isn’t always the case, which is why leverage often requires imagination, and salesmanship. In other words, you have to convince the other guy it’s in his interest to make the deal.” Fast forward to today, Trump’s provocative tariff rhetoric brings the world closer to the precipice of a full-scale trade war, casting ominous shadows over US stock markets. Yet, beneath the fiery speeches and headline roulette, the reality may be considerably less cataclysmic in our opinion.
In our last Navigator I’ll be back we opined that the biggest risks to the US economy and its markets are tariffs and reversal of immigration flows into the country. But we also countered that moderate fiscal easing including tax cuts and stimulative reshoring efforts coupled with animal spirits brought upon by deregulation provide counterbalance to anti-growth impulses of tariffs and immigration.
But in a world of megaphone newsfeeds and trigger-angsty investors, this ebullient spirits at the start of the year on the US have now descended into cauldron calls of impending recession and start of long-awaited bear market. This is where having a consistent and data-backed process is important to differentiate the noise, half-truths, and actual material changes. By now, most readers will be familiar with our process of accessing the global economy through the lens of “where are now” with nowcasting models and “where will we be” by using various forecasting methods. Our “nowcasting” models suggest the global economy remains resilient, albeit shifting growth leadership from the US to Europe. Specifically, US growth moderated slightly below potential to 1.3%, while Europe emerged from recession with an anaemic 0.4% growth. Still, the narrative of Europe’s “Make Europe Great Again” (MEGA) leadership might be overstated. Despite Europe’s incremental GDP improvement, the US economy still leads on absolute terms.
Nearer term forward-looking models like PMI collaborates with nowcast approach and disputing the common concern of pending recession in the US even as its growth takes a step down from the boomy pace of the last two quarters. Global PMI fell 0.3pt in February but at current level, it remains consistent to a 2.6% annualised global growth rate. In the US, PMI for Manufacturing and Services remains expansionary with manufacturing at 50.3 (marking two consecutive months of above 50 reading after 25 months in contraction) and services at 53.5 is an improvement of 0.7ppt from January resulting in a composite reading of 53.2. Eurozone Composite PMI was unchanged month-month at 50.2 but is an improvement from previous quarter average reading of 49.3. But its manufacturing remains moribund at 47.6 marking 33 months of below 50 reading, fortunately their services remain expansionary at 50, but is a 0.6ppt step down from previous month. PMI data points to US Manufacturing and Services sectors remain expansionary, comfortably eclipsing Europe’s mixed signals.
Wrapping up the state of play of the global economy, consensus full year forecast for 2025 reiterates the same points as Nowcaster and PMI with global growth remaining strong at 2.9% but with Euro Area (+0.2ppt) improving more from the previous quarter than the US (+0.1ppt). As we mentioned in our January macro podcast, we do think consensus forecast are too sanguine on US growth given the spectre of tariffs, immigration, and now adding DOGE into the mix. In recent weeks, we have seen consensus revising down their US full year GDP Growth to 2.0% with much of the downward revision front-loaded into these two coming quarters as tariffs kick in. On the other hand, Europe efforts to bolster its defense and infrastructure have lifted its forecast by 0.2ppt to 1.3%. Stock markets price on expectations and with the delta of change for these two regions economies shifting in favour of Europe, it is understandable why European equities have outperformed the US. Even with these undercurrents, US growth exceptionalism still prevails over Europe on an absolute basis and relative to their long-term growth potential with full year growth of US at 2.0% to Europe at 1.3% in 2025. Even the most bearish forecast for the US incorporating the plight of tariff wars shift US growth down, and the most bullish upgrades for Europe still puts US growing faster than Europe over the next two years.
This brings us back to our opening para. Is Trump’s bellicose rhetoric on tariff part of his art of negotiation technique to advance a broader agenda of making American great again and instilling irrational fear with its partners? We do not have a hot line to Trump, but we can simply look at numerous occasions he has walked away or watered down his initial outlashes. Case in point is his recent step back from his across-the-board 25% tariffs on Canada and Mexico to within “non-USMCA compliant goods” until April. The difference in the walk-back is significant. In an across-the-board tariff, the US effective tariff rate will rise from 2.8% to a punishing level of 15%, while a possible watered-down version suggested by his Commerce Secretary raises that to 10%. Since the estimated first order impact of each 5% rise in effective tariff rates will reduce US growth by 0.50% to 0.65%, the range of US GDP downgrades is from a manageable reduction of 0.40% taking it to trend-like growth rate 1.5-1.6% or to a more ominous fall to 0.8% but not quite recessionary yet.
Another way of calling Trump’s full-scale tariff war bluff is to simply think on how much of “a little adjustments” to the economy Trump is willing to wage. Below is the list of various critical items that US depends on Mexico, Canada, and China. Surely, he and his administration know the same calculus as all of us.
