Market Risks Persist After U.S.-China Trade Detente

Summary

Thoughts on the Market: Market Risks Persist After U.S.-China Trade Detente
Hosted by Morgan Stanley
Release Date: May 19, 2025

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Morgan Stanley's podcast, "Thoughts on the Market," hosted by Chief Fixed Income Strategist Vishi Tirupatoor, delves into the recent developments surrounding the temporary 90-day pause in reciprocal tariffs between the United States and China. Released on May 19, 2025, this episode titled "Market Risks Persist After U.S.-China Trade Detente" provides a comprehensive analysis of the economic and market implications of this trade detente.

Introduction

Vishi Tirupatoor opens the discussion by setting the stage for the recent trade developments. He highlights the market's immediate positive response to the announcement of the tariff pause, emphasizing the broader economic implications.

"The market response to last Monday's announcement has been resoundingly positive." [00:00]

Market Response to the Tariff Pause

Tirupatoor details the immediate impact of the tariff pause across various financial markets:

• Equity Markets: The S&P 500 surged by 4.5% in the four trading days following the announcement. This rebound has restored the year-to-date returns to positive territory, recovering from the significant declines experienced in April.

• Credit Markets: Significant tightening was observed, with investment-grade spreads narrowing by over 10 basis points and high-yield spreads tightening by more than 50 basis points.

• Treasury Markets: The treasury market factored in expectations of rate cuts, pricing in 50 basis points of rate cuts for 2025. This adjustment implies an anticipated rate cut of approximately 100 basis points by the end of 2026.

"The S&P 500 was up 4.5% in the first four days since the announcement and the year-to-date returns are back in the black..." [00:00]

Implications of the Trade Detente

Tirupatoor explores the broader implications of the tariff pause on the U.S. economy and global markets:

Reduction in Recession Risk

The easing of trade tensions diminishes the likelihood of a sudden halt in trade volumes and a sharp increase in unemployment rates. While acknowledging that the pause represents a temporary truce, he suggests that the probability of a U.S. recession has decreased.

"...the probability of a US recession therefore has fallen on the margin." [00:02]

Economic Growth and Inflation Outlook

The detente skews the economic outlook towards modest growth and slightly reduced inflation pressures. However, persistent trade tensions and elevated tariffs continue to exert upward pressure on inflation.

"It seems reasonable to infer that tariffs in the vicinity of 125% or 145% are substantially less likely now." [00:02]

Federal Reserve Policy

The stabilization in trade relations reinforces the confidence in the current economic expansion and supports the expectation that the Federal Reserve will maintain its current policy stance for the remainder of the year.

"...this detente gives us greater comfort in our baseline outlook and strengthens our conviction that the Fed will remain on hold for the rest of the year." [00:03]

Persistent Risks and Uncertainties

Despite the positive signs, Tirupatoor cautions against complacency, highlighting ongoing uncertainties:

• Continued Trade Tensions: The administration is actively investigating additional tariffs on sectors such as pharmaceuticals, semiconductors, and copper. The future trajectory of these tariffs remains uncertain.

• Global Negotiation Dynamics: It is unclear whether the current negotiation framework between the U.S. and China can be replicated with other regions, particularly Europe.

• Inflationary Pressures: Even if tariffs stabilize at current levels, they remain significantly higher—approximately four times—than pre-announcement levels, suggesting sustained inflationary pressures, especially into the third quarter.

"It is far from clear that the 90 day pause is an uncertainty clearing event." [00:03]

Impact on Risk and Credit Markets

Tirupatoor assesses the effects of the tariff pause on risk and credit markets:

• Risk Markets: The detente has mitigated the risk of substantial market drawdowns. However, ongoing policy uncertainty regarding tariff levels continues to pose challenges. The speaker remains optimistic that the extreme volatility observed in April is unlikely to recur in the near term.

