The forecasting business is premised on the position that “what-was-will-continue-to-be!” Within that framework, economists review historical precedents and assign probabilities to potential outcomes. The idea that predicting macro-economic outcomes is more art than science is recognition that forecasting exists in an environment of fragmented markets exposed to unpredictable crosscurrents and fraught with unknowable geo-political events. Despite the forecasting headwinds we could always count on economists to use reasonable inputs and rigid algorithms to support an economic thesis. So much has changed!
Surprisingly, Trump has surrounded himself with financial experts (Scott Bessent as Treasury Secretary and Howard Lutnick as Commerce Secretary) that should know better. The only explanation that we can see is that they suffer from the glitz associated with such powerful positions. Something that Anthony Scaramucci described as “Potomac Fever.”
Whatever the reason, we cannot escape the fact that the current economic landscape has no historical precedents. In a vacuous state, economists must assess outcomes based on the personality of Donald Trump. Data inputs assume that Trump’s instincts will dictate global economic and market trends which exponentially elevates the uncertainty level.
The markets initially assumed that past is prelude, that Trump 2.0 would build on “American exceptionalism.” Which is to say under Trump 2.0 the world would experience the same trends it saw under Joe Biden: US dominance of the global economy and markets, led by its big-cap tech businesses. Trends that were already extended and vulnerable to forces larger than the US president. What we witnessed on April 3rd and 4th was a seismic shift propelled by a competitive churn that has set the stage for a new norm.
Return of the contrarians
History shows that the global economy and markets move in cycles, not straight trend lines. Contrarian investing is rooted in these patterns. The hot investment theme of one decade typically gets overcrowded, sowing the seeds of its own demise, and does not stay hot the next. But here we are halfway through the 2020s, and the mega-cap tech trend that began around 2010 is still paying off.
In the past, the list of global top 10 companies by market cap has changed dramatically with each new decade. Yet the leadership position of the magnificent seven remains intact some ten years later. Entering 2025, most analysts agreed that the trend of the past 15 years was stretched amid the growing manias of American consumption and AI, which were supercharged by excessive US stimulus, the gamification of investing and the inevitable crosscurrents from algorithmic trading and passive investing.
Creative destruction has been a defining and indeed necessary feature of capitalism since its roots in the 18th century. Capitalism has always been rooted in two dynamics; either it’s 1) dead, or dormant or 2) poised for a comeback. Perhaps we are hampered by the alchemy of the optimist, but our bet is on the comeback. One heralded by a (belated) return for contrarian investment, starting with a shift away from the U.S. and its top tech companies towards global markets ex-U.S.
Momentum is Crashing
Momentum traders are the opposite of contrarians. They believe the past is prelude to the future and are willing to ride the wave until it crests. Last year represented a classic case study as momentum mania reached a climax as more than half the returns in the S&P 500 index came on the back of the magnificent seven stocks.
Despite the current tariff tantrum, we have reached a more telling watershed moment. When we exit from this macro-economic calamity, we will see a marked turn towards value stocks. Momentum strategies that outperformed the market by more than 20% in 2024 are simply not sustainable. It should come as no surprise that momentum stocks have experienced double digit underperformance since the beginning of 2025.
Momentum runs tend to reinforce the assumption that good times will roll, pulling in retail investors during the cresting phase. That unwinding is happening now. At the end of 2024, American consumers were more bullish on US stocks since surveys began tracking this sentiment. That has changed dramatically, and momentum stocks are poised to crash in a way that will hit investors hard.
Punishing Deficits
Under Trump 2.0, cuts in taxes and regulations were supposed to propel the US economy and market to new heights, or so the conventional wisdom goes. Though the pandemic is over, and jobs have recovered, the U.S. deficit is still strikingly high at around 6% of GDP. In fact, adjusted for the low unemployment rate, the U.S. deficit is five times the previous record high for a post-second world war recovery. And Trump’s agenda threatens to push it from extreme to eternity. Assuming the current budget passes the House of Representatives we suspect the US budget debt will rise by US $6 trillion before the end of the Trump term.
