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- Tariffs are worse than investors expected, focus moves to the possibility of negotiations
- Tariff impact – exporters to the US face margin pressure as equities face declines
- Expectations of significant European infrastructure and defence spending feeds into outlook of broadening market allocations
- Looking beyond headlines, macroeconomic picture remains resilient
Daniel Morris, Chief Market Strategist at BNPPAM:
“The tariff announcement was worse than most investors expected. The key question now will be whether there is scope for negotiation on the reciprocal tariffs.
The tariffs will lead to a largely one-off adjustment in equity prices as the impact on input costs and sales prices is accounted for. At the same time, US domestic producers will benefit from displaced demand, and the increase in US government revenue should benefit US Treasuries, leading to lower financing costs for companies.
For all the focus on tariffs, the primary driver of US equities at the beginning of this year was the modest slowdown in economic growth, in contrast to the continued ‘US exceptionalism’ investors anticipated. It is worth remembering that, prior to the election, the forecast for 2025 was for a ‘soft landing’, a slowdown in economic growth. That may be exactly what occurred, independent of the changes in the political landscape. Tariffs may now, though, accelerate the slowdown.
The two key data points that alerted investors to the new dynamic were purchasing manager indices (PMI) and retail sales. Encouragingly, both of these have steadied recently.
The initial shock came from the February flash US services PMI at 49.7, indicating a contraction in the services sector. Given the importance of services for the US economy, a decline in activity was worrying. The final reading for the month was revised upwards to 51, however, and the March data showed robust expansion.
In the manufacturing sector, the data had moved up above 50 beginning in January, suggesting that tariffs were not the primary driver of the change in activity. The March reading, though, fell back to just below the critical 50 threshold. Any benefit of increased domestic production as a result of tariffs is likely many months in the future.
The PMIs for Europe so far are mixed. Two out of the three countries reporting (Germany, France and the UK), have seen better PMIs, though the level for manufacturing is still below 50. One would anticipate an improvement to come in Germany given the recent agreement to increase infrastructure spending, though as in the US this may take many months before any impact is visible.
Finally, for China, data was also marginally better. The levels, though, are lower than they were in November/December, which is disappointing given the numerous stimulus initiatives announced by the government over the last several months.
Retail sales
PMIs are surveys, and hence a less precise measure of economic activity. Retail sales, however, are “hard data”. Hence the shock when January US retail sales showed a decline. The US soft landing was premised on modestly weaker consumer demand, but it was conceivable that the slowdown could occur much more rapidly and sharply than expected.
Encouragingly, the data again rebounded in February, and not just for the US. Every country reporting so far has seen a gain in sales, in contrast to the more variable pattern in previous months.
The improvement could be particularly important for Europe. The outperformance of European equities so far this year has been driven by a steepening yield curve benefitting the region’s banks, and expectation of greater infrastructure and defence spending boosting industrials. These factors may be already largely priced in, however, raising the question of what will drive permanence from here. The consumer sector could be the answer. Demand has lagged ever since COVID lockdowns ended, but consumer sentiment is holding up better than in the US. Given the challenges exporters may face as the US raises tariffs, more domestically focused sectors could be a haven.
Tariff impact
One thing is clear following the tariff announcements- these measures will hurt the US’ trading partners more than the US. While US companies and consumers will face costlier imports, there will be a shift in domestic demand towards US-produced goods. There will also eventually be an increase in US investment as companies look to manufacture in the US to avoid the tariffs. Exporters to the US, by contrast, simply face a decline in either margins or sales.
Relative returns over the last week bear out this divergent impact. As tensions ratcheted up ahead of the announcement, equities have declined, but the US outperformed most other markets.
For all the market’s worries, earnings expectations for US companies have been relatively resilient, rising 0.4% for the index over the last few weeks while those for the rest of the world have declined. The difference is particularly notable in more tradeable sectors.
While US economic growth remains steady, the outlook for other markets has improved relative to the expectations at the beginning of year. Europe now seems destined to see significant infrastructure and defence spending, while China should benefit from the development of the DeepSeek artificial intelligence (AI) model. We anticipate this model will be adopted widely in the country, spreading the benefits of AI beyond the technology sector.
Our multi-asset team are thus cautiously optimistic on the outlook for equities following the declines woe have seen so far this year. In contrast to the US-centric allocations immediately following the election, however, we see returns now coming from a broader range of markets.”
