Equity markets have already sniffed it out: The pressure on Donald Trump to make trade deals is too great to think tariffs won’t come down from the lofty levels advertised on “Liberation Day.” The question is whether the deals come too little too late — and if so, whether the Federal Reserve will bail out the president.

If you look at where stocks and bonds are trading, it’s clear many investors are betting that central bankers will ride to the rescue. I don’t think they will. That makes me somewhat negative on Treasuries. But it’s equities where the big disconnect is. I expect another leg down and a bear market. Today’s Fed announcement and press conference has only reinforced that belief. 

Here’s my train of thought:

1. Low-conviction voters who don’t really follow the news thought they were getting an inflation-slaying, pro-growth champion in Trump. The evidence is they’re not, and so they’re starting to turn on him. This suggests a Trump tariff capitulation is coming.
2. But we’re not going back to the baseline before Trump’s tariffs. We’re still talking about a 10% base, with levies on auto, steel and even some services on top of that.
3. Despite that, the economic data as of now are just fine, especially as companies and households stock up ahead of tariffs. It’s just that inflation is a tad high.
4. Given that jobless claims, unemployment and payrolls all still signal growth, and recessions always begin with poor labor markets, the Fed is going to keep waiting.
5. This points to an eventual recession, which inherently means a bear market, and one with few places to hide. The silver lining is that active investors finally can win.

Voters that won Trump the White House are fleeing

The latest economic data — 177,000 jobs added to payrolls, 4.2% unemployment, jobless claims under 250,000, personal consumption up almost 2% last quarter — suggests all is right with the world. But Trump’s agenda is taking a toll on attitudes.

Voters who tend not to pay attention to the news — the same ones who came out in droves for the president last year — are now experiencing serious buyers’ remorse after seeing his policies. Look at the data.

On his “Strength in Numbers” newsletter, G. Elliott Morris sums the shift up this way:

The people who pay the least attention to the news and are the least involved in the political process are now the least likely to support Trump, rather than the most likely. That is a complete inversion of the relationship between engagement and support for Trump in 2024.

What happened? Morris points to concerns about inflation and empty shelves. To this crowd, when Trump says kids should maybe have only three dolls instead of 30, it sounds like an out-of-touch billionaire who’s not focused on inflation like he promised he would be.

So tariffs — Trump’s favorite policy tool — are now seen as posing the biggest threat to the economy, and that makes them his Achilles. No matter how much he believes in their efficacy, he’s going to have to make a tactical retreat if he wants to keep voters onside for allies in Congress at the next midterm elections, events that traditionally show lower turnout.

But tariffs aren’t going back to the baseline of around 2.5%. Negotiations with Japan are indicative of that. Kyodo News reported that the US isn’t willing to negotiate the 10% levy baseline or tariffs on cars and steel — Trump’s only flexible on the 14% so-called reciprocal tariff on Japanese imports into the US. And remember, Trump just added a “Hollywood tariff” to the mix, the first big levy on services we’ve seen.

That suggests 10% is the new baseline, with sector-specific and country-specific tariffs on top. Japan, for instance, could end up with an average 20% tariff whereas the UK,  which has no country-specific levy, might get 12%. It suggests an overall tariff level in the mid-teens percentage.  

That might be a big tactical retreat from the April 2 announcement, but China, where levels are 10 times as high right now, is the elephant in the room, especially as Trump says he isn’t willing to lower tariffs unilaterally to jumpstart negotiations. So any retreat won’t be enough either to rescue the US economy or put low-engagement voters back in Trump’s camp. Prediction market Kalshi still sees recession as more likely than not this year.

Why doesn’t the Fed take action, then?

If everybody sees a recession coming, wouldn’t cutting rates now be the right thing for the Fed to do? The short answer is no. After all, we haven’t seen any material change in the labor market just yet. And inflation was already too high before tariffs began. So, just as Fed Chair Jerome Powell argued today, it makes sense to wait and see how things develop rather than rush headlong into a policy that might have to be reversed.

The Fed’s hands are basically tied because the starting point — low unemployment and elevated inflation — makes preemptive cuts seem irresponsible. We already saw last year that when the Fed is aggressively dovish and tries to stick a soft landing, rate cuts can cause bond yields to rise as inflation angst grows.

But this situation creates two-sided risk. On the one hand, the Fed is biased toward standing pat because it’s concerned that inflation expectations could become unanchored (much as they did in the late 1960s when the first great stagflation cycle was seeded). But they then risk cutting too late and being forced to do so aggressively as the economy turns down sharply. Historically speaking, the spike in tariffs is loosely akin to the oil embargo in 1973 because it’s a sudden price shock that will be felt much earlier than Fed policy.

Bottom line: Trump’s tariffs are taking a toll, and empty store shelves and higher prices are coming even if Trump eventually caves on 145% Chinese tariffs. Look at this one example of $417 million in tariffs on goods from just one cargo ship that was able to dock on April 24 in the port of Long Beach. It’s stuff like this that risks an inflationary growth slowdown, with a high likelihood of a recession. But the Fed can’t risk its credibility by bailing out Trump preemptively. It can only wait and react.

A few months into this trade war, evidence of a slowdown in consumption is mounting. The 1.8% level from the first quarter’s GDP was a lot lower than the 4% from the prior three months. And the next quarter will be even lower. That’s largely priced in to equities now, so the best case is one where the market treads water until the growth and inflation overhang is lifted, something that should take a few months.

My base case is mild stagflation that leads to a recession, thus creating a bear market in stocks. And  for the first time in nearly two decades, this will present active investors with some opportunities.

For one, the rotation in shares out of Big Tech has seen consumer staples as one of the biggest beneficiaries. But stocks in that sector have high valuations. Utilities look like a better bet given their lower multiples. And energy, which has been beaten up during the rotation, could be near a bottom in terms of expectations given that oil prices are now below breakeven for many shale producers.

Even within the large-cap tech stocks there is a clear differentiation. Tesla and Nvidia have the highest earnings multiples and thus the most to lose but are also some of the most exposed to China and tariff policy. Apple and Amazon have a lower multiple but high China-specific risk. Meanwhile, the three companies that showed the best results in the first quarter — Meta, Alphabet and Microsoft — also have the least tariff risk for now, being pure data companies.

I strongly suspect, though, that when the US economy rights itself, big tech won’t lead the market. There will be new sector leaders. And active management will outperform indexing in that transition. 

As this plays out, bonds will suffer some because of inflation risk. But a recession and massive rate cuts will make locking in yield a good bet, too. The question is whether we exit recession with high inflation. If so, bonds aren’t going to hold value after the recession-induced brief winning run.

I want to flag the possibility of a more aggressive downside scenario from a liquidity crisis. For example, I saw that elite colleges were pressuring private equity firms for an exit from their investments. That’s understandable given the risks to funding from Trump’s stance toward these institutions. But it also is a reminder that these PE companies have a lot of illiquid assets that they have had a hard time selling. A recession will create liquidity pressures that cause some investors to sell good assets when they can’t sell illiquid ones. And it’s that kind of liquidity pressure that leads to panics and exacerbate bear markets. 

Quote of the Week

Things on my radar

• The Buffett Indicator may have been saying buy on a tactical basis. But if you look at the chart, it’s pretty dire and suggests valuations will come down.
• Speaking of Buffett, he clearly leans toward freer trade.
• The fact that the EU is readying over $100 billion of US goods for tariffs speaks to downside risk of negotiation failure.

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