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President Trump has designated April 2 for unveiling a series of tariffs on trade partners, referring to it as America’s ‘Liberation Day.’ But businesses and investors won’t be liberated from trade policy uncertainty. There will likely be many unanswered questions: To what extent will tariffs be permanent or negotiable, and how will that vary by country? What is the anticipated end state of tariffs? Will other countries respond with concessions, retaliation, or both? Will Trump counter-retaliate?

Even with perfect foresight on tariffs, it is difficult to model their potential effects on an economy. To what extent will businesses pass through higher costs to consumers vs. absorbing higher costs into their margins? How does prolonged policy uncertainty weigh on hiring and investment decisions? How will countries respond with fiscal policy? Indeed, Trump’s changing strategy on the Russia-Ukraine war prompted a generational shift in German fiscal policy, helping to drive strong outperformance of European equities despite expectations for tariffs.

One thing we can say for sure: the distribution of possible outcomes across the world has widened. This creates opportunity as well as a need for conscious risk management.

We view the foundation of the US and global economy as solid, with still healthy private sector balance sheets in the aggregate. But the global economy will undergo a stress test in coming months, and we have reduced risk in portfolios accordingly. Our overweights in duration and gold continue to provide diversification, and here we stress the ongoing importance of hedging portfolios through balanced exposure across asset classes and regions.

In January we bought US Treasuries, arguing that US growth expectations were likely too optimistic given underlying cooling in the economy and a policy mix that was likely to be more nuanced than at the beginning of Trump’s first term. Like many investors, we have been surprised at the scale of Trump’s tariff escalation. This tariff escalation has made owning bonds more controversial – tariffs are ultimately a supply shock, putting downward pressure on growth but also raising inflation. Does owning duration make sense given that higher prices may make the Federal Reserve (Fed) more reluctant to cut rates.

Our view is yes. While higher prices may lead the Fed to delay easing for a couple of meetings, we think any delay in easing – due to large scale tariffs – will prompt the rates market to price in a need for further rate cuts later on. Tariff hikes are one-off rises in the price level and will weigh on real incomes. A slowdown in consumption can soften the labor market and create slack in the economy, ultimately bringing inflation lower. Encouragingly Fed Chair Powell appears to believe in this view, noting tariffs represent ‘one-time’ increases in the price level that the Fed could ‘look through.'

Most importantly, we believe the behavior of the rates market suggests it is embracing this take. The stock-bond correlation has shifted more negatively of late. While tariffs have boosted market-implied one-year inflation expectations, bonds have typically rallied on days where the market sells off due to tariff fears. It is understandable for investors to be wary of bonds given the generally positive stock-bond correlation seen over recent years, but downside growth risks have risen enough to shift it back into negative territory (Exhibit 1).

Exhibit 1: The equity-bond correlation is declining as growth risks increase

S&P 500 vs. US Treasury, correlation

That said, we acknowledge (as has Chair Powell) that in a scenario where longer-term inflation expectations become unanchored, the Fed may be forced into a more hawkish position. In an environment where the stock-bond correlation shifts higher again due to sustained inflation fears, we believe gold will continue to prove a useful diversifying asset. Gold has been driven higher in part because of steady emerging market central bank accumulation in the aftermath of Western sanctions on Russian FX reserve holdings. This structural support alone is a powerful reason to hold the yellow metal; but more tactically, gold tends to hold up well in periods of low growth and high inflation.

Exhibit 2: Gold demand from reserve managers remains strong

Just as we monitor and project shifting correlations that may improve diversification, we also must be prudent on assets that may be losing diversifying properties. The USD was widely expected to strengthen in response to more aggressive trade policy. This view was based on the idea that tariffs would disproportionately hurt countries more dependent on trade than the US.

This thesis has been proven wrong so far this year, with the dollar index down four percent. We see a few reasons for this.

First, broad policy uncertainty (related to reduction in federal spending, slower immigration and tariffs), as well as a scale back in tax cut expectations, led to a widespread downgrading of US growth forecasts. Moreover, the Trump administration’s focus on Canada and Mexico was ultimately viewed as more costly for the US economy given tight interlinkages in supply chains. Second, China has been reluctant to let its currency weaken despite a 20 percent increase in US tariffs, preferring to maintain stability and focus on domestic stimulus. Third, the aforementioned German fiscal response bolstered European rates, supporting the euro. And finally, weakness in US tech, due in part to more scrutiny on the sustainability of and return on capex spending, led to a broader shift in capital flows outside the US and into other regions.

We think the USD’s sudden positive correlation with US risk assets is an important development. Historically, US investors have held more ex-US equities than foreign investors have held in US equities. But this has changed in the last few years, as growing US exceptionalism led to a large build up in largely FX unhedged exposures to US equity from foreign investors. Foreign investors retained a natural diversification in holding US equities unhedged, as typically the USD would strengthen when US equities sold off, limiting the damage.

However, the recent experience of USD equities and the USD selling off at the same time may prompt foreign investors to increase hedge ratios on their risky assets, which could weigh on the USD in future. The correlation breakdown may also signal weaker safe-haven properties of USD in further US equity sell-offs.

Exhibit 3: Ex-US investors now own more US equities than US investors own foreign equities

US International Investment Position – Equity Securities, USD

Last month, we explored the benefits of less US-centric regional exposure (American ‘Un’-exceptionalism?), and there has indeed been a dramatic shift in regional leadership year-to-date. Idiosyncratic stories like Germany’s fiscal response and the DeepSeek surprise have triggered a rotation of flows from US tech into Europe and China respectively. Dramatic shifts in regional policy have accelerated the decline in correlations across equity regions.

Exhibit 4: Cross-country equity correlations have fallen sharply

Average pairwise correlation across different regions

This is important, because it enhances the benefits of diversification in reducing the overall volatility of equity and multi-asset portfolios. Suppose that the American ‘Unexceptionalism’ theme has become too stretched tactically, and US equities resume their outperformance trend for the rest of the year. While a more globally balanced equity portfolio might underperform one heavily concentrated in the US, low correlations could mean that the overall risk-adjusted returns would potentially be higher than a concentrated US portfolio, likely resulting in lower overall portfolio volatility.

Of course, in the case of a recession regional equity correlations would be expected to rise. But were that to happen, the case for adding exposure to bonds and gold would help the portfolio weather the storm.

The investment environment has become trickier due to sharp changes in policy, largely (but not only) driven by the Trump administration. At the same time, the benefits of diversification have increased, with correlations breaking down across assets and regions.

With a base case of economic resiliency, we maintain a modest overweight to equities and keep overweight positions in duration and gold for diversification against different economic outcomes. Regionally, we favor a balanced approach, combining quality (predominantly US) equities with right tail opportunities in European banks and Chinese tech. As the USD’s safe haven properties have weakened, we have reduced exposure and maintain JPY longs which should outperform should the economic outlook deteriorate.