Investor optimism returns

Equity markets rallied in the past few weeks, reversing all the losses posted since President Trump announced steep tariff increases on 2 April last.

Signs of a gradual thaw in the trade war pitting the US against the rest of the world have reassured investors. Following a first trade deal between the United States and Britain, talks between US and Chinese trade representatives also made progress. A significant reduction in the reciprocal tariffs for a period of 90 days was agreed, lifting what amounted to a trade embargo between the two countries. The US has slashed the reciprocal rate – on top of the existing tariffs – on Chinese imports from 145% to 30% while the tariff on US imports to China went from 125% to 10%.

The easing in tensions is a welcome respite helping to contain the adverse economic effects from the Trump administration’s protectionist measures. But the economic fallout is already visible: a surge in US imports in the first quarter, weaker sentiment indicators, and heightened currency market volatility.

US economy stalled in the first quarter

The contraction in the US economy in the first quarter (0.3% on an annualised basis) should be seen in context. It stemmed mainly from the steep rise in imports, especially of goods (up 50.9%), as US companies rushed to stockpile to avoid the additional costs imposed by Trump’s tariffs. The more moderate 1.8% growth in exports was not enough to offset the tariff-fuelled buying spree by importers boom in imports with the net result that international trade made a record negative contribution, dragging down headline GDP growth by 4.8%. Given the major inventory replenishment during the first quarter, the balance of trade should weigh less heavily on US growth over the next few quarters.

Source: US Bureau of Economic Analysis (BEA), Banque de Luxembourg

Sentiment indicators slide

Confidence indicators, led by the US consumer sentiment index, continued to weaken in April. The expectation components of the various surveys were the main drivers of the decline. Will the steep fall in sentiment ultimately be reflected in the economic data, particularly in consumer spending? Although spending was still up, the pace of growth slowed to an annualised 1.8% in the first three months of the year. The slowdown in retail sales in April confirmed that US consumers are pulling back on spending at the start of the second quarter.

Big moves in the currency markets

The US dollar weakened considerably against its main trading partner currencies tumbling almost 8% since the start of the year. The biggest moves were against Asian currencies: most notably the Taiwanese dollar rose 7% against the greenback in just two trading sessions at the start of May. This surge over a very short period of time seems to have been sparked by speculation that Taiwan would allow its currency to strengthen as part of a trade deal with the US.

Source: Bloomberg, Banque de Luxembourg

The increase in the Taiwanese dollar was probably amplified by market participants, such as insurers and export companies with high exposure to the US dollar, selling or hedging part of their positions to capture favourable interest rate differentials

Excessive optimism in equity markets?

While the prospects for trade deals are encouraging, it is clear that the tariff on goods entering the United States will not fall below 10%. Recent announcements put the average tariff at 15%. And while this is certainly lower than the 25% imposed in April, it is still six times the average (2.5%) at the end of 2024! Is it fanciful to bet against tariff-induced negative consequences for company profits and the broader economy? We think it is. In our opinion, the major rally in equity markets is driven by a very generous dose of optimism

Damien Petit, Head of Private Banking Investment,
Banque de Luxembourg