Beyond the obvious impact – a sharp equity market sell-off – there is a more subtle connected impact when the markets fall like a knife. Single stock volatility, a function of idiosyncratic (specific) risk, relative to index volatility is rising sharply. In basic parlance the domination of the Mag 7 has masked the increase in single stock volatility at an index level since the Trump inauguration. Previously when we have seen the VIX spike above 35 there has been a broad market sell off and recently the recovery period has been quite short due to the leadership of the Mag 7.
A little like inflation a rise in index volatility is not an issue until it has been high enough for long enough. This is because higher volatility increases the cost of hedging using options. Higher interest rates have a limited impact, generally, on leverage trading, but a rise in volatility can shut the trade down overnight. We saw this occur last August when the Yen borrowing to invest in equities globally was curtailed and a short sharp equity correction ensued. Will the Mag 7 rescue the market again or will the rise in specific stock/sector volatility undermine the confidence in US equities that has been the dominant theme since the GFC.
Will this time be different? Change is never easy and often not welcomed, so in some respects the market’s reaction to the Trump policy roll out is not a shock. The problem is that investors are finding it very hard to understand which economic sectors and stocks will be the winners and which will be the losers. Last week there was some capitulation when investors appeared to just sell US and shift into European equities. This may continue until the winners and losers of the Trump policies are better understood. Frankly, if an investor is uncertain then the only place to hide is in an Arculus ethically managed, capital preservation focused income fund.
One example here is the tariffs policy. So far it has not been implemented in any sort of cohesive manner. One day there is a 25% tariff on all Mexican exports to the US, the next there is nothing, only to see the wheel turn again and a tariff apply. While an economist may be able to work out which industry sectors will be impacted by a tariff, there is still no certainty that a tariff will actually occur and for how long it will remain. This has the potential to lead to a misallocation of the factors of production (land, capital, labour, entrepreneurship). Perhaps more importantly business leaders (entrepreneurs) will just hold off making US related investments until there is more certainty.
If we put to one side, then the uncertainty over tariff policy it may be possible to make some assumptions about the themes that the Trump White House will prosecute consistently. These may include:
- A smaller government administration sector. The Elon Musk efficiency drive is identifying targets, and it is then up to the Department Secretary’s to choose what changes to make. No one honestly believes that there is not some scope to cut the size of the ballooning bureaucracy. Certainly, the US debt issue has to be addressed at some point.
- Tariffs on Chinese based production where the Chinese Communist Party has actively interfered in the efficient allocation of resources. Back in 2008 the Chinese government reacted to the global slowdown by instructing the construction of brand-new cities that were not in any way linked to underlying dwelling demand. By 2017 it was clearly evident that China had a construction and linked debt overhang from this interference in market forces and Chinese GDP began to fall from the 8% 30-year average to well below the targeted 5%. The Chinese Politburo then instructed its state-owned enterprises (and lent them money) to go out and globally purchase the technology and the raw resources that underpin the UN push towards renewables. Chinese state-owned enterprises now manufacture the windmills, solar panels and electric car batteries with a comparative advantage over all other countries because they control the basic inputs. In response the EU has imposed a tariff on Chinese based renewable related products such as electric vehicles with the understanding that without such interference in market pricing everyone in Europe would be driving a Chinese made car under the EU broader environmental policies. We see the Trump tariffs on China targeting this type of problem, although, if the US government subsidies given to the renewables sector are removed then perhaps Chinas renewable supply chain will collapse?
- A private sector driven demand function for immigration. In the period just after the pandemic lockdowns left leaning global governments opened the flood gates to immigration. Right across the developed world we have seen an influx of low skilled labour and not all of them could be employed in the government bureaucracy where they were paid to do nothing. Perhaps the cuts to the US bureaucracy will increase supply of low skilled labour while the immigration cuts reduce supply and with a time lag, we will see this labour supply move from the government sector back into healthcare, construction and food processing sectors. Through this transition period we will see stocks in these sectors face some challenges.
Fundamentally, we do not believe that tariffs when universally applied to a country’s exports (e.g. Canada) work under a flexible exchange rate mechanism because the market automatically adjusts the value of the currency to offset the impact of the tariff. It can work when employed under a fixed exchange rate regime (e.g. China), however, China can currently afford to devalue its currency because it is suffering deflation, and this would offset the tariff impact.