The bull case assumes the fiscal recklessness will not trigger a crisis, since no obvious calamity has come despite decades of similar warnings. What the bulls are overlooking is that compared with other developed nations, America’s debt has increased more than two times faster as a share of GDP since 2015 and the interest payments on that debt is three times higher.
Given the amount of new longer-dated US Treasury bonds set to hit the markets in the coming months, 2025 could be the moment where bond vigilantes take notice. In recent years, traders have punished profligate governments from Brazil to the UK and — albeit less aggressively — France. Many observers assume that the U.S., as the premier economic power, is invulnerable to such attacks, but its increasingly precarious finances could shatter that assumption soon.
The Fallacy of American Exceptionalism
Buzz about “American exceptionalism” overlooks the artificial boost the U.S. received from fiscal support. Following the pandemic, government spending rose sharply as a share of GDP. More than 20% of new US jobs were created by the government, up from 1% in the 2010s. Something that the Trump administration has been trying to undo through Elon Musk’s Department of Government Efficiency (DOGE).
The challenge is that DOGE cannot make enough cuts to satisfy Trump unless it punches a hole in Medicare, Medicaid and Social Security which based on Trump’s campaign are off limits. Public transfers including Social Security account for more than a quarter of residents’ income in more than 50% of U.S. counties. That compares with just 10% in 2000.
The overstimulated U.S. economy was growing at a pace near 3% which at least gave the economy a chance to outgrow its deficit. However, fiscal stimulus has shuddered in 2025 as has the pace of monetary easing. Tariffs have painted the administration into a corner. Any attempt to stimulate the economy will, as suggested by U.S. Federal Reserve (Fed) Chair Jerome Powell, be an existential threat to inflation and may force the Fed and the bond market to raise interest rates.
The initial decline in U.S. rates was propelled by investors who were transferring out of stocks and into bonds as a perceived security blanket. But that too is falling under the tariff knife as bond investors worry that the so-called security blanket that supports the US dollar as the reserve currency (Read: The Fallacy of Trade Deficits) is coming into question.
The talking heads in the Trump administration has insisted that its’ tariff strategy would not be deterred by the stock market. But Trump capitulated when he announced that reciprocal tariffs would be put on hold for “ninety days to allow countries to begin negotiations,” which came about after a simultaneous decline in equities, bonds and the U.S. dollar. After the announcement, the equity markets experienced a one-day spike before giving back 50% of the rally the next day. The equity fallout experienced the next day could be traced back to the bond market whose initial response to the tariff’s pause was more sanguine.
One might think that Trump’s capitulation was immediate, but in fact it had been percolating since the April 2nd “liberation day,” which caused an equity market shock that spread to other asset classes, particularly the all-important Treasury market. Bonds initially rallied after the April 2nd fiasco but had been under pressure until the April 9th “capitulation day.” As the bond market selloff intensified, the yield on ten-year treasury notes surged to 4.47%. That was a critical moment because ten-year treasury notes are the marker that determines mortgage rates.
What made this even more concerning was a marked decline in the U.S. dollar which indicated that global investors were questioning America’s security blanket opting instead for a “sell everything American” mode reminiscent of what sometimes happens to emerging economies.
This change in mindset was particularly acute in the foreign exchange markets. The Dollar Index, which measures the US greenback against a basket of other currencies, did edge higher on capitulation day but was still lower relative to a day earlier. Ten-year Treasury yields have been hovering around 4.3%, which is still above the 4.2% rate on April 2nd.
These crosscurrents across asset classes caught Wall Street analysts off guard. Traditionally, the U.S. dollar would rise against other currencies especially in an environment where long-term Treasury yields remained stubbornly high. We think that was the result of markets reassessing the American exceptionalism position because if tariffs are bad for the economy, they should eventually lead to lower interest rates.
