Good morning. German yields, long frozen, are thawing. Yesterday, 10-year German Bund yields hit a 28-year high, after its chancellor-in-waiting agreed to exempt defence spending from the country’s strict debt rules. Meanwhile, US rates, once ripping, are now falling. And Chinese yields, which have plummeted for years, are flat, after some good market news and Beijing’s bullish forecast. We may just be entering a new world. Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.
The Trump put, maybe
How should markets price in tariff policy that changes, apparently, from day to day? One day after imposing 25 per cent tariffs on Canada and Mexico, the administration carved out an exception for carmakers, “so they are not at an economic disadvantage”. It came, naturally, with more ambiguity: it expires in a month, after which . . . what? Unhedged doesn’t know and doesn’t think you do, either. Opinions remain split on whether this administration thinks of tariffs as tactical negotiation tools or strategic priorities, and whether that thinking will change if markets fall.
Our question is: how much of the softness and volatility in markets comes from the administration’s apparently endless capacity for revision and ambiguity, and how much from the economic threat of tariffs themselves? It may be more the former. Our belief is stability, predictability and impartiality of policy is economically important, because it allows companies to plan and invest confidently. We don’t see the bull market returning until we know what the rules are.
Credit and the growth scare
While the S&P 500 index has fallen less than 5 per cent from its all-time highs of less than a month ago, that modest decline conceals bigger changes in the market’s internal composition and in the economic background. Leadership has switched wholesale from Big Tech and cyclicals to defensives. A nasty bundle of hard and soft economic data has growth estimates for this year falling fast. Volatility, implied and realised, has risen. The 10-year Treasury yield has fallen more than half a percentage point, as hopes for growth have fallen away.
It is still too early to say for sure that this is more than just a rough patch, one made somewhat worse by the market-unfriendly tariff policies of the new administration. But it feels like it could be something more — possibly a significant inflection point.
It is interesting, then, that the churn in equity markets has not been matched by similar signs of stress in the other big risk asset — corporate credit. Credit spreads (the additional yield over Treasuries offered by corporate bonds) have widened a bit, showing some appreciation for the growth scare. Credit spreads are traditionally correlated with stocks (and in particular small-cap stocks, which better approximate the average risk profile of corporate borrowers) and that relationship has, to a degree, held. Here for example are double B rated credit spreads (the highest grade of junk) plotted against the Russell 2000:
That chart, however, undersells exactly how low credit spreads remain by historical standards. Here is a longer term chart of double B spreads:
Compared to past benchmarks, spreads are vanishingly low. Does this make sense at a moment when the stock valuations of small and mid-cap stocks are at the low end of average, and everyone is nervous?
Brij Khurana, a fixed income portfolio manager at Wellington, thinks it is an uneasy fit. Given the fall in small-caps, and the high level of intra-sector volatility in the equity indices, he says, “I’m surprised spreads have not widened more . . . I’d say spreads have responded to lower growth expectation, but not to the higher volatility.”
He only sees signs of stress in the most cyclical parts of the market, specifically energy, which has also been hit by lower oil prices.
But spreads should respond to equity volatility, says Andrew Lapthorne, global head of quantitative research at Société Générale. “Credit spreads are a function of the volatility of the underlying assets,” he says — when lending against a more volatile asset, you demand a higher interest rate. He offers the below chart (which only extends to the end of February) of average realised volatility of US stocks against high-yield spreads:
Spreads “are not moving as they should” according to the standard models, he says. His best guess is extremely strong demand for fixed income investments is overwhelming the fundamentals, a pattern that can reverse quickly.
Not everyone in the credit world is spooked. Jenn Thomas, who manages consumer credit asset-backed security portfolios at Loomis Sayles, closely follows the underlying credit quality of the assets in asset-backed securities. She has not seen a meaningful change recently in delinquencies and defaults, which she attributes partly to the fact that loan originators, from credit cards to cars, have been quite careful about underwriting standards in the past year or two. While lower income, younger borrowers have been under stress for a while, she does not see that problem worsening now.
Consumer credit and corporate credit are different beasts, of course, but consumer debt is holding up. That takes some of the fear out of the overall growth picture, and helps to explain why spreads remain tight.
Tariffs, pulp and paper companies
Tariffs are leaving a mark in unexpected corners of the stock market.
Take paper and packaging. According to Karthik Valluru, global sector leader for materials and process industries at the Boston Consulting Group, the industry has become “increasingly integrated across borders” in North America. Smurfit Westrock, the cardboard box maker, and integrated paper group International Paper Company took big spills over the past few days:
Smurfit is particularly exposed. It makes about 10 per cent of its cardboard in Mexico, according to Jefferies, has a big mill in Canada, and gets revenue from food that is packaged in Mexico and shipped to US consumers. In its most recent earnings call, its CEO Tony Smurfit warned US tariffs would hurt:
All the food and vegetables . . . [and] protein that we do on the Mexican border . . . is going across the border and we package a lot of that. So there will be, I would say, a very significant customer effect . . . Canada is slightly different for us because we’ve one big mill in Canada that exports to the United States . . . if that mill had to apply a 25 per cent tariff, we’ll have to figure out how we would adjust that mill situation there because that would be very uncompetitive very quickly.
According to Philip Ng and his team at Jefferies, the bigger threat to Smurfit might be from Mexican retaliation:
The bigger risk would be retaliation from trading partners, notably Mexico, which is the US’s largest cardboard export mkt (~30 per cent), and tariffs could drive food inflation higher for agriculture/produce imported from Mexico.
IP is facing similar pressures, and is also threatened by retaliatory tariffs. Meanwhile, Trump’s tariffs have caused the cost of lumber to go up, squeezing both companies’ bottom lines. Lumber futures have been rising throughout the year, and jumped higher on Monday:
While the recent tariff dynamics are crushing pulp and paper companies, they are helping some of their suppliers. Weyerhaeuser, a US-based lumber company, has had a great run this week:
At a Citi conference on Tuesday, its chief executive David Stockfish explained that “a relatively small percentage of [its] Canadian manufactured lumber . . . comes into the US”, and the majority of its US sales are from US-grown trees. That gives it an edge over its competitors with more cross-border sales.
It’s a complicated industry, and tariffs will shuffle it even more. But what all this demonstrates is that one effect of tariffs for markets is that they might bring back that long-neglected creature, the stock picker, who was driven to the sidelines by indexing and the Mag Seven. In a de-globalising world, security selection may matter more.
(Reiter)
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