There is an expectation building that the proposed tariffs will be inflationary. This is not yet evident in either the core PCE of core CPI data. The Producer Price Index core reading, however, is more revealing given the consistent increase since 2023. The decline from the PPI peak in March 2022 to the low point in December 2023 represents the restoration of the global supply chains after the pandemic lockdowns disruption period. This is the ‘transitory’ impact that the central banks referred to initially. The ‘transitory’ decline in durable goods prices ended in December 2023 and the rise since then looks like cost push inflation (wage increases in response to inflation feeding into costs and then final prices).
Interest Rates
Bond yields were basically unchanged for the week despite volatility in all financial markets. Investors are caught between responding to weaker growth and a possible inflation rise. Any risk-off sentiment is also failing to move treasury yields. The week before investors were switching into bonds on the basis that Trumps fiscal cuts would lead to an economic contraction but last week they were switching into European equities. The US 2-year yield finished at 4.02%, the key 5-year at 4.09% and the 10-year at 4.32%. This weeks Fed meeting may reset expectations.
Yields tracked changes in US bond yields with all the attention on the equity market which dived. The 10-year finished at 4.43% but will likely trade up to 4.47% on Monday morning. The key 5-year bond finished the week at 3.97%. The Federal Government is expected to call a Federal election for May 10 now so the focus will shift to the Federal Budget on March 25. The budget will be framed with the assumption that tax revenues will surge so that the underlying budget deficit looks politically acceptable.
Major Credit Markets
All credit markets widened last week. The continuing tariff shocks and plunging consumer sentiment eventually becomes reflected by widening credit spreads in all credit markets. US investment grade (IG) markets are not immune. The US CDS iTraxx jumped by 5 points to 0.55%, off lows in mid-February of 0.47%. In context, the current level is still historically very low. The chart shows the IG levels in 2022, which for the US was over 1%.
Australian IG credit market spreads also widened on uncertainties and jumps in rates and equity market volatility measures. The Australian CDS iTraxx index rose by 6 pts to 0.76%, the recent low in February being 0.63%. The index reflects senior bonds. Otherwise, the bank sub note market has been particularly weak. APRA changes to TLAC will require the banks to increase Tier 2 capital from 2% to 3.25% with the phasing out of Tier 1 securities. Recent T2 spread lows near 1.52% will not hold. The past few weeks Kangaroo Tier 2 issuance has backfired. All these bonds are now 0.120-0.20% wider in spread.
High Yield Markets
US high yield spreads have jumped over the week being heavily influenced by the equity market volatility of the day as well as sentiment to the economy. Average HY spreads widened by 0.20% to 3.40% mid-week, recovering slightly on Friday. Investor sentiment has turned, the HY funds steady inflows over recent months have now turned to outflows. Average Triple C spreads gapped out to 841bp, their widest levels since September last year based on how tariffs will impact smaller companies.
Hybrids held quite steady over the week despite the equity market volatility. The average major bank hybrid margin rose from 1.89% to 1.98%. Volumes were again concentrated in short term hybrids. WBCPH topped turnover with $17.3m traded, a weekly high for any hybrid in 2025. Most longer-dated hybrids also traded well with the exception of NABPK. This issue is at a tighter margin than other long-dated hybrids.
Listed Hybrid Market
Hybrids – buying yield when volatility rises.
Stock markets have finally caught up to Trumps tariff machine going into overdrive. Volatility has jumped, with most of the market being hit, including banking stocks. Whilst large falls in banking stocks is a negative for hybrids, given the recent share price highs and the solid nature of bank balance sheets, especially the major banks, any hybrid price weakness will be a buying opportunity. Further, as previously discussed, APRA’s recent cessation of hybrid issuance and requirement for repayment at the first possible date has lowered the risk profile of the current crop of issued hybrids. Additionally, it is always important to focus on the reason for price weakness. This is not a credit event and thus is not to do with banks’ lending practices or souring loans. Hence investors can be confident the hybrid security will fulfill its intention. Volatile markets are a moving beast. Often it is possible to sit in the market at a price which returns the desired yield. The chart shows a banking index of the four major banks including dividends over time. Observe the pull back in recent weeks. Also shown is the average major bank hybrid margin. Note little change in recent weeks, in fact margins have fallen over the recent bank share price volatile period.
Forward Interest Indicators
Australian rates
Swap-rates steady with bond rates.
Swap rates:
- 10-year swap 4.35%
- 7-year swap 4.16%
- 5-year swap 4.02%
- 1-month BBSW 4.09%
