What Now?

The Credit Strategist Blog

I’ve written much of the following on Notes but I wanted to repeat it here on a Post that will be sent to all of my more than 8,000 readers. A lot of readers are asking me what I think is going to happen with tariffs and the markets so let me summarize my recent Notes as I continue to keep a close eye on events as they unfold.

First, President Trump’s tariffs are a response not merely to other countries’ tariffs but all of their trade barriers that he believes create an uneven playing field in the global trading system. That is why his tariffs were much higher than expected; they are designed to counter not just tariffs but other trade impediments. This was unexpected despite the fact that the President spoke for decades about these multiple barriers. The President and his advisers say that they want other countries not merely to lower their tariffs but to remove other trade barriers (like the EU’s VAT tax) which means that negotiations to reverse or lower tariffs will take time.

Second, there is little question that tariffs will raise inflation and lower economic growth in the short-term and, if not reversed through negotiations, in the long-term. This will hurt corporate profits and corporate credit quality directly by hurting company performance and indirectly by causing serious uncertainty among corporate executives and their confidence in their ability to plan for the future.

Third, stocks were already weakening before the tariff announcement. Concerns about tariffs were just one reason for this. 1Q25 earnings are expected to be disappointing and 1Q25 GDP was weak according to the Atlanta Fed’s GDP model. Concerns about the federal deficit were increasing and corporate credit markets were starting to weaken after credit spreads dropped to near historic lows in the face of weakening credit quality.

The S&P 500 was trading at ~22x earnings before the sell-off which was too high; we’ll see where the multiple lands in a bear market that may morph into something worse as it already is for many stocks. The 200-day moving average on the S&P 500 as this is written mid-day April 7th is ~4674 (the current trading level is ~4988) so breaching that level would be a negative technical symbol. Stock prices were inflated by massive deficit spending, cheap debt, manipulated earnings, and a bubble mentality among investors. Markets were overdue for a correction (10% drop) and those caught off-guard ignored many warning signs. One of the risks of overvalued markets is their vulnerability to shocks. The new tariffs definitely qualify as a shock that many bullish investors were poorly positioned to withstand.

Fourth, junk spreads widened by ~100 basis points late last week to ~450 basis points. That is not wide enough to reflect a recession or the risks associated with owning hybrid debt/equity securities with no covenant protections, inadequate yields (as expressed in spreads over Treasuries), and limited liquidity. CCC-rated bonds traded out to 1200 basis points over Treasuries which is also woefully inadequate considering that historically 40% of these low-rated bonds default with extremely low recoveries. Corporate credit markets will suffer badly in an economic slowdown especially with trillions of dollars of bonds and loans with weak covenants, a work-out market littered with creditor-on-creditor violence, and limited visibility on pricing due to a huge percentage of the market held in non-mark-to-market vehicles. My philosophy has always been to buy high yield credit when spreads are extremely wide (over 1000 points at least) and sell them when they are tight (under 500 basis points) and that remains my advice which unfortunately sounds better in theory than practice since market liquidity is so poor. It is far too early to start buying beaten-down bonds; if this continues, sellers will be begging for buyers and prices will collapse lower.

Fifth, the two most likely events that could stop the sell-off are (1) reversals on tariffs or (2) Fed intervention in the form of rate cuts. First, the fake news report from Reuters this morning (and immediately rebroadcast from CNBC) that there would be a 90-day pause on all tariffs except those for China was another example of the carelessness and irresponsibility of the media. The Trump Administration is making it very clear it has no intention of changing course on tariffs. Understanding what the administration is trying to accomplish helps understand why that is the case. There will probably be deals that lower tariffs with individual countries but overall tariffs are almost certain to remain much higher for a prolonged period of time. Second, Fed Chairman Jay Powell made it clear last Friday that he’s in no hurry to lower rates. Furthermore, lower rates might calm the market but won’t solve the problems caused by high tariffs. There is nothing else on the horizon that is likely to help stocks until drop low enough to attract buyers.

In summary, we are experiencing more than a run-of-the-mill correction or a market that is going to be rescued by government intervention. Investors weren’t prepared for President Trump’s tariffs because they are more than mere tariffs - they are tariffs designed to counter a panoply of trade barriers that he wants to see disassembled in order to open foreign markets to more American products and compel manufacturing to return to the United States.

President Trump launched a revolutionary effort to reorder the global trading system that has never been attempted before and involves radical change. Revolutionary change requires breaking things. It offends tradition and upsets people emotionally and intellectually. Many revolutions end in tears. Dealing with periods like this requires confidence in your ability to identify and understand what’s happening and the objectivity to see the world as it is rather than how you would like it to be. Right now, decades of international trade practice based on centuries of economic orthodoxy are being smashed. The existing system needed reform. It could reformed more slowly or in stages but President Trump decided radical change imposed all at once. What President Trump did is only surprising to those who didn’t pay close attention to his words and thinking over the years. And if anybody doubted he would go “all-in” before he re-entered the Oval Office on January 20th, his policies since then should have disabused them of that notion.

Debate regarding the merits of President Trump’s approach will dominate our media and politics for years but it is too early to know the outcome now. History will have to play out. We are blessed to live in interesting times and we should all do our best to learn from them. But we also have to live in them and try to prosper. Uncertainty is as high as it’s been in years so it’s important to proceed with a cool head while everyone around you is losing theirs. My advice to investors acting in real-time is the following:

1 - Eliminate all margin leverage.

2 - Reduce exposure to high P/E stocks.

3 - Buy gold. Save yourself.

4 - Buy TIPS (Treasury Inflation-Protected Securities). Inflation was already higher than reported and will keep rising. Keep maturity 5 years or shorter.

The world will not come to an end. It won’t enter an “economic nuclear winter” as Bill Ackman warned last night (while simultaneously asking for “cooler heads to prevail”). We are going to be living with this new regime for a while.