Markets have been on the edge of their seats in anticipation of US President Trump’s global tariff policy announcement on 2 April. Price action in US equity markets has broadly been mimicking the path it took during the first Trump trade war in 2019, selling off and later rebounding once Trump withdrew his tariff plans (Fig. 2).
Trying to make sense of the potential outcomes of the tariff war for European equities, comparing the two timelines, we see that although implied volatilities have increased as in 2019 heading into the tariff date announcement (Fig. 4), we have seen a divergence in price performance for the STOXX 600, which has remained close to all-time highs due to a mix of factors, namely: 1) market rotation into the region from deep under-allocation entering 2025; 2) expectations that the US will claw back its tariff plans and come to an agreement as in 2019; and 3) fiscal spending in the EU will offset any growth drag from the US imposing blanket 25% tariffs (Fig. 6).
In the US, on the other hand, stagflation fears have taken a greater toll on equities’ performance over the last month, where the market has increased the probability of a recession to 33% on average, albeit varying across asset classes (Fig. 7). We believe that although tariffs could be a drag on growth, markets anticipate that both the Trump administration and the Fed will likely counterbalance growth pressures with lower rates and tax cuts. In essence, although the sky is not as blue for the US, the market is currently pricing out a more global recessionary hit, as negative effects from tariffs are expected to be softened by lower rates and tax cuts in the US and further fiscal spending in the EU. The currently low probability of a recession priced in EU equities poses asymmetric risks to the downside.
With the 2 April announcement looming, we see the following scenarios and ways to position ahead of the event:
Blue-sky scenario 1: Under the blue-sky scenario, the markets are right and the effect of tariffs has a limited drag on growth over the medium term, where we expect the latest US cyclical underperformance to rewind (Fig. 5), supporting underperforming EU cyclical sectors, like Autos. In this scenario, we see the recent rotation into defensives as overdone and returns in sectors like Telcos will be capped on the back of competition squeezing margins further.
Grey-sky scenario 2: Under the grey-sky scenario, the market reprices its recession probability significantly upwards. The recession probability currently priced in credit spreads reflects a highly asymmetric risk-reward to the downside in the Banks sector, the perceived bellwether to the economy. The market will also be hit by a sharply lower interest-rate environment as a reaction to economic decline paired with subdued lending activity. We favour allocation to Utilities, a perceived bond proxy, with tailwinds in this scenario from lower rates and large EU infrastructure spending.