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What happened?

Global markets declined by more than 10% in the two trading sessions after US President Donald Trump on 2 April announced major tariffs on imports from other nations. This represented the fourth worst two-day decline in the past 50 years.

Selling was exacerbated in Friday’s trading session by news that China would retaliate with 34% tariffs on imports from the US, raising fears of a tit-for-tat escalation in tariffs, and focusing minds on the risk of retaliation by other major trading partners, including the European Union.

Federal Reserve Chair Jerome Powell also contributed to market weakness by implying that the Fed may take a cautious approach to interest rate cuts. He said, “While tariffs are highly likely to generate at least a temporary rise in inflation, it is also possible that the effects could be more persistent” and “Our obligation is to...make certain that a one-time increase in the price level does not become an ongoing inflation problem”.

Technical factors also contributed to the sell-off. The VIX index of implied volatility spiked to 45 on Friday and US high yield credit spreads widened to around 450bps, both the highest levels since 2020. Meanwhile, the steep rally in the US dollar and weakness for gold prices also pointed to signs of illiquidity, deleveraging, and market stress.

On Sunday, President Trump showed no signs of backing away from his trade plans, telling reporters that “sometimes you have to take medicine to fix something” and to “forget markets for a second.”

What do we think?

Markets are likely to stay volatile in the weeks ahead as they reflect changing investor theories on what President Trump is thinking. These include the following:

1. He is manufacturing leverage to rapidly make deals. 
2. He is serious about leaving most of the tariffs in place.
3.  He is not done imposing tariffs.
4. He is actually trying to drive the economy into a deep recession.

Our base case is that after an initial phase in which tariffs could rise further, US effective tariff rates should start to come down from the third quarter as legal, business, and political pressure mounts, and as deals with individual countries and industries are struck. We also expect the Fed to cut interest rates by 75-100 basis points to support the economy. In this scenario, we believe the S&P 500 can recover to 5,800 by year-end.

At the same time, investors should prepare for additional near-term downside. We do not believe the S&P 500 is currently pricing much beyond a mild recession (3,500-4,500 would be more consistent with historical recessions—see “What are some key levels to watch” below—and our downside scenario target for the S&P 500 is 4,000).

And while an about-face from the Trump administration or court injunctions can’t be ruled out, in the near term we think it is more likely that news flow continues to worsen, including potential EU retaliation, US counter-retaliation on China, and an end to exemptions on pharmaceuticals and semiconductors.

Given the wide range of outcomes, empirical evidence from past selloffs may be the best way to ground our thinking. From drawdowns of this magnitude, longer-term investors have typically been rewarded by putting money to work. Analyzing the 12 occasions when the S&P 500 has fallen by 20% from its peak since 1945, the index has delivered a positive subsequent one-year return on 67% of occasions, with a mean return of 12.9%. Over a three-year horizon, this rises to 91% of occasions with a mean return of 29.2%.

What catalysts could help drive a turning point for risky assets?
In the near term, we believe that markets, sapped of confidence, are likely to want to see more evidence supporting our base case before we see a sustained turning point.

Delay, court injunction, or “change of heart.” In the very near term, the biggest (albeit unlikely) potential catalyst for markets would be a change of heart from the Trump administration in response to the market volatility and business uncertainty. This could include a delay to the scheduled implementation of reciprocal tariffs on 9 April.

A court injunction to halt the tariffs could also provide some breathing room for markets. However, it is unclear how willing major US corporations or law firms may be to challenge the Trump administration. Additionally, we believe any challenges would most likely be made at an individual product or sector level, limiting the overall potential impact even if successful. It is also not clear if such challenges would ultimately succeed, limiting the scale of their impact on markets.

Evidence that US effective tariff rates are on a path toward 10-15%.
News on Friday that Vietnam and Cambodia are cutting tariffs as a prelude to negotiations was encouraging. But cutting tariffs on Vietnam and Cambodia to the “baseline” of 10% would only reduce the US effective tariff rate to 22% (versus 9% prior to the 2 April announcement and c.25% currently).

It would require successful negotiations with China or the EU to effect more meaningful overall change. For example, if Trump lowered all country-level tariffs to a 10% baseline and only implemented 25% tariffs on targeted products, the US would have a 13% effective tariff rate.

For now, we think markets are likely to remain more fearful about how high tariffs might rise than hopeful about how low they might fall. China’s retaliation on Friday may yet trigger even higher tariffs from the US. We also expect the EU to impose the equivalent of c.20% tariffs on US imports. In the near term, if Trump doubled the reciprocal tariff on China and the EU and imposed additional 25% tariffs on semis and pharma, the US would move to a 30% effective rate.

The Fed steps in. Shifts in the Fed's policy stance played an important role in establishing market bottoms in 2018, 2020, and 2022. While Powell’s speech on Friday suggested a cautious approach to rate cuts as the Fed attempts to balance growth and inflation concerns, we believe the Fed is likely to be concerned by the degree of stress in credit and financial markets in evidence by the end of Friday's trading session.

