Minute by minute, the financial blowback of the global trade war gets more dramatic.
We’re currently in a discovery phase where financial markets try to discern how tariffs will influence economic growth, inflation and corporate profits. Markets were close to despondent on Wednesday morning as they sized up the latest developments, and euphoric by afternoon.
What investors should do for the moment: Nothing. Literally, n-o-t-h-i-n-g. Do not react to the daily spasms of stock and bond markets where nobody has a firm grasp of what’s going on. That’s fair because the U.S. president and his advisers don’t, either.
Before trading began Wednesday, the S&P 500 stock index had fallen more than 10 per cent in three days. A daily blast from BMO Economics this week said market declines that sharp have only happened three times – in 1987, 2008 and 2020. “Not great company,” the note said.
Fine, stocks do fall hard from time to time. If you invest in stocks, that’s your life. You own bonds to take the edge off these declines, and bonds were doing fine until a sharp decline this week.
Bond market action is vastly less dramatic than what goes on in the stock markets. The health of the bond market is measured by the yield on government bonds, notably the 10-year U.S. Treasury bond. Yields go up when investors sell and drive bond prices lower, and they fall when investors are piling into bonds and sending prices higher.
What we’ve seen this week is a wave of selling of U.S. government bonds that has dragged the broader global bond market along for the ride. We saw big declines for stocks over the past several days, and a shaky bond market.
U.S. Treasury bonds are the world’s bunker investment – they’re the ultimate shelter in uncertain times. But the trade war has shaken confidence in these assets and caused some selling. There’s speculation that China has sold Treasuries in retaliation for U.S. tariffs applied to the country’s exports.
Another reason for weakening bonds on Wednesday was a flood of money moving back into stocks. By late in the afternoon, small losses had turned into meteoric gains of 9.5 per cent for Nasdaq, 7.3 per cent for the S&P 500 and 5.1 per cent for the S&P/TSX composite index.
The turnaround was ignited by U.S. President Donald Trump’s decision to halt reciprocal tariffs against countries around the world for 90 days. Before the news got out, owning both stocks and bonds looked like di-worsification.
The rebound in stocks may not stick, but it does show how resilient stocks can be if the news is good on tariffs. Likewise, there’s a case for sticking with bonds. If you agree about bonds, guaranteed investment certificates and cash vehicles like money market funds and investment savings accounts should be considered.
Remember that bonds were doing nicely before this week’s dust-up. Plunging stock markets had sent money pouring into bonds, as per the usual script. Expect to still be up on the year in the bond side of your portfolio, even after the latest setback.
Going forward, bonds must contend with the risk of recession, the potential for rising inflation as a result of tariffs and a new mood of suspicion about U.S. Treasuries being rock solid investments. Bonds could go up or down as these factors play out, but one thing looks certain: stocks have the potential to drop much more than bonds.
That BMO Economics note looked at 11 stock market pullbacks on the S&P 500 going back to 1962 and the maximum peak-to-trough declines for each market cycle and five of them were worse than 28 per cent. An epic bad year for the bond market was the 11.7 per cent decline of 2022, which includes a total return of bond interest and falling bond prices.
Losing less in bonds is the weakest of positive outcomes. To hedge against that result, you could use GICs to supplement your bonds. GICs won’t lose money, but neither will they give you the gains offered by bonds if central banks are forced to cut interest rates in the trade war.
Selling stocks and bonds and going to cash is a bet on further market disruption that may or may not happen. If there are further declines, expect an eventual rebound that comes out of nowhere and makes cash returns look pitiful.
Where cash does have a role is in diversifying your stocks and bonds. Having a slice of your portfolio in cash gets you roughly 2.5 to 3.5 per cent right now with minimal risk. Not a big win, but OK for now.
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