In all the noise and rapid market moves of the past week, it is worth going back to where we were before President Trump’s Liberation Day announcements. 

Even before that development, our macro team had been steadily reducing their expectations for growth in the United States. The economy is clearly late cycle, and won’t expand at a constant rate of 3 per cent forever. And the threat of even minimal tariffs, as the administration has long telegraphed, promised to be inflationary. Therefore, the odds of a stagflationary outcome were already rising before 3 April. 

That day’s initial tariff announcements were significantly steeper and broader than the market was expecting. And the market reaction was clear. Now we have a pause in those tariffs - and for now it is only a pause. 

Moments like these prove your worth and the distinction between long-term investors and short-term speculators is crucial right now. “Real money” like that wielded by Fidelity for our clients is the counterweight to short-term fears. We are able to distinguish between transitory market noise and fundamental shifts that require portfolio adjustments. 

A primary area of concern is that the market came into this period looking for double-digit earnings growth in the US over the next two years. For that to happen from here, we need a recession to be avoided. Growth and its impact on corporate earnings has been the oxygen driving the equity market and both are now at issue. 

No bubble

No crisis is ever the same, but things do rhyme, and starting points matter. Valuations in the US were stretched but were much less so elsewhere. In the UK and emerging markets, we were actually looking at cheap valuations relative to history. So fundamentally we were not in bubble territory at the start of this sell-off. 

A second risk is leverage. Yes, there will be leverage in the system somewhere, as there always is. But at this point we don’t see the kind of issues in financial markets that could cause panic.

That brings us back to earnings. Right now we’re working through our forecasts, country by country, sector by sector, stock by stock, to understand, investment by investment, whether the valuation continues to offer an attractive opportunity for our clients. History suggests that these periods of stress offer long-term investors opportunities to generate excess forward-looking returns. But to benefit from these opportunities requires a realistic appraisal of the significantly riskier environment we face - earnings, valuations and balance sheet risk all need to be considered carefully.  

In general, everything that has happened follows the patterns we were seeing develop at the start of the year: we are late cycle; we have late cycle volatility, and this is accentuated by the fact that some of the well-established “rules of the road” are up in the air. 

Let’s put recent volatility in context

Volatility in US Treasuries meanwhile has been at levels rarely seen since 2008. Yet we should put that volatility in context. We came into this period with credit spreads at record low levels and equities at all-time highs. Which is to say, there was no volatility priced in at all. 

Now we have seen credit spreads widen, and that’s normal in a volatile environment. Equity volatility and credit spreads tend to move together. And we have gone from high-yield credit spreads in January below 300  basis points - not far off record tights - to peak panic in the high 400 basis point range. But in a recession, they normally go to 600 or wider.

So yes, the US Treasury market has definitely shown some signs of dysfunction. Liquidity is impaired. But it is better than what we've seen in previous crises. In an environment where risky assets have come under pressure, longer dated government bonds have performed very poorly - the safe haven “risk-free” rate has de-anchored to some degree. But that makes them more interesting as investments. If we are in fact headed for recession, or at least a substantial slowdown in growth, then bonds should do well. 

One important concern, looking back at the Covid crisis, is the risk of spillovers into other markets. When you have a big sell off in government bonds in the US, there is a high correlation to other sovereign bond markets. And those countries may have less fiscal headroom to tolerate those shifts. The UK is one obvious example. 

Shifting sands

There may well be a change in the longer-term ordering of things here. The US exceptionalism of the past year has taken a hit. For Europe, openness to trade remains a priority and the continent has options as the world order changes.

Some of Europe’s major economies, like Germany, are in a decent fiscal position. The governments are coming together and working together. The region has strong companies, trading at reasonable valuations. That suggests there are parts of the market where you can see a positive setup that has improved in recent months. 

Of course, if the number one and number two economies in the world are at loggerheads, and if they head into a recession, the entire world will not be immune. We still see a bright future ahead, but it may be a rocky road to get there.