The disorderly selling spree that started on capitulation day shocked analysts because prior to the Trump pause the spread between bond yields and rates on interest-rate swaps, which are another way to trade where rates are expected to be in the future, suddenly widened. Tellingly, this was more pronounced among short-term maturities. Yields on one-year Treasury bills bounced back even as swaps pointed to interest rates going lower.
Some of this forced selling was propelled by hedge funds. In recent years, hedge funds have engaged in large leveraged bets on Treasurys through something known as the “basis trade.” This entailed buying the bonds while selling similar futures to asset managers. The goal was to make money by arbitraging the spread between prices in the cash market versus expectations in the futures market (for more on this please read the section entitled: How Basis Trading Impacts Financial Markets).
As witnessed in March 2020, these trades can unwind quickly and place the Treasury market under significant stress. The issue on April 9th became serious as basis trades were being unwound because of margin calls and limitations among dealer banks that are the buyers banking sector as stricter regulations limit the balance-sheet capacity to absorb too many bonds when things go south. The swap-spread widening suggests this is still the case.
While the spreads at the short end of the Treasury curve narrowed through capitulation day, they were still higher than they were on April 2nd. At this point, it seems unlikely that large foreign holders such as the Chinese government, which has about $800 billion in Treasurys, are dumping them as part of their retaliation against tariffs, or the moves would likely be even larger. But the notion that China does not have cards to play seems questionable.
To which we say, so much for American exceptionalism.
Next Steps
Many countries, including Canada, have languished in the shadows. The one factor that resonates with the reciprocal tariffs is a marked change in attitude. Investors that have dismissed much of southern Europe and to a lesser extent Canada, as hopeless, may change their view if the tariff crisis brings about serious reform. The European nations formerly dismissed as “Pigs” now include some of the continent’s bright spots, led by Portugal, Greece and Spain.
The dark spots — Germany and France — could also find themselves unexpectedly compelled by their weak economies to change for the better. Which is why the leading political parties in Canada have been eliminating trade barriers and talking up an east west pipeline.
Whereas global investors ignored most of the developing world, that is also beginning to change. Among the large developing economies, fewer than one in two saw faster per capita GDP growth than the U.S. in the last five years. In coming years, however, that share is expected to rise to more than four out of five, with big boosts coming from investment in plants and equipment, and the onshoring of consumer spending.
Disciplined government spending helps explain why credit rating agencies are now more sanguine on developing nations, with upgrades outnumbering downgrades by margins not seen in years, including positive turns on recent basket cases like Argentina and Turkey.
While global investors have yet to react, locals have. Domestic equity cultures are propping up markets from Saudi Arabia to South Africa. India is already becoming one of the global market stars outside the U.S.
Investable China
The bear case that has engulfed China is hard to ignore. No country with a shrinking population and a heavy burden of debt has ever been able to grow at even half of Beijing’s target rate of 5%. But contrarians seeking value are beginning to revisit China which is no longer being dismissed as “uninvestable,” despite it being the world’s second largest economy.
Diamonds can be found in this rough by focusing on profitable publicly traded companies with high cash flows. There are now about 250 companies in China with a market cap more than US $1 billion and free cash flow yield above 10% — roughly 100 more than in the U.S., and 60 more than in Europe. The bearish sentiment that has long dogged China is beginning to turn.
Compare their leading electric car companies, BYD and Tesla. Both generate similar revenues and offer a similar return on equity, but sales volume is growing twice as fast at BYD, which is rapidly expanding its share of the global market. BYD now has a 10% market share in Norway which is the poster child for electric vehicles. Yet BYD stock sells at a price-to-earnings ratio of 15, compared with around 120 for Tesla. Its market cap is just over US $100 billion, Tesla’s is more than US$ 700 billion. In the coming year, investors may come to see China as investable again, at least in its profitable parts.
That said, it is still too early. The watershed moment will require a workable trade deal between the U.S. and China. At the moment these two superpowers are engaging in a losing game of chicken.
