Visualizing What’s Next

THIS IS NOT INVESTMENT ADVICE. INVESTING IS RISKY AND OTEN PAINFUL. DO YOUR OWN RESEARCH.

Given how volatile this market environment is, I am going to stick again to bullet points and keep it brief.

1. Erratic economic policy will create economic weakness. Whether the tariffs are 10%, 20%, or 100%, not knowing what tariffs will be means anyone running a business cannot make an informed forward-looking decision. As a result, capital spending and employment will be weak, both in the US and globally. Moreover, erratic policy is driving stock prices lower, which creates a negative wealth effect, further weakening economic activity. The US economy is likely to contract or at least slow meaningfully.

2. The pricing on many assets looks off. US stocks are trading at about 21 times forward earnings, assuming earnings slow modestly. If US stocks were to trade at more normal levels relative to forward earnings, prices would need to fall by 15%–30% to become sensible. Meanwhile, US bonds have a 2% real yield at a time when forward growth is weakening. The dollar is at record highs (adjusted for inflation) against many of its peers, at a time when US policy is targeting these investors with protectionist measures.

3. The US budget deficit is 7% and will widen, perhaps to 10% or 12% if US economic growth slows. Congress is seeking to cut taxes, and while tariffs raise taxes on US households, they also slow economic growth and increase unemployment. The net effect will likely lead to record budget deficits. As a result, the two pillars of US asset allocation (long US stocks and long-term US bonds) are both risky. While high real rates may support short-term bonds, long-term bonds could suffer a crisis of confidence due to incoherent economic policy. Rising bond yields exacerbate weakening growth and can drive stock prices to the lower end of their potential range (closer to a 30% decline).

4. The Administration ignored protests over tariffs from US CEOs, foreign allies, and Congress. However, they did respond to the bond market, which catalyzed the White House to suspend some tariffs on many countries while massively boosting them against China. Many people don’t understand bonds, but they are a fundamental element of capital markets. Prices up, yields down, and vice versa. Typically, if stocks fall sharply, bonds rise (yields fall). This week, that did not occur. As stocks fell, US government bond yields rose sharply. Municipal bond yields rose even more sharply. A true collapse in the bond market—or even a sufficient disruption—could force the Administration’s hand on tariffs. The President described US bonds as “yippy.” I’d describe the decline in bonds and rising yields as a dire signal that the risks of significant financial disruption have risen intolerably high. And yes, the Chinese and other foreign investors own a lot of US bonds.

5. The Federal Reserve cannot easily cut interest rates because tariffs are inflationary, they don’t want to appear to be bullied, and the Administration’s chaotic policy makes it difficult to forecast growth and inflation. Other central banks have more latitude to ease, which can help support their assets as economic conditions deteriorate.

6. The earnings yield of Japanese stocks is around 6%, and the bond yield is less than 1.5%, meaning there is a risk premium in Japanese stocks that is absent in US stocks. In a disruptive environment for sure opportunities will appear on the long side, but I know I need to be very careful and rigorously analyze any apparent opportunity.

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