Getting Down to Brass Tacks

1.) News + Notes from the Overnight Session

a.) In China, the PBoC fixes the USD/CNY rate at its highest level in 19 months raising concerns that authorities could turn to currency devaluation to stem the economic pain from Trump’s tariffs. 

Our take: I’d still reckon that’s a bit of a long shot. The summer 2015 devaluation led to capital outflows and a collapse in confidence domestically – which is precisely the sort of thing that Chinese policymakers are working hard to ensure doesn’t happen now. 

Staying with China, the commerce ministry responded to President Trump’s latest threat of an additional 50% tariff using unusually bellicose language that China would ​“fight to the end”.

b.) In Japan, markets rallied and reversed Monday’s decline following reports that the country had secured priority tariff negotiations with Trump.

Our take – Japan is a massive net creditor to the US. One way to visualize that is to remember that it owns the most amount of US Treasuries officially among foreign buyers. As such, it behooves the US to play nice here, and it wouldn’t surprise me at all to hear that there’s some form of understanding here.

c.) In case you missed it – WH senior counsellor Navarro penned an op-ed for the FT laying out the case for punitive tariffs. It’s worth a read to get a sense for how his mind works, if anything. 

Having read the piece, I’ll make the following points:

• Navarro completely looks past the fact that the structural reason for the trade imbalance is that the US can borrow at artificially lower rates.
• He also ignores the fact that the US real incomes have actually risen as trade imbalances have increased. 

Sure, there are kernels of truth in some of his points but his conclusions are extremely flawed. If anything, the piece is an indication of the mercantilist, zero-sum view of trade that currently resides in this WH administration.

d.) Also, more signs of pushback against Trump’s tariffs. Including the commerce secretary from his first term.

2.) Markets:

a.) The story overnight was the bounce back in Japanese equities – which basically erased Monday’s decline. Elsewhere, gains have been a bit more tepid and speak more to the much-needed ​‘breather’ after a couple of sessions of massive declines. The latter is also the case for North American equity futures.

In rates, US Treasuries are outperforming across the curve. Most notably, duration has come under a fair bit of pressure in Japan and the antipodes (Australia and NZ). For instance, Japanese 10-year yields have shifted higher by over 20bps(!) – which is a big deal that could have meaningful repercussions for global flows.

The trade-weighted USD is under a fair bit of pressure. The AUD, NZD and JPY are at the top of the overnight league table.

b.) Over the medium-term, assuming that extant tariffs remain in their current form, we’d still be inclined to say that:

• The equity picture in the US looks far less robust. There’s more room to the downside for large caps as valuations need to adjust lower a bit more, while small and mid-caps remain vulnerable for fundamental reasons. 
• For instance, after the last few days, the current forward P/E ratio is 18.8x – which is not that far away from the pre-Covid average, but is still artificially high given that we haven’t really seen earnings estimates revised lower. 
• On the rates front, the hitherto rally (yields lower) since ​‘Liberation Day’ speaks largely to the market prioritizing recession risks over stagflation. Nevertheless, we still feel that the market jumped the gun in pricing in an aggressive Fed easing profile for this year – which implies upside risks to yields at the front-end.
• Further out, there’s still more room for breakevens to rally which should push nominal yields higher and steepen the curve a bit more from here. Indeed, we’re still a bit circumspect on duration going forward for that reason, alongside others (including supply indigestion and additional hedge fund liquidation of ​‘basis trades’).
• On the USD – I suspect we’ll see greater divergence on a bilateral basis and more volatility on the crosses. For instance, we’re constructive on EUR/USD and USD/CAD (which implies that EUR/CAD should keep ripping higher over time).

3.) Macro Take:

As we flagged in our note from Sunday evening – there are three ways in which the Trump tariff situation will end:

• A Trump put
• A Fed put
• Or valuation gets to a cheap enough level

To us, the last 24 hours has increased our conviction that the Trump put is the most likely outcome. That could mean anything from a delay in tariff implementation, to a shift away from ​“broad tariffs” to a focus on certain countries (China), to a reduction in overall level, or a complete reversal.

Admittedly, a complete reversal feels like a stretch. Nevertheless, any other action could compound hopes that extant tariffs won’t last in their current form. At the very least, that shred of hope is worth some consolidation and possibly some upside.

b.) Why do we feel that a Trump put is the most likely outcome? 

There is just way too much pressure on the White House coming from four channels. Those are: household sentiment (already tanking aggressively), business sentiment (uncertain backdrop for investments and hiring), markets (destruction in value across the economy), and congressional Republicans (who will face a bloodbath in the midterms if the economy veers towards a recession).

The Fed put is out of the question unless we see a deeper, more protracted selloff (think closer to 30% from peak). Yesterday’s price action in the rates market spoke volumes about how ridiculous things had gotten in terms of expectations for Fed cuts.

Valuation is still a bit too rich for our liking (see 2b above). And even we do get to a ​“cheap enough” level, we hardly think that’s cause for an extended rally given the structural shift in the macro.

3.) In Canada:

a.) The release of the spring edition ​‘Business Outlook Survey’ from the BoC brought the tariff-induced bad news that you thought it would. Importantly:

• Two-thirds of the firms surveyed clearly highlighted that they’d have to pass on the costs of higher tariffs to their customers (higher consumer prices -> slower economic growth).
• Most firms reported that extant capacity was enough to meet anticipated sales needs and that they would be less inclined to hire more workers or expand capacity over the coming year.

The ​‘Canadian Survey of Consumer Expectations’ also flagged an expected shift among household spending habits away from discretionary spending as their financial health is expected to deteriorate. That’s not least as the cost of living is expected to rise considerably due to tariffs.

Our take: This is in-keeping with the ​‘stagflation’ risk that tariffs bring. It also (at the margin) is supportive of the notion that the BoC will likely keep rates on hold in the coming months – assuming no material degradation of the trade backdrop from here. 

b.) The market is currently pricing in a 58% chance of a cut next week. We think that is something to fade.

Further out, the market expects the BoC to ease to the 2.00%-2.25% range over the course of this cycle. We’d argue that the risks are likely higher – not least as a healthy dose of fiscal stimulus is to be expected in the coming quarters.

c.) And speaking of fiscal matters – here are the updated polls from 338Canada.

• The Liberals are expected to win 192 seats (unchanged from last week)
• The Tories are expected to win 125 seats (unchanged from last week)
• The BQ are at 16 seats (-3 from last week)
• The NDP are at 9 seats (+3 from last week)

The odds of a Liberal majority are at 87% (from 89% last week).

4.) For Today:

There are no major releases to watch for today. Unfortunately – this is going to be another of those sessions (like yesterday) where we remain glued to our monitors/​phones to check for headlines. 

I hate those types of days.