Generative AI Undercuts Big Tech
Big Tech’s supernormal profits and massive cash flow have been a significant draw for investors. But that advantage is shrinking fast. Taken together, Apple, Microsoft, Google, Meta and Tesla are on pace to invest nearly US $280 billion in artificial intelligence this year, up from US $80 billion five years ago. The race to dominate AI is on, and as a result, free cash flow growth for the biggest tech companies recently turned negative.
As we discussed last month, AI mania may be getting ahead of itself. Fewer than one in 20 workers say they use AI daily. Fewer than one in 10 U.S. companies have incorporated AI into their operations. That does not mean they won’t, just that it is far from clear how this technology will be applied — much less how strictly it will be regulated, or which mega firms will make money from it. Remember, few if any established firms emerged as big winners of the internet or shale oil revolutions.
Though it is tough to imagine what could derail Big Tech firms longer term, one answer is overspending on data centers and another, AI infrastructure. One of the biggest capital spending booms that America has seen since the Second World War may be great for the consumer but could be the straw that finally breaks the supernormal profits of Big Tech companies and inspires investors to question their current valuations.
Trade Without America
If Trump’s tariff threats are a negotiating tactic, as his aides say, the recent G-7 meeting in Canada brought other countries to the table leaving the U.S. on the outside. Canada is leading this trend as witnessed by Prime Mister Carny’s recent visit to France and the UK. After 25 years of talks, representatives of 31 nations finally agreed on plans for the world’s largest trade union, linking the EU with the Mercosur group in Latin America. If ratified, it would cut tariffs by 90 per cent among member states, which account for 25 per cent of global GDP.
Spooked by America’s use of tariffs to cut off rivals from the dollar-based international finance system, many countries are making deals to promote trade with regional neighbors, without having to access the US dollar as the reserve currency. India has agreements with 22 countries to conduct trade in rupees; 90 per cent of India-Russia trade is transacted in local currencies. Petro states including Saudi Arabia have cut deals to sell their oil in currencies other than the US dollar as well.
In recent years global trade has shifted, and today its biggest channels are within the developing world. Eight of the 10 fastest-growing trade corridors do not include the US, but many of them do have one terminus in China. The more the US threatens tariffs and weaponizes the US dollar, the harder its current partners will work to promote trade without America.
HOW BASIS TRADING IMPACTS FINANCIAL MARKETS
Basis trading attempts to profit from the mispricing of financial instruments. The strategy is only used in markets that have considerable liquidity (eq: foreign exchange, interest rates, some commodities and equity derivatives).
Institutional hedge funds take on sizeable positions using leverage to earn small profits when the value of the cash market drifts from the expected value in the futures market.
If the price in the cash market is high relative to the value in the futures market, the hedge fund would buy futures and sell the cash equivalent. The table below cites a simple example.
In this case the cash market for Treasury Bills is trading at a slight premium to the price of one year T-Bill futures. The Hedge Fund would sell the Treasury Bills in the cash market to a dealer bank and buy the T-Bill Futures that would be held in the account of the hedge fund. In one year, the price of both securities will mature at $1,000 and the Hedge Fund will pocket the differential.
Because these two securities represent the same underlying security, the Hedge Fund can execute the trade by only posting capital to cover the differential. The risk in this trade is that the prices between the two securities before maturity drift further apart (i.e. the price of the Futures contract declines at a faster pace than the cash market). Depending on the degree of leverage being used, the Hedge Fund may have to exit the position prematurely to answer a margin call.
Another risk is the regulatory environment under which dealer banks operate. The stringent rules governing dealer bank balance sheets mean that they are limited to how much they can hold in Treasury Bills. If the dealer bank takes on more inventory than regulations allow, they force Hedge Funds to exit the trade prematurely. Depending on the amount of leverage being employed, bond markets could be frozen as Hedge Funds are unable to exit the position with acceptable losses.