We also note that while Powell sounded concerned about inflation expectations rising because of tariffs, longer-term market-implied inflation expectations have dropped sharply. This could help shift the Fed’s attention toward managing slower growth, which in turn could help reduce the probability of more extreme market downside scenarios, though on its own Fed action may not be sufficient to drive a sustained turning point for markets.

What should investors do?
In the absence of clear catalysts to drive market upside, and at times of heightened uncertainty and elevated volatility, there are broadly three strategies investors can pursue:

• Manage volatility. For investors concerned about the near-term risks and looking to hedge portfolios against potential further downside.
• Take advantage of volatility. For investors unsure about the near term but looking to utilize high levels of volatility to earn additional portfolio income.
• Look through volatility. For investors who were under-invested going into the sell-off and/or are willing to take on near-term risk for potential long-term reward.

Managing volatility
Capital preservation. High levels of implied volatility mean that downside hedging is no longer “cheap” to implement, but the potential range of outcomes is wide and strategies with a degree of capital preservation can be an effective way for investors to manage potential downside risks to portfolios that could materialize if markets begin to price a deeper US recession.

Manage political risk with gold. Gold prices sold off on Friday, but this is not altogether surprising as during periods of extreme market stress investors sometimes use the metal to meet margin calls. We believe the sell-off offers a good opportunity for investors looking to build exposure to an asset that we believe will continue to offer portfolio diversification benefits, particularly in downside scenarios. In our base case, we target gold prices of USD 3,200/oz.

Seek durable income in quality bonds. While 10-year US government bond yields of 4.0% are close to our year-end target, this should still offer respectable total return potential and diversification benefits for portfolios. In a downside scenario, we would expect 10-year Treasury yields to fall to 2.5%, offering potentially significant capital gains for investors. Investors at the longer-end of the yield curve need to remain mindful of volatility related to fiscal policy.

Diversify with hedge funds. By dynamically adapting to macro shifts, hedge fund strategies like discretionary macro, equity market neutral, select relative-value or multi-strategy can cushion portfolios in down markets. We believe that the alpha orientation and conservative posture of multistrategy funds will mean near-term performance is likely to be largely insulated from market volatility. Similarly, we expect that macro strategies will have generated positive outcomes amid the volatility.

Taking advantage of volatility
Trade the range in currencies. In the near term, we believe investors can benefit from currently elevated levels of currency volatility by trading what we expect to be near-term ranges in key pairs, including EURUSD (centered around 1.10), USDCHF (centered around 0.87), and GBPUSD (centered around 1.31).

Over the medium term, we believe a more sustained period weakness for the US dollar is likely, particularly if the Fed starts cutting interest rates more quickly than expected in response to weakness in US economic growth. Investors looking to position for longer-term dollar weakness while monetizing short-term volatility can consider selling dollar upside.

Looking through volatility
Equities
We hold a Neutral tactical stance on equities, including on the US, Europe, and China. However, periods of market stress have historically and consistently offered long-term rewards for diversified investors who look through near-term volatility and stay the course, and/or put fresh money to work.

We can use historical context to understand what is being priced at different levels, to give investors a sense of near-term risk and reward:

What are some key equity market levels to watch?
4,915: The S&P 500 would officially enter a bear market, down 20% from its peak, a level which would likely increase political pressure on President Trump and could increase the appetite to strike deals.

Analyzing the 12 occasions that the S&P 500 has fallen by 20% from its peak since 1945, yields the following results:

• One-year horizon:
• Positive subsequent return on 67% of occasions.
• Mean return of 12.9%.
• Three-year horizon:
• Positive subsequent return on 91% of occasions.
• Mean return of 29.2%.
• Five-year horizon:
• Positive subsequent return on 100% of occasions.
• Mean return of 52.7%.

4,153: The S&P 500 would be down by 32.4% from its peak, consistent with the average S&P 500 decline during the past 10 US recessions (since 1958). This is also broadly consistent with the median S&P 500 decline during the 12 bear markets since 1945. In previous bear markets, the S&P 500 rallied by an average of 42% from its bear market trough over the subsequent year and fully recovered losses two years later, on average. Over a five-year time span, the S&P 500 rallied by an average of 97% from its bear market troughs.

3,686: The S&P 500 would be down by 40% from its peak. This is broadly consistent with the average of the S&P 500 declines in the four worst recessions since 1958. These levels bring the index close to its October 2022 low. The S&P 500 would be trading at less than 16x “trend” earnings since 1960. Such valuations are consistent with the COVID lows in March 2020 and substantially lower than the average of 20x over the past 30 years. The S&P 500 surged 78% in the 12 months following the COVID low.

High yield credit
While we believe it is still premature to buy the dip in riskier credit, we believe the dislocations in credit markets on Friday have made spreads (now c.450bps) significantly more attractive, and we note that US high yield credit spreads have historically not remained above 500bps for extended periods. We also note that absolute yields of more than 10% for many US high yield issuers may lead to concerns about financial distress and compel the Fed to act, providing a potential catalyst for the asset class. For now, we focus on select BB-rated issuers we consider to be rising star candidates, as well as select subordinated/hybrid bonds