President Trump’s first couple of weeks: market implications

In part one of our analysis, we focused our attention on the US economic implications of President Trump’s policy agency, concluding that there could be significant downside risks for US growth. Now, we turn to the potential prospects for global equity, bond, and currency markets.

The tariff threats and subsequent de-escalation follow the template from President Trump’s first term in office. For Canada and Mexico, US tariffs are almost unequivocally bad news: 70% of Mexico’s exports, and 60% of Canada’s exports, go to the USA. 

For context, that represents even more concentrated export exposure than the UK’s dependence on European trade in 2016. If these tariffs are sustained for more than six months, we believe a recession is probable in both Canada and Mexico.

In contrast, China’s export markets are much more diverse. Only 15% of exports go directly to the USA. In isolation, therefore, these tariffs are not a big concern. However, they could represent a downpayment on more punitive action to come in April.

Market reaction and outlook: equities

The equity market reaction to President Trump’s announced tariffs has been relatively muted, and surprisingly uniform in local currency terms. The immediate aftermath saw equity markets in Europe and Japan fall by a very similar magnitude to futures markets in the US, all declining by between 1.5% to 2.5% on Monday. Both indices have since registered a modest recovery.

For the European market, around 25% of sales go to the US. However, of that, three-quarters is either accounted for by services or produced in the US itself. Neither of those are subject to tariffs, but the remaining 6% of European sales are particularly ‘tariff-vulnerable’. 

The US equity market is where the range of outcomes is broadest. Commonly used heuristics suggest that a 10% rise in tariffs on all goods is worth 2-3% on S&P500 earnings. However, that ignores any additional costs from retaliation, from higher discount rates in the wake of additional uncertainty, or the potential for higher rates in response to a strong near-term inflation profile.

The conventional wisdom is that the mega-cap tech names have few competitors and limited exposure to China. That creates a veneer of invincibility to the threat of tariffs. 

While the US is a relatively closed economy by global standards, its equity index still derives 40% of sales from overseas. Retaliation from China or Europe could take the form of regulation or taxation of tech operations. And for at least two of the ‘Magnificent 7’[1], China represents either a critical end market or production base for goods. 

The sustained nature of the gains in US equities in recent years may have instilled confidence in US policymakers in pursuing an aggressive stance on tariffs. But we believe the rest of the world likely has more ability to drag the US equity market down with it than the President would like to admit. 

Market reaction and outlook: rates

The bond market impact of tariffs is complicated. President Trump’s policies are generally inflationary in our view, but as discussed in our previous blog, we believe the growth impacts are likely to be negative. It is unclear whether that pushes treasury yields higher or lower. 

Within the US market, we would expect lower real yields and higher breakeven inflation as the market prices monetary policy paralysis in the face of a stronger inflation profile. The kneejerk reaction on Monday morning has also been to sharply flatten the yield curve: short-dated rates have barely moved because of the mixed implications for the Federal Reserve, while longer-dated yields have rallied on the ‘flight to safety’ and weaker growth backdrop, and saw a partial correction on Tuesday morning.

Outside of the US, we believe the impact on government bond markets is clearer with lower yields as markets anticipate lower interest rates to stimulate domestic economies. Countries with higher trade surpluses with the US look particularly vulnerable in our view.

Europe is potentially next to be at risk. There is already concern over the growth and inflation outlook as a result of German industrial malaise and French uncertainty, and we believe there could be space for bunds to rally if recession fears grow.  This dynamic could be hard to shift until the cloud of uncertainty has passed.  

Market reaction and outlook: currencies

In principle, the impact of tariffs on currency markets is straightforward. Countries subject to tariffs tend to see their currencies depreciate as demand for their exports declines. With the US as the world’s largest importer, a reciprocal trade war could still be expected to put upward pressure on the US dollar relative to countries running trade surpluses.

We’ve seen that dynamic play out in the wake of the weekend’s news. The broad dollar index rallied approximately 0.5% on Monday, with larger moves against the Canadian dollar and Mexican peso. However, the overall scale of the moves on the day were somewhat limited, which we believe can be largely attributed to two factors:

1)     How much of this was already priced in

2)     Market expectations that the imposition of tariffs will be short-lived

We believe it’s likely that both are playing a part: tariffs have been a topic of constant discussion for financial markets for the past few months and currencies such as the Canadian dollar have already moved some way to reflect this risk.

The reprieves for Canada and Mexico triggered a bounce-back in both currencies: both the Canadian dollar and Mexican peso are currently marginally stronger year-to-date against the greenback.  

 

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All data sourced from Bloomberg, correct as at 5 February 2025.

Assumptions, opinions, and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass. 

[1] For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.