Is “recession” now spelled T-A-R-I-F-F?
Markets were gripped by the recession trade after President Trump’s tariffs on Wednesday threatened a global trade war. Treasury yields, stock futures and the dollar all plunged .
This isn’t mere market hyperbole. Thursday was only the sixth time in history that the S&P 500 had fallen more than 4% while the dollar also fell more than 1%—with investors shocked that the greenback had failed in its usual role as a safe haven.
The carnage in the markets might be just the beginning: If the biggest U.S. tax rise since at least the 1950s causes the economy to shrink, stocks and Treasury yields still have a long way to go down.
As recessions take hold, stocks are hit both by lower earnings and by lower valuations, as spending falls and savers switch to safer assets. Defensive stocks better able to maintain sales—such as sellers of food and other household staples—beat those selling optional purchases such as luxury goods and cars, known as cyclicals.
Since the S&P 500 peaked in mid-February, investors have been moving fast to dump cyclical stocks and switch to defensives. My measure of cyclical sectors, which equally weights stocks within each sector to avoid megacap distortions, has lagged behind defensives by the most over such a short period since the pandemic lockdown in March 2020.
The lowest-rated junk bonds, most likely to default in tough times, have also been hit hard. Their extra yield above Treasurys has risen by more than 2 percentage points. They last had such a big jump over a similarly short period when economists were sure recession was imminent in 2022 (in the end there was no recession).
Yet, while the market is moving fast to price in a higher chance of recession, it is far from fully prepared. The S&P 500 is only down 12% from its all-time high and back to where it stood in September. Usually in recessions, stocks eventually fall at least 20% and give up far more than seven months of gains. The S&P is still valued at close to 20 times forecast earnings, too, which would surely be unsustainable in a recession.
The same goes for junk bonds. Higher-quality junk, where most bonds are issued, has barely been hit so far, and even those rated CCC and lower which are closest to default are only back to their September levels. Spreads will probably widen further, but in actual recessions, when defaults are expected to spike, spreads could easily soar to double the current level, bringing huge losses.
We can get more granular. Stock options imply about a 15% chance of recession over the next year, up from 10% before Wednesday’s tariff announcement , on a measure used by Pimco, which gauges the probability of valuations dropping below 15 times earnings. Interest-rate derivatives imply about an 18% chance of recession, measured as the chance of rates being below 1.75% in two years’ time. Neither is a surefire measure; after the dot-com bubble, valuations took years to return to more normal levels, despite the recession. Tariff-induced inflation could also limit the Fed’s room to slash rates in a downturn.
Treasury yields haven’t actually fallen all that much. The 10-year is off 0.76 percentage point from its high earlier this year. But it has had bigger falls over such a period three times in the past two years. Two of those times, they ended up dropping more than a percentage point.
Since recessions commonly cut rates by three points or more, a much bigger fall in yields would be needed if recession became a certainty. Unless, of course, stagflation prevents the Fed cutting—but that would mean the economy, stocks and corporate bonds would suffer even more.
For now, markets think the Fed will look through the tariffs and cut even as the new taxes push up prices. While Fed Chair Jerome Powell is unlikely to repeat his description of the 2022 inflation as “transitory,” he could reasonably treat the tariffs as one-offs so long as inflation expectations don’t rise too much.
Markets think this is likely: The chance of a rate cut next month priced into futures doubled to 24% after the new tariffs, according to CME FedWatch, and three or more cuts are expected by the end of the year.
Investors who think the return to tariffs higher than the 1930 Smoot-Hawley rates will hammer the economy into recession should expect much bigger falls in stocks and bond yields as the year goes on.
Those who think the rest of the world won’t seriously retaliate and that Trump will quickly negotiate the rates away can be happier with the still-high levels of prices. But even they ought to worry about the damaging effects of prolonged uncertainty on the economy.
Write to James Mackintosh at james.mackintosh@wsj.com
