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What happened?

The S&P 500 fell 2.7% on Monday as markets reacted to signs that the Trump administration could be willing to tolerate a temporary “disturbance” to economic activity and higher inflation in pursuit of its economic agenda. Concerning the risks of an economic contraction, President Trump suggested the nation could face a “period of transition.” Asked whether higher US tariffs could lead to higher inflation, he said “you may get it.”

Monday’s decline in the S&P 500 follows a 3.1% fall last week, the largest decline in six months. The index has now given up a nearly 8% rally following Trump’s reelection in early November, which had kindled hopes that business would benefit from deregulation and looser fiscal policy. US Treasuries benefited from safe-haven demand, with the yield on the 10-year bond falling 5 basis points to 4.21% on Monday.

Selling extended into the Asian markets on Tuesday with a 1.1% decline in Japan's TOPIX index and a 1.3% fall in South Korea's KOSPI. At the time of writing, S&P 500 futures are pointing to only a modest rebound of 0.3%.

What’s the context?

We note that while the moves in the S&P 500 have been dramatic, swings in other market segments have been more muted. For example, the equal-weighted version of the S&P 500 is flat for the year and the Russell 1000 value benchmark is up slightly.

Our takeaway is that the sell-off has been exacerbated by the unwinding of extended positioning in certain market segments, such as momentum and tech stocks, and is not necessarily a signal that US economic risks have escalated significantly.

Of course, signs that consumer and business confidence are weakening are not helping sentiment—the ISM Purchasing Managers' Index of business activity, consumer sentiment, and consumer spending data have all been weaker than expected. Meanwhile, markets are questioning the notion that the Trump administration would adapt policies in response to equity market volatility or economic growth concerns.

Investor nerves are also likely being added to by the potential for a US government shutdown this weekend and more headlines about “reciprocal” tariffs coming out on 2 April.

Our updated scenarios

We have updated our House View scenarios to reflect recent developments. We now assign a 30% probability to our combined downside scenario of a stagflationary or cyclical downturn, compared to the 20% chance we assign to our upside scenario.

In our base case, to which we attach a 50% probability, US economic growth is likely to moderate compared with last year but remain positive. While we treat the economic data and the words of the Trump administration seriously, enacting and sustaining policies that contribute to a potentially protracted slowdown of the US economy in hope of better growth or economic dynamics in the medium to long term would require a shift from an approach that has so far focused on achieving quick success.

Our base case is therefore characterized by an aggressive tariff policy, but for the effective tariff rate for US imports to remain below 10%. We also expect rhetoric and action on government spending cuts to cool down by late spring.

How do we invest?

In our Monthly Letter, we highlighted our core message of staying invested but also hedging equity exposures to manage near-term risks. Over the coming weeks, we expect further volatility and potential weakness in equity markets, and so hedging the downside remains key.

At the same time, we maintain an Attractive outlook on equities based on our year-end targets and expect the S&P 500 to rise to 6,600 by the end of 2025. Our base case remains that the Trump administration’s aggressive stance on trade will weigh on growth, but not so much as to drive the US into recession. We also expect ongoing structural AI advancements, and would consider using pockets of tech volatility to build portfolio exposure to quality AI stocks via buy-the-dip and structured strategies

In short, while we see medium-term upside for stocks, investors will need to navigate political risks in the months ahead. In equities, capital preservation strategies can help manage downside risks. We like high-quality fixed income like investment grade corporate bonds, which may provide a hedge against trade risks, and long USDCNY positions could serve as a trade hedge. And we continue to believe gold remains an effective portfolio hedge against geopolitical and inflation risks, while certain hedge fund strategies can improve portfolio resilience.

We have also made a number of adjustments to our equity recommendations to account for the latest developments.

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• We have downgraded Asia ex-Japan equities from Attractive to Neutral after year-to-date performance of 5%. Asian equities have been supported by healthy fundamentals, including expansionary regional PMIs and expectations of high-single-digit earnings growth in 2025. However, tariff uncertainty has intensified, which could weigh on Asia’s export cycle, and signs of a slowdown in US economic indicators could further weaken Asia's growth expectations. Given this uncertainty, the risk premium for Asian equities is likely to rise, limiting near-term upside. The 12-month forward P/E for the MSCI Asia ex-Japan Index stands at 13.5x, slightly above historical levels, and does not fully reflect tariff risks, in our view.
• We have also downgraded China's technology sector from Attractive to Neutral, after year-to-date performance of 32%. Chinese tech stocks have rallied strongly, driven by enthusiasm around the recent Chinese AI successes and emphasis on AI development at the National People's Congress. However, following the rally, we no longer believe that markets underappreciate the potential for Chinese internet stocks, and we believe further tariff escalation between the US and China is likely as structural concerns remain unaddressed. As such, we recommend tactically booking profits and waiting for greater clarity on tariffs or lower re-entry levels to position back into the sector. We retain a Neutral stance on Chinese equities overall.
• In December, we flagged that the potential for more pro-growth policies following the German election, a peace deal with Ukraine, and a cyclical recovery in manufacturing could support the German equity market. Although last week’s German fiscal announcement leaves Europe better placed fundamentally, in the near term, market expectations around each of these positive catalysts for our tactical call have largely played out, and upcoming news flow around tariffs and economic growth uncertainty are near-term risks. So, with the DAX index up close to 14% year to date, we close our tactical recommendation to invest in the DAX via structured strategies. We prefer selective exposure to Europe via our “Six ways to invest in Europe” theme.