In a remarkable turn of events, former President Donald Trump has proposed eliminating all tariffs on China. He’s now pictured this being included in a larger trade agreement. This would be a major shift in the key story of U.S.-China trade relations. It might just be the portent of a larger change in market dynamics. The proposal could potentially reroute supply chains and capital flows, establishing new economic relationships in a rapidly changing global landscape.
The notion of decreasing tariffs couldn’t be more timely. Today’s tariff cycle looks very different from the one we experienced during 2018-2019. The previous cycle was largely about China. Today’s climate features a much wider set of commercial competitors, like the EU, Canada, Mexico, and ASEAN member states. As we tabulate the recent expansion, it’s a reminder that no one is more insulated against the fallout of the current tariff wars. Consequently, uncertainty reverberates throughout global markets.
The financial markets are currently divided, with institutional outflows coinciding with retail inflows, giving rise to two distinct market personalities. Another group fears the possible trade war escalations. On the other side, there’s another species of FOMO—a much deeper fear of missing out on all potential benefits if tariffs are lowered. This simplistic dichotomy makes any investment strategy harder to ascertain, as historical approaches to pricing risks are no longer trusted in a time of heightened turmoil.
Market analysts are understandably excited that volatility sellers are coming back into town. This change is indeed putting downward pressure on implied volatility rates and forcing companies to rethink their approach to risk management. The real action, though, is being taken within the foreign exchange and interest rate volatility spaces. Recent developments suggest that a full rupture in U.S.-China trade relations is unlikely in the near future. This recent news has added a little bit of hope for investors.
The last tariff cycle considered China the sole villain in the trade war. To say this view is inadequate today would be an understatement. Rather, macroeconomic signals are still all mixed up, forcing central banks to juggle policy prescriptions that usually wind up shooting straight past the target. Our uncertainty shows through in the ups and downs in global equity exposure. It has plummeted precipitously from an 8 out of 10 when measured at early-year peaks to only a 1 out of 10—levels we haven’t observed in more than a year.
Just last week there was a big de-risking event of $53 billion. This episode was largely attributable to short positioning and the literal deathbed of Commodity Trading Advisors (CTAs), risk parity funds, and volatility control funds. This movement shows how precarious the current market landscape is. It highlights the difficulties investors face when attempting to cut through this confusing patchwork.
Looking ahead, analysts suggest that a soft confirmation of tariff détente or indications from Federal Reserve Chair Jerome Powell regarding data-dependency policies could instigate a rapid bid from CTAs. Even such a move would be a grossly excessive overshoot and thus an even greater distortion of the market’s reactions.