Quick market update (17 March 2025) Contractionary Fiscal Policy vs Tariffs + favorable positions

Markets have seen the fifth-fastest drawdown in history, with the S&P 500 falling 10% and the NASDAQ falling 13%. Tariff war fears, weakening consumer sentiments, and austerity are causing enormous uncertainty in the fundamental health of the US economy going forward. Whether the quantum of this initial drawdown is justified or not, there is truth to these concerns, and they should be taken seriously. Mexico and Canada are the US’s largest trading partners, and Trump has proven he is hell-bent on rebalancing the trade deficits to bring back domestic manufacturing. Concurrently, Elon Musk and his DOGE team are performing internal audits of the federal government in the pursuit of cutting wasteful costs and corruption by $1 trillion and improving the efficiency of the American bureaucracy, which has arguably been left unquestioned for too long. These momentous efforts constitute generational shifts in fiscal policy that will be written in history books. Along with other factors such as a historically overvalued market and euphoric activities in high speculation trades, we suggest increasing hedging exposure and even tilting towards a negative beta portfolio as the market recovers from the recent breakdown.

The March drawdown wiped out all gains in the S&P 500 and NASDAQ since Trump began his candidacy on November 5th, 2024, now even below the pre-election levels. We believe this is an initial overreaction; let’s look at the technicals: RSI for the SPY dropped below 30, seen notably recently in the 2022 bear market; price level has broken far below the 200-day EMA, VIX spiked to the 30s and made higher highs. Recent history exhibits that when these conditions happen, the market will definitely experience a short-term recovery. But what we cannot predict is whether this will end up being a dead cat bounce (Jan 2022) or a correction in a longer-term bull market (Sept and Oct 2024), urging caution in our investment strategies.

To decide where to go from here, we should dissect both the fundamental head and tailwinds the US is facing and will face going forward. For context, in my 2024 H2 Outlook, one of the main points I hammered was the overextension of interest rates. I put forward that inflation was largely transitory and exacerbated by intangible factors. From the CPI breakdown, the convenient conclusion to draw is that free money made everything more expensive. But in summary, the specific causes of inflation were primarily overworked supply chains and energy policy, with supplemental stimulus from monetary and fiscal policy. Energy cost increases affect the marginal cost of doing business thoroughly by increasing manufacturing and supply chain costs at every value-adding step, meaning that goods become exponentially more expensive. This is one of the main reasons the Trump administration focuses on reducing energy prices through promoting energy production and cutting regulations. The stickiness of inflation is partly psychological and partly due to a new rung of fiscal spending.

Despite a 1% decrease in rates from our previous post, the likelihood of the economy adapting to a 4.5% federal funds rate, let alone a 5.5% rate, without a necessary economic restructuring is diminishing day by day. Consumer spending has been sustained by fiscal spending, buy now pay later schemes, and sticky employment due to the lagging effects of rising interest rates (The US is slowly riding down the vertical section of the Phillips curve). As time progresses in a relatively expensive borrowing market, the economy's vulnerabilities will become increasingly apparent. Existing debt rollovers and new debt seekers will feel the strain of high asset prices coupled with high debt costs. Ongoing efforts in austerity from the swift execution of government spending cuts by Trump and DOGE significantly accelerate short-term pain.

While tariff-driven inflation is a topic of frequent discussion, the potential risks are quite contained. Although tariffs in a vacuum could trigger inflation, the existing context of one-way tariffs against the US and substantial trade deficits suggests that the reciprocal tariffs set to be implemented in April are more of a balancing act than an overexertion. Moreover, the deflationary effects of fiscal tightening and mass deportation carried out in the same period will counterbalance any inflationary pressures that may emerge.

I maintain the position from our H2 Outlook 2024 analysis that the equity markets are running too hot. Given the fundamental factors, especially the large target reductions in government spending, along with the technical indicators mentioned before, the S&P 500 earnings ratio looks to be past the peak of its cycle. Take note we often neglect the Earnings as a denominator in the ratio. Tariffs and weaker consumer sentiment are headwinds against spending (consequently corporate revenues, spending, and CAPEX).

**S&P 500 forward PE Ratio**
Source: MacroMicro

Everything at this point signals a short-term bounce to slightly above 200-day EMA levels until the end of March. At that time, it would be advisable to increase hedge positions (discussed below). If aggressively bearish, one should also look to lower the market beta on the portfolio by a vigilant shorting of high-growth and speculative assets. (Quantum computing and other momentum sectors)

Adding to our defensive stance provided back in our H2 Outlook 2024, we recommend tilting towards a neutral and even negative beta strategy. The positions listed below constitute some ideas designed to shield investors from weakening consumer sentiment and a softening economy.

