Here’s my brain dump from the last few days. TL;DR: we still have more downside then upside.
Context
We’re in uncharted territory - similar to the February 2021 COVID scenario. This situation is unprecedented in the modern global economy, making it difficult to rely solely on pattern matching. In my opinion, the market remains in denial and hasn’t properly processed the situation. We saw evidence of this yesterday when the S&P jumped 8% following fake news about tariff suspensions. During COVID, it also took several weeks for the market to price things correctly.
Scenario Analysis
Scenario 1: Tariffs as Short-Term Negotiation Tactics (60% Probability)
This appears to be what the market is currently pricing in. However, evidence suggests otherwise - the Vietnamese offered zero tariffs, but the Trump administration rejected this proposal. Even if tariffs were abolished now, we still face problems from arbitrary border controls, annexation rhetoric, and companies already restructuring investments.
Scenario 2: Tariffs Remain in Place
This breaks down into two sub-scenarios:
Scenario 2.1: Trump Administration Miscalculation
There’s no deeper plan behind these tariffs, and the administration doesn’t understand the implications of their actions. The demands they’re making are impossible for trading partners to implement. If tariffs remain active, the US economy suffers, potentially entering an escalation spiral with the EU or China. Additional pain could follow, such as China massively dumping US treasuries.
Scenario 2.2: Bretton Woods 2.0
The plan is actually to establish a new trade order, as suggested by Trump’s advisors and analysts like Ray Dalio. US debt is no longer sustainable, and the current system only functions with massive deficits. The administration wants to devalue the dollar while ideally maintaining its reserve status. China is the primary adversary in this scenario. An escalation spiral remains possible and potentially more critical since it involves the division of global markets. We’ve essentially fast-forwarded the AI arms race from 2027. Such a restructuring would likely take several months at minimum, and there’s always the tail risk that they’ve miscalculated, potentially costing the US dollar its reserve status.
Additional Risk Factors
We haven’t even considered other wildcards:
- Escalation of the Ukraine crisis due to Russian pressure from low oil prices
- US military action against Iran
- China invading Taiwan
In my view, executing this strategy to refinance debt makes little sense. Bond yields have already risen. The Federal Reserve will likely only react when unemployment or inflation increases, both of which lag behind current events.
While I believe Scenario 1 remains most likely at approximately 60% probability, the other scenarios aren’t properly priced in. We’ve only seen markets decline by about 15%, and the Shiller PE ratio remains above 30. This means if Scenario 2 materializes, we could easily see another 30% drop. Therefore, I’m considering selling portions of my portfolio where I’m currently negative and hedging the rest with shorts.