  "A return to last month's mind boggling volatility driven by trade policy is probably behind us..." [00:03]

• Credit Markets: The reduced recession risk is favorable for credit markets, which currently enjoy strong fundamentals. The anticipated rate cuts have kept credit yields attractive for yield-seeking investors, such as insurance companies.

  "For credit markets, a lower likelihood of recession is indeed welcome news, especially considering the current strong credit fundamentals." [00:04]

Conclusion

Vishi Tirupatoor wraps up the analysis by reiterating the cautious optimism stemming from the temporary pause in U.S.-China tariffs. While the immediate market reactions are positive, the underlying uncertainties related to broader trade policies and inflationary trends necessitate ongoing vigilance.

"...the all in yields for credit remain in the range to sustain the demand for yield buyers such as insurance companies." [00:04]

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This episode of "Thoughts on the Market" offers a nuanced view of the current economic landscape, highlighting the delicate balance between short-term market optimism and long-term structural risks. For investors and financial enthusiasts alike, Tirupatoor's insights provide valuable context for navigating the evolving trade dynamics and their implications for the global economy.

Transcript

[A]

Welcome to Thoughts on the Market. I am Vishi Tirupatoor, Moghas Stanley's Chief Fixed Income Strategist. Today I'll talk about the impact of last week's 90 day pause in the reciprocal tariffs between the US and China and the impact on the economy and markets. It's Monday, May 19th at 11:00am in New York. The market response to last Monday's announcement has been resoundingly positive. The S&P 500 was up 4.5% in the first four days since since the announcement and the year to date returns are back in the black after the Liberation Day drove steep declines in April. Credit markets have also rallied, notably with investment grade spreads tightening by over 10 basis points and high yield spreads by over 50 basis points. And the treasury market took out 50 basis points of rate cuts in 2025, leaving market implied rate cut by the end of 2026 at around 100 basis points. While these moves across markets are significant, it is really important to put them into perspective and tease out what this detente in trade tensions implies and more importantly, what it does not imply. On the positive side, we think that the de escalation reduces the risk of a sudden stop in trade volumes and a sharp rise in unemployment rate. While this is clearly just a truce, and we don't know exactly where the tariffs between the two largest economies in the world will end up, it seems reasonable to infer that tariffs in the vicinity of 125% or 145% are substantially less likely now. Overall, the probability of a US recession therefore has fallen on the margin. To be clear, a recession during 2025 was never really our base case, but the de escalation shifts risks in the direction of a little more growth, a little less inflation, and keeps unemployment rate at near current levels. If the world before Liberation Day was bimodal and close to a coin toss, it is still bimodal but skewed towards an expansion, not contraction. Since we were in the expansion mode to begin with, this detente gives us greater comfort in our baseline outlook and strengthens our conviction that the Fed will remain on hold for the rest of the year. The positive wipes from Geneva notwithstanding, we would stress that it is far from clear that the 90 day pause is an uncertainty clearing event. Trade tensions are likely to remain elevated. The administration is still investigating tariffs on pharmaceuticals, semiconductors, copper and other products. It is also unclear if the template of negotiations between the US and China can work for other regions, especially Europe. Even if US tariffs on imports from China and the rest of the world end up roughly around the current levels, they would still be about four times higher than the levels at the start of the year. This means inflation should continue to move higher into year end with a surge that peaks in the third quarter. While the impulse to inflation from tariffs is likely to be smaller, it still is coming. Likewise, higher tariffs will will dampen growth even though recession will continue to be avoided. For risk markets, we think that the detente has reduced the risk of substantial drawdowns, while policy uncertainty about the ultimate level of tariff remains. A return to last month's mind boggling volatility driven by trade policy is probably behind us, so it is unlikely that we will see markets revisiting the lows of April in the near term. For credit markets, a lower likelihood of recession is indeed welcome news, especially considering the current strong credit fundamentals. With the market taking out a couple of rate cuts, the all in yields for credit remain in the range to sustain the demand for yield buyers such as insurance companies. Thanks for listening. If you enjoy the show, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today.

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