The US economy has entered a period of heightened economic policy uncertainty. Significant policy changes were anticipated under the Trump administration. This includes trade protectionism, finding ways to reduce government expenditure, and delivering on tax reductions in the next budget. All of these policy areas are being tackled. However, the manner in which policy is being conducted exposes businesses to considerable uncertainty. This is happening at a time when some indicators of real economic activity have weakened considerably. As a result, we have reduced risk in our portfolios.
The Trump administration’s inclination to increase tariffs was well telegraphed months in advance. Experience during his first administration, however, suggested that tariff threats were mostly used to reach new trading arrangements. This time around, however, it appears tariffs are also being used for political leverage. Colombia was sanctioned with tariffs over an immigration issue. The Tariffs on Canada and Mexico are ostensibly due to fentanyl smuggling, an activity that is already illegal in both countries. This makes the current application of tariffs difficult to negotiate, because the targeted outcomes are not necessarily something which trading partners can deliver.
Another layer of uncertainty arises from the proposal for reciprocal treatment in trade. At face value, reciprocity sounds appealing and fair. But trade agreements are notoriously complex. The devil is in the details over rules of origin of each component of the value added in each product. In a world where components are sourced from multiple jurisdictions, superimposing a system of reciprocity will result in an unfathomably complex trading system. If such details are ignored, however, then many businesses can find their production uneconomic.
Importantly, it is difficult to take any comment from administration officials at face value. . Treasury Secretary Bessent claimed that tariffs would be introduced gradually in 2.5% increments, yet they were imposed abruptly all at once shortly thereafter. Similarly, Commerce Secretary Lutnick said that the Canada and Mexico tariffs can be reversed hours before President Trump signaled differently. A day after tariffs were imposed, they were partially paused for another month.
Fiscal policy is also a source of uncertainty. The Department of Government Efficiency has, with limited success, been identifying areas of potential spending cuts. But some of these may be reversed for legal reasons. At the same time, the speed with which changes are taking place leaves little room for planning. As a result, the job security of many is uncertain. The administration has also announced the intention to repeal the CHIPS Act, which underpinned the business case of some large investments. How businesses will respond to these challenges is uncertain.
Perhaps the most consequential question regarding fiscal policy is the trajectory of the deficit. The recent budget resolution comprises policies that will likely increase the deficit over the next 10 years, as mandatory spending cuts fall far short of expected revenue losses from tax cuts. Given that the deficit is already at an elevated level, such a policy leaves the government with no ammunition in the event that the economy slows down or slips into recession.
Over the past years, we have preferred US equities to other equity markets. Our conviction was based on high earnings growth, the absence of meaningful economic growth elsewhere, and the appealing sector composition of the US market. Over time, we recognized that rising valuations called for caution, and we reduced our exposure to the highest valued segment of the market. However, we also recognize that the market was valued for clear blue skies, not for an environment with gathering clouds of uncertainty.
As a result of recent developments, we have increased our overweight position in fixed income. By doing so, we also modestly increased our exposure to duration. While long -term bond yields are likely to remain volatile in response to the stubborn outlook for inflation, the heightened risks to economic growth justify some extension.
Looking elsewhere, while European equity valuations are reasonable, recent strong performance may not sustainable if the US market wobbles. Europe is a lower growth, lower profitability equity market. In emerging markets, we are sceptical that many markets can be resilient to the adverse effects of trade wars.
