It’s a progress scare first and a tariff scare second | USAEMALL.com

Good morning. Yesterday was a wild ride in the stock and bond markets, with shares forming a reverse N shape (down, up, down again) through the day and Treasury yields forming a reverse hockey stick (flat, then sharply up). Remember your Mandelbrot: over any given timeframe, markets have momentum and follow a trend, but in the transition periods between trends, they bounce around quite randomly. This feels like one of those indeterminate transition periods. So when does the bouncing end, and the next trend take hold? Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.

This is a growth scare first and a tariff scare second

Markets are volatile and uneasy, and it is easy to attribute this to the US tariffs just imposed on Canada, Mexico, and China. But what we are seeing in markets is more consistent with a general growth scare than a tariff-specific sell-off. And this makes sense: the tariffs were an unpleasant surprise that followed and added to, rather than caused, a bundle of bad signals from the economy and markets.

That was certainly true of Monday’s equity sell-off which, as we detailed yesterday, looked like a classic risk-off day, with defensives rising and cyclicals falling. And it was certainly true during Tuesday’s rollercoaster. The biggest losers on the day were US banks, with the BKW bank index falling 4.5 per cent.

Why banks? Because most US banks’ lending businesses are leveraged to domestic growth, and their margins will be diminished by the lower interest rates that slower growth will bring in its train. And the market does see rates coming down: the futures market has added almost two full rate cuts to its expectations for 2025 in the past month.

More evidence that growth rather that tariffs is primarily in play: the dollar has been falling for more than a month, and fell sharply yesterday.

If there is one reliable consensus about tariffs among their fans and foes, it is that they are dollar-positive (tariffs reduce demand for imports and therefore the foreign currencies needed to buy those goods). So what is driving the greenback down now? Again, lower growth expectations; they drive down interest rates (in particular real rates), lowering the differential with rates in Europe and elsewhere. The currencies adjust accordingly. Signs of expansionary fiscal policy in Germany reinforce this effect; the fact that a few weeks ago every trader and his dog were long the dollar does, too. One might wonder, in addition, whether financial flows are weakening the dollar as well, as US risk assets no longer look like a one-way bet. The fund flows data over the next few weeks will be interesting in this respect.

The growth and tariff effects are not mutually exclusive. Tariffs, in the short term, are growth negative. But right now there is much more going on than that.

Investor sentiment, the wall of worry, and valuations

The standard measure of retail investor sentiment, the AAII Survey, has undergone a remarkable crash over the past month. The latest reading of its bull-bear spread (the percentage of respondents feeling bullish about markets over the next six months, minus the percentage feeling bearish), from the last week in February, hit -41, a low only equalled twice in the past 20 years. See the light blue line here:

On the standard reading, this is a bullish sign — “be greedy when others are scared” as they say, or “stocks climb a wall of worry”. Indeed, for a long-term investor, the previous deep lows in the survey, in 2009 and 2022, were excellent times to buy stocks.

That might be the case this time, too. But there is something to keep in mind. Stocks are currently only 10 per cent off their all-time highs last month. But at the previous lows in sentiment, equity prices had already fallen much harder. Stocks, in other words, look like they might have a ways to go before catching up (down?) with sentiment, should sentiment stay so depressed.

Another way to make the same point is with valuations. At the previous lows in the bull-bear spread, price/earnings valuations had hit lows (see the dark blue line above). And while valuations have dropped recently, they are still very high by historical standards.

Doge, growth and the labour market

It is hard to analyse the economic impact of the Department of Government Efficiency (Doge), Elon Musk’s effort to shrink the federal government. Like all things with him and Trump, it’s messy. Its accomplishments have been overstated, and nearly all of its actions are under legal review and could be reversed.

Doge could, in theory, severely slash government spending, with a negative flow through to GDP. But there are many who would argue that less government spending would be offset by a surge in investment and a private sector unburdened by oversight. At the same time, Congress would probably oppose any significant cuts to spending.

The larger and more pressing risks are to the labour market. The government employs 3mn civilian workers, and even more government contractors (estimates vary, but a decent rule of thumb is 2:1, according to Torsten Slok at Apollo). The federal government started to grow at a faster rate in 2023:

Over the past 18 months, the government has added roughly 3,000 federal employees each month — a big step up by its own standards, but a small change compared to the average of 186,000 jobs added per month last year. According to Skanda Amarnath at Employ America, the federal government has never been a major driver of employment growth, but it has been a drag:

During past examples [of government downsizing], like the budget sequestration in the early 2010s, the federal government was a drag on hiring, about -4,000 to -10,000 a month. We might see a net reduction of something like 13,000 off of payroll growth, in the worst-case scenario.

Last month, the US economy added 143,000 jobs — far below what many predict is our current break-even. A steady-to-fast reduction in government employees at a similar scale to the early 2010s would weaken an already softening labour market. And Doge-led reductions in federal employees is likely to go hand-in-hand with cuts in other sectors that receive federal money: state and local governments, non-profits and higher education, and professional services (where contractors generally sit).

A flood of government lay-offs would not necessarily trigger a recession, however. In general, an uptick in the three-month moving average of national unemployment of 0.5 per cent precedes a recession, or so says the Sahm rule, an indicator widely used by policymakers. Doge would have to increase the unemployed population by more than 1mn to trigger the rule, according to Claudia Sahm at New Century Advisors, who came up with it. Most of the estimates Unhedged has seen suggest that Doge could lay off a maximum of 800,000 to 1mn federal employees and contractors.

But even if there is not a recession, Doge’s job cuts could cause pain in communities where the government is one of, if not the, main employer: areas around army bases and the DC-suburbs, for example. And a weakening job market could put the Federal Reserve in a tough spot. Inflation is not dead, and the economy is weakening. If today’s new tariffs and whatever retaliation they invite causes prices to go up, the Fed needs to feel good about the job market to keep rates where they are or raise them further. If Doge makes the employment picture look significantly worse, the central bank could be caught between its two mandates, and the market might realise its worst fear: stagflation.

(Reiter)

One Good Read

Royal shade.

FT Unhedged podcast

Can’t get enough of Unhedged? Listen to our new podcast, for a 15-minute dive into the latest markets news and financial headlines, twice a week. Catch up on past editions of the newsletter here.