We saw this play out in the late 1990s when Long Term Capital collapsed under the weight of their currency trades. This also occurred in the United Kingdom in 2020 when the bond market would have collapsed had the Bank of England not stepped in.
The US bond market faced the same problem on April 9th, which is why President Trump capitulated.
THE FALLACY OF TRADE DEFICITS
What are we to make of Trump’s so-called liberation day reciprocal tariffs. Is he orchestrating a trade policy that is built on inconsistencies and unachievable objectives? The markets post-liberation day rection endorses the position that investors understand that Trump’s tariff war is anything but “reciprocal.”
The “Tariff Man” loves the word ‘reciprocal.’ We know that because he told us so! He even provided a simplistic “you-tax-us-we-tax-you” definition that likely appealed to his MAGA base. Maintaining the keep it simple theme, he then proceeded with an absurd reciprocal presentation that was bolstered by colorful cardboard visuals underwritten by grade ten arithmetic.
The White House applied a mathematical formula supported by Greek symbols / letters which appear to have been added more for appearance than substance. Unfortunately, adding Greek letters to tenth-grade arithmetic does not change the fact that it is still tenth-grade arithmetic.
Effectively the tariff placed on the United States by another country is equal to the trade deficit divided by imports, the formula published by the Office of the US Trade Representative has two additional terms in the denominator that just so happen to cancel out: (1) the elasticity of import demand with respect to import prices, ε, and (2) the elasticity of import prices with respect to tariffs.
The elasticity of import demand represents the degree to which higher prices push consumers to seek out alternatives. The Trump Administration sets the elasticity of import demand at 4.0 and the elasticity of demand with respect to import prices at 0.25. When you multiply 4.0 by 0.25 the product is 1.0 which effectively cancels out any impact that would have on the calculation.
The White House set the tariff rate on more than sixty countries (some of which are uninhabited by humans) using a formula that inputs an amount that the target country exports to the U.S., subtracts what that country imports from the U.S. and divides the result by the country’s total imports.
In the spirit of generosity – Trump’s words – the administration assesses the tariff at half the rate as calculated by the formula with a minimum tariff set at 10%.
There is nothing reciprocal about this approach. How else do you explain a 10% tariff being applied to goods imported from Australia when Australia has no tariffs on U.S. merchandise. This is not about levelling the playing field. It is about serving a Trump agenda to eliminate all trade deficits which he sees as subsidies paid for by American taxpayers.
Of course, there is no circumstance where a small country can import enough U.S. goods to eliminate a trade surplus. More importantly, trade deficits are not subsidies but rather are a natural extension of capitalism fostered by the comparative advantage thesis.
In trade, comparative advantage refers to a country’s ability to produce a good or service at a lower opportunity cost than its trading partners. This means a country can produce something more efficiently and with fewer sacrifices in terms of other goods it could have produced. By focusing on producing and exporting goods where they have a comparative advantage, countries can benefit from trade through increased efficiency and potentially lower prices for consumers.
For example, Columbia exports coffee to the U.S. which substantially impacts their GDP. Within the context of U.S. GDP, the numbers are insignificant. The U.S. imports coffee because it does not have the climate to support domestic production. Columbia’s GDP is simply not large enough to import U.S. goods in sufficient quantities to balance the bilateral trade. So, the U.S. collects tariffs that are eventually passed onto the consumer.
Maybe Columbia will ship less to the U.S. market, but then consumers and businesses in America will be deprived of their favorite morning pick-me-up unable to find a suitable alternative. Since the U.S. cannot grow coffee, the idea of putting up a tariff wall will not alter the trade imbalance. It will only raise prices for U.S. consumers. This is a fatally flawed approach that ignores the protectionist benefits on which the tariff wall strategy was initially designed. Applying tariffs to protect domestic producers is not valid if there are no American producers to protect.
