The trade war is not a shock. It is a slow train.

Note: this will be the last weekly until September 1st

The three things investors need to know this week:

1.      We would be less worried about UK and more worried about US inflation. Having said that, numbers still remain well within normal bounds.

2.      Robust supply chains and consumption inertia, pre-tariff inventories and low energy prices have contributed to economic stability beyond the original post-2nd April projections.

3.      If we assume that the slow-moving economic consequences will eventually materialise, by reducing their appetite for forecasts, investors may be under-pricing economic downside or even possibly upside risks.

Summary

Despite rising U.S. inflation and heightened trade tensions, markets remain stable—perhaps too stable. Robust supply chains, early inventory buildup, and low energy prices have buffered short-term shocks. However, investors may be underestimating longer-term risks. With tariffs at historic highs and political interference pressuring the Fed, inflation could become more entrenched, especially if monetary policy shifts. Bond markets appear complacent, at least not pricing in a regime change, while equities ride on dollar weakness and steady earnings. The economic impact of the trade war is a slow-moving threat, but a real one. By ignoring it, markets risk mispricing downside.

The most important issue of the time is, of course, inflation. British inflation’s pickup to 3.6% last week did not inspire particular fear. Stagflation (very low or no growth and higher prices) doesn’t tend to last very long. Either prices spiral (which requires strong demand) or growth subsides further. Usually it’s the latter, and with higher unemployment and sluggish growth we’d be less worried about sticky prices going forward, and more anticipatory of lower interest rates once the data allows it.

But the pickup in US inflation is a different sort of beast altogether.

The long-expected inflation rise last week to 2.7% even cheered some economists who were wondering why US prices didn’t rise earlier, despite more than half the firms passing tariffs on to consumers. It’s not just a slight rebound in oil prices, but also higher core services prices that drove up headline inflation.

Despite the pickup, most of the US economic data remains robust. Growth at 1.5% this year isn’t great, but certainly it’s not a recession either. Consumption data from June was also good, suggesting that consumers aren’t shocked.

Meanwhile, the US stock market is near all-time highs once again.

And even as the White House presses for Fed Chair Jerome Powell to be replaced (presumably with a Chair that will be willing to floor short term rates long enough for the US to refinance a very high amount of short-term debt rollover this year), long-term borrowing rates (where inflation lives) and the yield curve (the difference between long and short-term rates) haven’t really reflected rising inflation risks.

Nor have market-implied inflation expectations

In other words, the US economy is not collapsing, even as tariffs are 6x the previous long-term average and the highest they have been since the Second World War.

Why is that? Why hasn’t inflation skyrocketed along with borrowing costs yet, and growth collapsed? And why are equity markets so unfazed?

For one, supply chains are proving robust. Unlike China, whose pandemic-related economic convulsions shocked global supply chains, leading to shortages and spikes in demand, skyrocketing container costs and blocked ports, the US is at the end of the supply chain, not at the heart of it. The inflation spike of the time was a combination of supply-side disruptions (the pandemic, the war in Ukraine) and the wake of sharp US monetary expansion during the early stages of the pandemic. These conditions are not met today. Supply chains work, and, since the trade war hasn’t proliferated between third countries (yet), the main problem is one of US erratic and possibly slower future demand. Inventories were built early, so that economic activity was brought forward.

Second, some assumed that their own dismal forward-looking outlook would instantly translate into consumer and investor disappointment. But, as we know from previous examples, economic decisions are not the same as market/financial shocks, or event-driven shocks like the pandemic. They are decidedly slower-moving trains. Consumerism is specifically designed to induce consumption, over possible economic fears. While consumers may be worried about what they read in the news (and worried they are), paradoxically they might as well vent those worries with a weekend spent shopping! (In case you ever wondered why three Economics Nobel Prizes have been given to behaviourists). US core retail spending is slowing, but at 4% it is still at the post-pandemic average.

Third, energy prices are persistently low. Whether by design (a deal) or not, oil prices are down 10% since the inauguration, and nearly double that in Euro or GBP terms. Saudis, like the Chinese, have pegged their currency to the Dollar. Because they are not big importers, they don’t suffer much from their own devaluation (China might eventually if commodity prices begin to spike as product-focused tariffs pick up). Now to be fair, this hasn’t quite translated at prices “at the pump” (average gasoline prices are at $3.63, nearly at the same level as they were in January, $3.59) mostly because of inventories and maintenance issues, seasonal issues, as well as increased export demand, but, considering the lower Dollar it’s still a boon that American consumers may enjoy.

Now, equity markets are not really unfazed. In fact, they have wisely priced in the lower US Dollar. While US equities are at all-time highs, and trading at expensive multiples, they are in fact negative for Euro and GBP Investors. Investors expect a healthy 5.3% year-on-year growth in US earnings, a bit lower than the 7.7% average but still well on track to deliver 10.7% by the end of the year.

Our bigger concern is the bond market. The market has not priced in a meaningful shift in the inflation regime, which means that investors are quite relaxed about a change of paradigm at the central bank. They also don’t see risks rising from profligate fiscal spending in the US and across the globe. This creates upside risks, especially for longer-dated bonds, where inflation lives. Conversely, it could create opportunities for short-term bonds if the Fed somehow capitulates and embarks on a rate-cutting binge.

The larger picture is one of summer lull (some would argue complacency), where investors, tired from the noise, don’t extrapolate economic and financial risks into the future until something actually happens, be it an inflation or growth surprise, an escalation (or de-escalation) of trade wars or any other such similar event. In other words, if we assume that the slow-moving economic consequences of the trade wars will eventually materialise (unless it is scaled back), by reducing their appetite for forecasts, investors may be under-pricing economic downside or upside risks. This is why it is best to remain neutral in terms of risk, despite the recent equity rally, vigilant and diversified.