It’s so-called Liberation Day, the day when US President Donald Trump is expected to announce the most expansive trade restrictions in a century. The announcement is slated to take place after US financial markets close but, apparently, his team is still hashing out the details as I write this. Investors have already made up their minds, with bonds trading as if a recession is a major risk and stocks doing their darnedest not to price that in.

Only one side will end up being vindicated — and based on my analysis of investment super-cycles, the ramifications will play out for years. Let’s unpack what’s at stake and how the different markets are priced.

My thinking will go as follows:

1. The bond market actually wants a recession because that will calm price pressures somewhat, helping bond values soar. But maybe today’s bond pricing is simply a reflection of the Fed cuts to achieve a softish landing after tariffs.
2. Equities definitely don’t want a recession. In fact, if you look at the recent rotation in stock-market allocation, it suggests there is a lot of downside risk.
3.  That downside looms larger than we’d like to believe simply because we’ve never seen an experiment with stagflationary macro policy this large. And stagflation isn’t good for asset values.

Maybe the bond market just wants a Fed rescue?

If you want to get a sense of what the bond market is saying about the US economy, look at the two-year Treasury yield. That’s because most economic events that draw a monetary policy response from the Federal Reserve which bond investors can price are packed into that time period.

By that metric, investors have been through some wild shifts in sentiment over the past year. They started last spring convinced the Fed was going to hold the line on the fed funds rate for the indefinite future, only to see those bets crumble as the US economic data deteriorated into a potential recession. The Fed’s outsized half-point rate cut in September turned things around, though. The two-year yield then vaulted higher to signify increasing confidence in the economy (with a hint of inflation worries, too). But as the Trump economic agenda took hold from January forward, we’ve seen yields plummet again despite inflation worries. Right now the two-year yield is about 30 basis points lower than it was on election night in November.

The yield isn’t as low as it was during last year’s recession scare. And a lot of that owes to worries about stagflation. We can see those worries via the difference between the two-year yield and the yield of the equivalent inflation-protected securities (TIPS).

Fed cuts certainly eased recession fears. But they also stoked inflation fears that have become even more pronounced with tariffs looming. The breakeven between normal Treasuries and TIPS is around 3.30% now, which tells you the bond market thinks inflation is going to go accelerate. To give you a sense of the angst here, the last time expected inflation over the next two years was as high as it is today, the then-current inflation rate was about 5%. 

So bond investors appear to be terrified of tariffs because of inflation, which erodes the value of bonds. But investors also think the economy will slow so much that the Fed has to cut rates. Three rate cuts are priced in for 2024 alone, according to the swaps market and fed fund futures. Are bond investors predicting a recession? It’s hard to say. At a minimum, it screams stagflation — slowing growth and rising inflation.

On the equities side of the ledger, I did an analysis of the 1960s for terminal clients at the beginning of the week (terminal link here). One of the key takeaways from that “stagflation-lite” period is that even moderately high levels of inflation are bad for equity investors. From the beginning of 1966 to the end of 1969, the consumer price index increased by 18.4% in total or 4.3% annually. And the S&P 500 was barely changed. Basically, you lost almost 20% in real terms.

Equity investors want nothing to do with “stagflation lite,” if that’s what tariffs entail. And you can see equities already pricing in this possibility, given the steep declines in in March from recent all-time highs that briefly sent the S&P 500 Index into correction territory. Still, the market has retraced some of those losses. And despite a 20% decline in the Mag 7 market leaders, investors haven’t given up on equities as much as they have taken profits and re-allocated some of their investments to more defensive sectors such as health care and consumer staples. For example, the iShares US Consumer Staples ETF (IYK) has gained more than 1% in the last month and nearly 10% over the last three months.

So stocks are saying, “Yes, the economy is slowing and inflation will stay a bit elevated. But we think we avoid a recession. Inflation-resistant stocks are going to ride this tariff stuff out.”

Markets are not priced for downside risk

In essence, the stock market is priced for the best of the four economic scenarios I presented you two weeks ago. And while it’s debatable if bonds are predicting a recession, they aren’t priced for worst-case outcomes. That leaves investors vulnerable to tail risk, that area of outcomes to the extreme left of the curve of potential outcomes. I’d even put this risk at a sizable 15% — far from remote.

To give you a sense of what I mean, look at the valuation of some of the beneficiaries of the rotation. The biggest holding in IYK is P&G, with a P/E ratio of 23 and a price-to-growth (PEG) ratio of 4. Coca-Cola is next with a P/E of 25 and a PEG of 4. Phillip Morris comes next with a P/E of 26.5 and a PEG of 2. So, we’re talking about companies with P/E ratios in the mid-twenties where you’re paying two, three or four times over the actual growth they deliver. That’s not cheap.

The good thing for bond investors is that a high-risk or worst-case scenario is bond bullish. The only question is inflation and the Fed. If inflation is 3% or more, can the Fed really cut, even if the labor market is deteriorating? It’s hard to say. Fed Chair Jerome Powell wouldn’t answer such a hypothetical even if asked. But, there is the risk that tariffs stoke inflation enough to limit the upside on bonds from those higher-risk scenarios. And that means the loss in equities will far outweigh anything bonds can do to compensate.

As we await Trump’s tariff policy, let’s remember that we haven’t seen an economic experiment this large in a very long time. Anything could happen. But basic economics would tell you that US growth is likely to slow as trade slows and the economy adjusts. Tariffs will in some cases make their way through to end customers, resulting in higher prices, too. Stagflation, if only in a mild form, has to be the base case.

More than that though, we have to expect retaliation. Mexico has already said their retaliation policy will land tomorrow. And Europe has also indicated it will retaliate. Between the tariffs, the retaliation and sundry negotiations over tariff policy at a bilateral level, we’re going to see knock-on effects for months if not years. The risk to capital spending in the US is high and I think investors don’t appreciate what that means for a market where equities are priced for only the best-case scenario.

The 1960s is sort of a worst-case scenario for “stagflation lite.” In the late 1960s, inflation around 4% ended with a Fed hike, not a cut — even as growth deteriorated. Decade-long real returns were about -30% at their worst during the 1970 recession. And they only got back to flat as the economy recovered and inflation fell to an intermediate low in 1972. Avoiding stagflation is imperative because, even in a mild form, it means several years of poor equity returns.

How do you compensate for those losses though? Gold, residential property, foreign equities? It’s hard to say. But I will be looking for historical parallels to tell you what I come up with. With that, let’s see what President Trump has in store.

Like getting The Everything Risk? Check out these newsletters:

• Markets Daily for what’s moving in stocks, bonds, FX and commodities
• Odd Lots for Joe Weisenthal and Tracy Alloway’s newsletter on the newest market crazes
• Economics Daily for what the changing landscape means for policymakers, investors and you
• CFO Briefing for what finance leaders need to know

You have exclusive access to other subscriber-only newsletters. Explore all newsletters here to get most out of your Bloomberg subscription.