The Columbian example is rooted in the theory of comparative advantage which results in a trade scenario that benefits both parties. Columbia benefits from the export of a product that it can grow efficiently keeping the cost of coffee in line with consumer expectations, while the U.S. exports dollars that reside in Columbia’s surplus account and underpin the greenbacks supremacy as the world’s reserve currency.
The U.S. is a consumer driven economy where consumer spending and imports are highly correlated. And that is not likely to change. America has no national sales tax and a tax system that incentivizes the use of debt to encourage consumption over personal savings. That composition is an outlier on the world stage. Until other countries employ tactics that encourage citizens to spend all their disposable income, any attempt to eliminate trade deficits will be futile. Most countries treat thrift and savings as a virtue. You will not change another country’s culture by initiating a trade war.
Debunking the subsidy argument requires us to understand the role and benefits that come from being the world’s reserve currency. No one questions that the depth of U.S. foreign exchange dealers and perceived safety of its fixed income market that provide the foundation for the greenback’s reserve currency status. However, that only works if other countries provide capital through trade deficits which grease the wheels of this infrastructure.
When a country has a trade surplus with the U.S. it receives U.S. dollars in exchange for its exports. That is referred to as the country’s capital account surplus. Those funds are then invested in U.S. equities and treasury bills that provide the liquidity underpinning the reserve currency arrangement. These surpluses, create wealth and income streams that flow into the U.S. as part of the natural balance of payments which, as the name suggests, must balance.
What the Trump administration doesn’t seem to realize is that for the U.S. to retain its position as the world’s reserve currency, the U.S. deficit on trade necessarily coincides with accumulated trade surpluses which is why foreigners hold $15-trillion worth of U.S. equities and fixed income. This capital represents one-quarter of the market cap for U.S. equities, which unfortunately, seems to be unwinding.
That Trump is now willing to “negotiate,” seems to have more to do with the fallout in the U.S. equity market where the average retail investor has a record 70% exposure to equities within their asset mix. The end game comes down to how entrenched the subsidy position is in Trump’s psyche.
Whether it causes an upward shift in consumer prices and ultimately a recession becomes the worst-case scenario. That is economics 101. That is a dangerous game of chicken, because unlike 2022 and 2023, there are no excess “Biden” pandemic savings left for the household sector and based on negotiations for the current budget, no fiscal stimulus to ease the downward slide.
Trying to decipher Trump’s deficit / subsidy thinking is why the Fed is sitting on its hands. There is no policy option that can deal with the combination of higher prices and slowing growth (i.e. stagflation).
The one positive is the continuing explosion of investment in generative AI. The question is whether that will continue at its current pace, which already seems to be slowing on fears of an oncoming recession. If this capital expenditure continues to ebb, then we would be entering a prolonged recession with no apparent offset. Trump has already raised this issue with his administration when he said that he could withstand a recession but not a depression.
The latter point is the only off ramp that we can see. We may already be in a recession although we won’t know until the data comes in. Certainly, there are warning signs: the slide in the U.S. dollar, the rise in mid to long term treasury yields being at the sharp edge of the recession sword.
If you believe that the deficit / subsidy argument is sacrosanct then, you must believe that America will end up relinquishing its role as being the reserve currency. Maybe that is really President Trump’s hidden agenda because if he believes that trade deficits should be eliminated, then in the name of consistency, he must also want to see the capital account surplus go away.
The byproduct of being a reserve currency is that it brings down the cost of capital which underpins superior rates of return on financial assets. Without the trade deficits, all this vanishes. This is the “burden” of a reserve currency status – trade deficits caused by capital account surpluses. If this is the game plan, then as we have been doing, increase exposure to gold and silver.
If you think Trump eventually backs away from the deficit / subsidy analogy which is possible although Trump hates to admit he was wrong, then we emerge unscathed from all this instability and do not go into recession. In that scenario, overweighting equities and underweighting bonds is the appropriate strategy. Bearing in mind, that equities and fixed income assets have not fully priced in a recession or more disconcerting stagflation.
Richard N Croft
Chief Investment Officer