This week saw a real whipsaw between headlines signaling an escalation of trade tensions under the Trump administration. Traders and investors grappled with weekend headlines on Saturday, February 1, 2025, after the administration declared, they were going to impose tariffs of 25% on imports from Mexico and Canada and a 10% levy on Chinese goods only for the administration to announce a 30-day reprieve as negotiations on border security were being worked on. The initial announcement caused futures markets to fall through Sunday, February 2, 2025, leading to market declines on the S&P500 and Nasdaq of 2.5% and 1.2% respectively. Only for the market to bounce back on the positive news that these tariffs would be delayed.

While the news was welcomed by market participants, the volatility it created left a lasting impression on the type of market that we could possibly face for the reminder of the year. This new regime caused the VIX (Volatility index) to spike during Monday’s trading session to an intraday level of 20.36, up 24% from Friday’s close only for volatility to drop ~10% by Monday’s close highlights the market’s sensitivity and the possible repercussions tariffs represent for the broader market. Beyond immediate market volatility, capital markets will now have to grapple with ever changing estimates and impacts to corporate earnings, economic growth projections, and potential retaliatory measures from global trade partners that may not be priced in or discounted fully. This represents a really challenging environment for traders and investors alike as they assess their current positioning across all asset classes, gauge market sentiment and the likelihood of possible future events leading to spill over effects and unintended consequences. 

Market Reactions and Investor Sentiment

Initial Reactions: Volatility and Strategic Adjustments

Let’s look at the first order effects that the latest round of tariffs triggered on Monday, February 3rd.

The S&P 500 fell 2.5%, led by declines in trade-sensitive industries, alongside the Dow Jones Industrial Average which dropped 2.1% and the Nasdaq which fell by 1.2%. Higher valuation growth stocks in the tech sector were hit much harder as their earnings rely heavily on foreign markets such as China with many semi-conductor and consumer technology stocks down between 4-6%. The bond market retreated with the 10-year U.S. Treasury yields falling 15 basis points, signaling a flight to safety. And other US consumer discretionary stocks, including major retailers and automakers, posting declines between 3-5% due to fears of higher import costs.

We see think that jitters after the U.S. delayed some tariffs, concerns persist over prolonged trade tensions, affecting capital market flows and global risk sentiment ([1],[2]).

Market Sentiment Projection (Next 6 Months)

• 50% Probability: Continued market volatility as trade negotiations remain uncertain.

• 30% Probability: Market stabilization as diplomatic efforts yield incremental progress.

• 20% Probability: Full-scale trade war escalation, driving prolonged equity market declines.

  
  

Economic Implications and Projections

Inflationary Pressures and Federal Reserve Response

The latest tariffs will likely push inflation higher, affecting interest rate expectations and monetary policy:

• Current inflation rate: 2.8%

• Projected post-tariff inflation rate: 3.2% - 3.6%

Oxford Economics estimates that sustained tariff implementation could result in U.S. GDP growth slowing from 2.1% to 1.5% in 2025. Higher consumer prices due to increased import costs could also prompt the Federal Reserve to hike rates sooner than expected, despite previous expectations of a pause ([3],[4]).

Federal Reserve Response Probability:

• 40% Probability: The Fed maintains a neutral stance but signals willingness to adjust policy.

• 35% Probability: The Fed hikes rates preemptively to counteract inflationary risks.

• 25% Probability: The Fed adopts a dovish stance to cushion economic slowdown.

  
  

Sectoral Impacts: Winners and Losers

Industries Facing the Greatest Risks

Automotive Industry (-15% to -20% Earnings Risk)

• Higher costs from North American tariffs disrupt production supply chains.

• Major manufacturers in American OEM’s (Original Equipment Manufacturer’s) face shrinking margins and potential price increases for consumers. ([5])

Technology Sector (-10% to -15% Earnings Risk)

• Companies with deep ties to Chinese manufacturing, could face supply chain disruptions and potential retaliatory actions. ([6])

Consumer Goods & Retail (-8% to -12% Earnings Risk)

• Higher costs on imported clothing, electronics, and appliances could curb consumer demand. ([7])

Industries That May Benefit

Domestic Manufacturing & Industrials (+5% to +10% Earnings Growth)

• Companies that are U.S based industrials may see demand rise due to domestic substitution effects.

Energy Sector (+5% to +8% Revenue Growth)

• Domestic oil and gas producers could benefit from protectionist policies driving local energy investment.

  
  

Potential Trade War Scenarios and Market Reactions

Scenario 1: Negotiated Settlement (50% Probability)

• Outcome: Diplomatic resolutions lead to rollback of some tariffs.

• Market Reaction:

  • S&P 500 rallies 8% to 12%.

  • Treasury yields rise as risk appetite improves.

  • U.S. dollar weakens slightly, boosting exports. ([8])

Scenario 2: Prolonged Stalemate (30% Probability)

• Outcome: Tariffs remain in place, but no significant escalation occurs.

• Market Reaction:

  • Moderate equity losses persist.

  • U.S. GDP growth slows to 1.5%. ([9])

Scenario 3: Full-Scale Trade War (20% Probability)

• Outcome: The U.S. imposes tariffs on Europe, Japan, and South Korea, leading to severe retaliatory measures.

• Market Reaction:

  • S&P 500 declines 15% to 20%.

  • Recession fears intensify as global supply chains fracture. ([10])

Conclusion

The market is currently facing the headwinds of uncertainty, that being said, traders and investors are so far discounting the more severe scenarios discussed in the article. With markets opening higher Monday, February 11, 2025, even as the Trump tariffs on China were set to come into effect Sunday, February 10, 2025. The microstructure of the market is seeing particular support from retail flows, with buy side volume rushing into magnificent seven single stock names. JP Morgan Strategist Emma Wu noted that we have seen “a level reached only 9 times (as of last Friday) in the past 3 years with 5 times occurring this year after the Inauguration”[12].

This tends to be a strong sign of investor confidence, especially as markets digest a better than expected earnings season for the most of the reporting S&P500 companies. However, one thing to note, is that institutional buy side volume has been lacking. We see this divergence as a sign of fragility, as traders pair down and hedge downside exposure. It could be wise for investors to not try and crowd into concentrated positions and look to diversify some of their individual high valuation growth equity positions with less correlated and non-correlated fixed income positions, just in case the market begins pricing in sensitivity to the possibilities of higher inflation, slowing corporate growth and economic uncertainty.