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Are US equities finally capitulating?
Another day and another tariff announcement from the Trump administration. This time it is the decision to delay the imposition of 25% tariffs on Mexican and Canadian imports for another month to April 2, the date that reciprocal tariffs are due to be levied on many of the US’ global trade partners.
President Trump’s rationale for pushing back the Mexican and Canadian tariff date was in recognition of those countries’ progress in addressing (if not stemming) illegal immigration and fentanyl trading across the US borders. More sceptical commentators have pointed to the sharp sell-off in equity markets in response to tariff announcements as the real reason the Administration has backed down on imposing Mexican and Canadian tariffs on the announced date of March 6.
Since its high point in mid-February, the S&P 500 measure of US equity performance has fallen by 6.6% as the Administration’s tariff announcements have escalated. The tech-heavy NASDQ index has fallen by 9.9% since its mid-February highpoint, a whisker away from a “correction” of 10%. Although US equity markets have been steadily trending down since mid-February, the path has been volatile. The Chicago Board Options Exchange Volatility Index (VIX) measure of S&P 500 volatility has risen from a level of 15 to 25 since mid-February and is now substantially higher than its 12-month average of 16.
A significant cause of US equity market volatility has been the announcements, and then reversals, of the imposition of tariffs; i.e., market sell-offs on announcements of tariff impositions and market rallies on reversals or push backs on tariffs. However, the market appears to be shifting to the conclusion that the Trump Administration is either determined to forge ahead with a significant tariff program or that the Administration is simply chaotic, shifting policy on the whims of the President. In either case, the impact on the economy, inflation and interest rates and the fallout for corporate earnings and equity discount rates are leading to a turn in investor sentiment against the tech/AI/US exceptionalism narrative that has provided the rationale for the outstanding run of equity markets. In fact, despite President Trump’s delay in imposing tariffs on Mexico and Canada, equity markets sold off overnight counter to their previous relief rallies following similar reversals in tariff policies over the last month.
Of course, the Achillies heel of US equity markets was always likely to be their stretched valuations, predicated as they are on an extremely strong corporate earnings outlook. Looking at simple valuation metrics used by many equity analysts, such as Price/Earnings (PE) multiples, the S&P 500 market looked priced for an optimistic outlook for the economy and individual stocks. For example, the S&P 500 is currently trading at a PE multiple of 22, significantly higher than its long run average of 16. To place this level of the PE multiple into perspective, a price correction of around 25% would be required for the PE multiple to revert to its long run average. In our view, a correction of this order of magnitude is unlikely as while the economy is slowing, it is far from collapsing and the US Federal Reserve also has scope to ease monetary policy if an equity market correction became disorderly.
Following three years of government fuelled growth, the US economy is finally showing signs of slowing at a time when tariff hikes threaten to accelerate the slowdown whilst simultaneously add to inflationary pressure. Added to this are the geopolitical uncertainties circling Ukraine and Russia, not to mention risks associated with China. Slower growth, earnings disappointments, higher-than-expected interest rates and escalating geopolitical risks are anathema to equity markets. We expect the conviction investors have displayed in the tech/AI/US exceptionalism narrative to be tested over coming months.