Nonetheless, our primary apprehension isn’t the tariffs per se, but rather their pernicious secondary effects on consumer and business confidence. Already, we’ve discerned wavering sentiment, with businesses reticent to invest and consumers circumspect about spending amid higher inflation expectations.
The last point on tariffs is to take heed of what happened to inflation during the first tariff war of Trump’s presidency. The first tariff was enacted in Mar 2018 with 25% tariff on steel and 10% aluminium from all countries, followed by 10% broad-tariff on all China’s goods in Aug 2018. An additional tariff on $500bn worth of targeted items from China was imposed throughout the year until Aug 2019. The effective tariff rate in the US rose from 1.6% to 2.8% during their period.
Back then, the common assumption was that inflation would rise significantly past 3% and the economy would falter. This led to Powell making first of the many policy mistakes in his tenure. He raised policy rates pre-emptively by 125bps to 2.5% in 2018 on top of the previous year’s increase of 150bps in anticipation of tariff inflationary impact. While CPI did rise to 2.9% by the middle of 2018 but by the middle of 2019 it retraced to below 2.00% even as Trump 1.0 tariff war was already in full swing. Core CPI never went above 2.5% and Fed preferred inflation measure PCE barely rose above 2.0% during this period. Tariff impact to inflation proved to be transitory and Fed has over-reacted and by Sep 2019, they reversed their tightening! There were several reasons why consensus, including us, were wrong about the knock-on impact of tariff on inflation and economic momentum. First and most importantly, the Dollar rose 10% as investors sought flight to safety as global uncertainty mounted. The rise in the dollar softens the impact of higher imported inflation. Second, corporates shifted their supply chain to keep prices competitive and third, consumer traded down. Meanwhile throughout this period, US real and nominal GDP grew on average of 2.75% QoQ and 4.63% YoY respectively debunking recession fears. The Fed’s overly aggressive rate hikes during that period proved precipitate, a lesson now unequivocally acknowledged by Powell. His recent dovish comments—indicating any tariff-induced inflation spike would likely be ephemeral—signal a more sagacious stance ahead and we welcome that.
We believe the final version of tariff will be less destructive than feared as it will exact heavy economic costs if they are implemented as it is. There is also the mitigating second-order effect of tariff can elicit such as an expansionary fiscal policy response as we have already seen in Europe and China. Moreover, we believe it is too early to conclude tariff will lead to higher inflation as the case of 2018-2019 has taught us the folly of consensus view on this matter. We welcome Fed’s learnings its lesson not to be pre-emptive in their reaction and communicating patience and the next policy path is to continue to ease. We also disagree with the view that MEGA trades (Make Europe Great Again) out-Trumps MAGA and recent outperformance of European equities over US is overdone.
Equities: Remain Neutral but we are now upgrading US equities to Neutral after being Underweight from 3Q24. We expect US exceptionalism to prevail contrary to current market narrative and undue discount on Trump’s induced volatility. As we have illustrated above, US GDP growth is still stronger than Europe even after we discounted the first-order impact of tariffs in the US and enlarged deficit spending in Europe. The table below also shows EPS growth for US to remain superior to Europe, generating 2years CAGR of 17% for S&P500 and 38% for NASDAQ which are higher than the broader global market and far higher than Europe. Even if we factor a further back of envelope reduction of 2% in EPS for every 50ppt downgrade in GDP to 1.5%, it will still put S&P growing at 5 to 7% in 2025 higher than Europe’s growth rate of 2%. The 3 months EPS revision in the US is still positive and is larger the Europe revision. S&P500 PE has retreated to 21.9x, which is still high relative to our long fair value multiple of 19.5x but on PE to growth regression line, it is not overly expensive.
NASDAQ is the most attractive on PEG of 0.58 over a 2-year horizon but has seen the largest dollar amount of outflows of $3bn in the ETF since the start of the year. Lastly, when we dissect what are the factors driving year-to-date returns, much of Europe returns have been driven by sentiment and low positioning as reflected in expansion of PE and significant flows in the ETF and not by EPS revision, which has been minuscule. On the other hand, S&P and NASDAQ have been de-rated despite having its EPS upgraded and generate 45% higher ROE than Europe.
We close our 6 months long underweight in the US since valuation has become less expensive. We added NASDAQ ETF in the last few weeks and added US Financials as it has the best EPS revision momentum post first quarter stronger than expected results and we believe this will continue with the upcoming easing of capital requirement which should lead to larger dividend and share buyback programs. The construction of our US Equities remains a blend of low beta long-short manager and defensive ETFs with growth such healthcare and utilities, supplemented with higher beta trades like tech-oriented fund manager, tech stocks and tech ETFs.