I would add a comment that at this stage, we downgrade U.S. investment-grade bonds to Neutral. The new administration's zealous policy implementation justifies a larger risk premium and, thus, a larger credit spread all around. What we believe will likely happen is that high-yield and investment-grade bonds stay at roughly the same rates or even inch slightly higher while US treasuries drop in yields and increase in pricing.

Position Idea 1 (medium term)- CHF Leveraged Long on IEF/TLT (5, 7, and 20+ year treasury)

The underlying philosophy behind the trade here is a US high-yield credit spread widening and interest rates declining view. There are multiple ways to do so, but we simplified it to a leveraged long position on TLT and IEF. Though it is a second-order trade, it captures the more salient points that will be discussed further down.

We recommend leveraging the position to capture the price appreciation potential given to us in the form of a historically low price base presently. Leverage should be obtained in Swiss francs to take advantage of lower lending rates and a rather safe haven currency. This position focuses on duration playing its role in providing price appreciation from changes in interest rates while harvesting incremental coupons. At the same time, we think the exchange rate risks are limited; a US dollar devaluation means a dovish fed and falling interest rates, which we benefit from in price appreciation of our long treasury position.

The higher conviction trade is to complete the other end of the trade by shorting US high-yields, but take note: the interest cost associated with shorting high yielding fixed income products and the spread cost for purchasing the CDS reduces the risk/reward to the trade, and if we are truly moving toward an increasingly uncertain environment, the widening of the risk spreads will be contributed mainly from the treasury yields dropping. In the scenario that the US economy experiences only a relatively minor slowdown in growth, high-yield yields may stay where they are while credit spreads widen and treasury rates drop, nullifying any benefit of the short position. High-yields also have generally been reweighing to higher-rated companies over the past few years; BB- rated has increased in proportion compared to CCC rated and below.

On the other hand, in an immediate total recession, this two-sided trade will yield a higher return.

The thesis behind this position has two significant rationales: 1) the Fed will cut the federal funds rates in the face of an economic slowdown and low inflation. 2) fiscal policy uncertainty grows even larger as tariff wars and austerity take actual shape. In addition to that, we have not seen spreads so thin in the past 18 years. The fixed-income markets are still largely pricing stability.

**BofA US High Yield Index Option-Adjusted Spread**
Source: FRED

Federal fund rates of 5.25-5.5% and even now at 4.25-4.5% are not sustainable in the long run. CPI in February came much cooler at 2.8%, closing in on the inflation target of 2%. As discussed above, inflation risk from tariffs is highly limited to various other deflationary forces.

During the previous bear market downturn in 2022, TLT and IEF had a positive correlation with the S&P 500 and lost almost as much as the equity index, but if we analyze the pivotal variables, this phenomenon is unique to that market. It occurred as a function of an overheated economy and uncontrollable CPI prints that forced the Feds to turn aggressively hawkish and cool down stimulated demand birthed from considerable monetary and fiscal easing. Rising risk-free rates reduce prices of related fixed-income instruments and simultaneously reduce valuations of equities as a result of higher discount rates. We are now sitting on the other side of the fence.

Depending on its proportion to the portfolio value, this trade could either be used as a directional bet or a hedge to a beta-positive portfolio. In my opinion, positions in equities should be reduced starting at the end of March, and this trade should be taken during that time.

Position Idea 2 (long term) - Cash-secured puts/Covered Calls on Reddit Inc

Reddit Inc. is poised for significant growth in the next 5-10 years. While its share price was not attractive when it was over $200, the recent market volatility and drawdown have created opportunities (such as the two-week drop to $110 levels) and will continue to do so in the coming months. Our discounted cash flow model, which discounts ARPU and DAU growth (12% and 17% YoY, respectively) to recent quarters, removes SBC from free cash flows and uses a reduced forward market EV/EBITDA multiple, generates an equity value per share of $155. Any levels below $100 present an excellent buying opportunity for the long term, either through the gradual exposure to covered calls or by selling cash-secured puts on significant drawdown days.

Reddit Inc. stands out in the social media landscape with its potential for significant DAU growth. Currently, at roughly 100m, CEO Steve Huffman has set a 500m target for the near future. For comparison, Twitter/X’s DAU is estimated at 200m, but Twitter generally leans towards US markets, while Reddit’s community is undergoing healthy growth in its international user base. I anticipate Reddit taking more initiatives to improve shareholder returns, either through future monetization to increase ARPU (by beginning to add premium services or pay-wall locked features) or by simply buying back shares to offset SBC and accrete per share value.

Reddit began its footprint roughly two decades ago as a casual comedic forum. But as an avid user myself since 2012, to see the platform grow and mature into one that hosts the endless curiosities that exist in the world we live in, whether it be to find out how to repair the infotainment system of a 2014 Prius or to discuss the unending theories on the birth of the universe, has been an incredibly impressive and fascinating journey. You will often see Reddit users with a 10+ year badge roaming around all sorts of subreddits, pointing to the capability of the platform to attract and maintain a loyal user base.

