Liquidation Day
- sebastienpautrot
- 3 days ago
- 3 min read
04 April 2025
At the start of 2025 we suggested that the market unfriendly elements of the Trump Agenda – tariffs, destabilising alliances, and reduced labour supply – would likely occur first. That feels like an understatement today. As we have also put it, markets have experienced a “reverse feedback loop” or the unwind of forever and ever policy. It is important to note that the detox is a feature of the policy agenda, not an accident. Stated differently, a recession would be “the good outcome” for debt sustainability.
The additional elements at play for markets were also the valuation, extreme crowding in consensus positioning and beliefs in US mega-cap technology and AI, leading into this episode. Leverage was evident in index funds on US technology combined with peak index concentration. That has acted as a negative gamma like downside accelerator and amplified the correction. The good news is that tactical sentiment and positioning indicators (e.g. CTA net exposure) are already near extremes and consistent with an advanced stage of the correction. Price itself became rapid and emotional today, consistent with capitulation.
From a fundamental standpoint, even before the Liberation Liquidation Day announcement, there was a sharp deterioration in consumer, business confidence and the best leading indicators of the growth and profit cycle. The detail of the March ISM Manufacturing report was an extremely poor growth-inflation trade off. New Orders fell to 45.2, inventories jumped to 53.4 which implies a sharp fall in future production (a leading indicator of earnings revisions and equity prices). ISM employment also fell sharply to 44.7. By contrast, the prices paid sub-index jumped sharply to 69.4 which implies material downside risk to profit margins.
Chart 1
Our fear is that there has been a legitimate and sharp deterioration in global growth that will be amplified by today’s announcement. The ISM new orders inventory time series is also a decent leading indicator of the global production, trade, and inventory cycle. The markets in this region with the greatest beta or sensitivity of earnings to global industrial production are Korea, Japan, and Taiwan. This was a key reason why we reduced exposure to these markets ahead of the episode. Moreover, the Japanese yen is the likely beneficiary of a reflexive or self-reinforcing liquidity, carry unwind and correlated volatility event.
According to UBS, the tariff proposals announced today are likely to raise the weighted average tariffs on US imports from 2.5% to 24%, levels not seen since the 1920s. Both the magnitude of the “reciprocal” tariffs imposed per country and the set of countries that were imposed on were larger than many had reasonably anticipated and priced. The critical issue as we noted above is that consumer and business confidence had already deteriorated from the reduction in the fiscal impulse (forever and ever policy) and immigration over the past few years. Corporate earnings revisions were already under pressure.
For credit, the key fundamental point is that companies repay debt out of cash flow. The major cause of wider credit spreads is a deterioration in business and consumer confidence that might spill over into actual spending, cash flow, raising the probability of recession. Credit is sensitive to a large deterioration in the economy raising the odds of a recession. In this context, the cost of protection for potential payoff is still inexpensive if the business cycle deteriorates sharply. US credit spreads are still around half a standard deviation below average. Credit has been defensive so far in this episode. However, the asset class appears extremely vulnerable to a major deterioration in the business cycle.
As we have noted in the past, human beings are not particularly good at non-linear thinking. A key reason why there is resistance to consider extreme or non-linear outcomes is that most investor portfolios are short convexity and long carry. Put another way, most market participants tend to benefit when asset prices rise, not fall. The good news in EM/Asia is that valuations have priced a material deterioration in growth. The bad news is that the outcome is the growth outlook (amplified by today’s announcement) is even worse than feared. Nevertheless, asset prices in this region have a very large margin of safety and the best investments are made from a position of deep discomfort. From our perch, its also important to look at this episode through the lens of the Art of the Deal (escalate to de-escalate). There will likely be negotiation and deals over the coming days or weeks. The maximalist outcome is unlikely to be the destination.
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