Outside of US we have added China equities in the quarter and have kept our overweight in Japan equities and underweight in European equities. Back in Oct 2023, we wrote about the risk of Japanification of China which was an inflammatory topic to say the least, High and dry, but we caveat there are a few differences. China has more monetary and fiscal tools to deploy. In terms of its economic development cycle, it is still at an earlier stage than Japan was when their population dividend peaked. Unlike Japan, the Chinese banks are subservient to the government since they are major shareholders of the major banks in the country. A coordinated bazooka of fiscal, monetary, and curated property and bank rescue plans must be enacted if it is to exit is dangerous spiral of a property, banking, and demographic crisis. We believe they are finally at their turning point now.
In their recent “Two sessions” meeting, the government pledge an increase of fiscal spending by 4.4% yoy funded by an increase of government bond net issuance quota to RM 11.9tn for 2025, up from RMB 9.0 trn in 2024. This will result in an augment fiscal deficit rising by 2.2ppt to 12.6%, the second highest on record outside of 2020 Covid. The key areas of expenditure increased will be on upgrading its technology (8.3% yoy increase, +2ppt more than previous year), local government debt swap program (+7.7%, -1.1 ppt less), improving healthcare (+5%, +14.2ppt), strengthening their Social security and improving employment prospect (+4.7%, -0.9 ppt), and stabilizing and ensuring more public housing supply (+4.4%, +3%).
Since the start of its property downturn in 2020, banks’ reserve requirement ratio was reduced by 3ppt to 9.50% and we expect another 50-75bps cut by the end of this year. The prime lending rate has fallen by 100bps to 3.10% and another 25-50 bps decline is probable for this year. But the most important development for the banks is the authorities have finally decided to backstop the banks with an expected RMB500bn capital injection by this year and more will be done for specific systemic banks. This will improve the CET-1 ratio by an average of 21bps for the industry. A large reprieve from central government debt transfer to local government is in store with over RMB10.3trn (+8.4% yoy) budgeted for the year. In the last 14 months, over RMB 8 trn of LGFV debt has already been restructured and on average it carries 250bps lower interest rates than prevailing stock.
All these measures combined have led to finally green shoots emerging from the property sector. Primary and secondary sales have started to rebound with the Tier 1 cities rising by 30.4% yoy and 48% yoy respectively year-to-date. Selling prices have finally bottomed out for both primary and secondary sales. Tier 1 cities inventory has now normalized, and Tier 2 and 3 cities inventory are on the downtrend too. Only start and real estate investment have not recovered but this is expected in a deleveraging stage.
Fixed Income: Underweight. The rates and credit markets have been sending quite different signals from the equities markets with the formers pricing in a more sanguine macro environment. Whereas SPX and NASDAQ at its recent bottoms have retraced all of post-Trump election victory falling 10% and 15% respectively from the peak, 10-year yield rose 30bps post-election and investment-grade credit spreads only rose 10bps in the same period. Only the high-yield spreads have reacted in synchrony to equities concern on the economy increasing by 40bps to 300bps which is still insignificant if indeed we are heading into a recession.
Within fixed income, we believe high yield debt is most vulnerable to a slowdown. While the leverage ratios in low relative to its long-term history, it has been increasing in the last eight quarters to 3.98x. The common adage is you do not go broke because you are highly leveraged, you go broke when you cannot pay off the debt and declining coverage ratio since 1Q22 is a concern. As illustrated in the chart above, the current yield of high-yield credit of 7.5% can wiped out if spread widen by another 784bps in a recession. Whereas for investment-grade debt, the yield can fall by 40-50% in a recession but will still be positive. We initiated a short on US high-yield debt but kept an exposure to investment-grade debt which typically has far lower default incidence and much higher recovery ratios than high-yield.
Commodities: Gold has surpassed our near-term target of 2800 on the back Trump’s induced uncertainty. Our long-term target of $3500 remains but in the near-term we believe there is too much fast money there and have trimmed our position when it traded above $3000. Gold futures are near its highest ever open positions worth $770mn while GOLD ETF inflows are the largest on record since Russian invasion. Any peace dividend from Trump’s inspired diplomacy could see the metal trade back to our near-term range of $2600-$2800.
We have been exploring Bitcoin as an investment option for our multi-asset allocation strategy. The recent policy changes under the Trump administration, such as the repeal of SAB 121 and the establishment of a national digital assets stockpile, could encourage institutional adoption. The launch of Bitcoin ETF is another impetus as it significantly enhances investor access, attracting a net USD 39 billion inflow so far making it the fastest launch of over $10bn of any ETF on record. Additionally, with more derivatives products expected to launch as this asset class becomes more institutionalized will reduce Bitcoin’s volatility, making it more attractive as a stable investment.
Alternatives: No change with 30% allocation to hedge funds to improve our risk-reward because of their less correlated returns streams versus traditional stocks and bonds.
Cash/FX: Cash is reduced as opportunities arose in the US market and macro-shorts in high-yield credit presented in the quarter. We remain bullish on our long Yen/USD trade not just on a diverging monetary path but also as a risk-off hedge.
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Edward Lim, CFA
Chief Investment Officer
edwardlim@covenant-capital.com
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