This communication platform has become the largest database of opinions, reviews, and cultures structured in a format that accommodates any and every sort of individual. Many of them have captivating experiences from distinctive parts of the world and spend hours of their day feeding them to Reddit. Some simply want to share their life stories, while others would like to market a niche product from their newly established business in subreddits. You will often see passionate users respond in great volumes to those posts, especially when the topic speaks or challenges their beliefs, and make an effort to either agree or disagree through their own perspectives. Collectively, you get an amazing amalgamation of information that effectively could provide someone in the future with a fairly detailed representation of the post-internet boom culture.

Position Idea 3 (medium term) - Long Gold/Silver

Gold and silver, which have performed remarkably over the past five years, even outperforming the S&P 500 three of those years, offer another effective hedge against volatility. In addition to their historical track record as negative beta assets, gold and silver perform exceptionally well in times of a dovish Fed. The chart below provides a clear comparison of the returns on the major asset classes, reaffirming the potential of gold and silver as a reliable hedge.

**Annual performance of 7 headline asset classes**

In 2020, we experienced rate cuts to 0% from a 2.5% base level while gold performed well. But the precious metal lost its way in 2021. One of the reasons for this lag is the euphoria of investor sentiment resulting from enormous fiscal and monetary expansion. Investors in 2021 were fully risk-on, as seen obviously from ridiculous multiples given to companies like Peleton, Snapchat, and various SPACs.

Gold and silver have proven to be a great asset in distressed times. If the base case is an economic slowdown and rate cuts (which, in our opinion, it is), Gold hedges against both those risks well, along with treasury bonds.

Looking historically, we can compare how previous rate cycles have impacted the price of gold and silver, and determine if an opportunity can be captured between the two products.

Gold Futures (Blue) vs. Silver Futures (Purple)
Federal Funds Rate (Gray, Left Scale)
Source: TradingView, COMEX, Fed

First and foremost, prices of these commodities rise far after a rate-cutting environment. We can safely assume that the prices of these will not fall far below current levels, even though both have experienced a decent price appreciation (favored towards gold) over the past year. But zooming out and adjusting for the large increase in money supply, they have increased fairly comparably. In the coming volatility and paradigm shift, we could see the Fed turn dovish to cut rates and protect the economy from a recession and see the federal funds rate drop to the 1-2% range.
The second observation is the divergence and convergence in performance between the two. Over the past twenty years, the returns on the two precious metals have seen convergences in times of recovery and stable periods (2013-2018, 2021-2022) and divergences in times of volatility (2007-2011, 2019-2021). Gold has had a strong head start over silver in the past two years since the peak of the federal funds rate, giving investors a potential convergence trade through a simple long in silver or a pair trade.

Position Idea 4 (short to medium term) - Calendar spread on VIX futures

Another directional trade to benefit from an assertively bearish outlook on the US economy, specifically that we will experience a dead cat bounce in the near term, would be to take a position on the VIX curve. The 1-month forward VIX has already softened from its $30 peak to $20; any levels around $18-19 would be an opportune time to long the 1 month and short the 7 month. This trade will need to be closely monitored for changes in the curve itself, economic data, leverage sizing, and volatility. At current levels the first month rolling costs for the VIX are roughly 2.5% for the 7-month period to November.

Position Idea 5 (medium term) - Short on the shipping sector

I was bullish and long chemical and liquid tankers in 2022, citing that spot and TCE rates will remain elevated for a while as a result of the trade route disruptions caused by the Russia-Ukraine war, new emission regulations in shipping, and the passing of the long-term 10-year trough experienced by the shipping sector post-GFC. However, several factors have surfaced that provide us evidence the sector will return to its underperformance in the coming years.

The sector has seen a massive leap in the ordering of new vessels, both in dry and liquid goods, induced by windfall profits lately. Coupled with Trump's efforts to resolve conflicts across the globe and lubricate trade routes, we foresee headwinds and material challenges for the sector going forward. The deglobalization trend perpetrated by the new administration is also worrying for cross-border trade volumes. Thus, we think a short position in the sector through non-dividend paying and highly leveraged shipping stocks will be a high-risk, high-reward play in the next two years.

Stay clear of risk-on

We advise against being swayed by short-term price fluctuations, particularly in the case of risky equities (tech) and speculative sectors. Instead, we recommend maintaining a defensive stance until the Q4 economic results this year. It's crucial to closely monitor economic data, policy changes, and earnings during this period, as they will provide valuable signals for a change in positioning.

Contractionary fiscal policy will have a larger impact on price levels than reciprocal tariffs. Markets seem to neglect this and fixate on one side of the action. A 20% target reduction in the 2024 US trade deficit means $140B, 50% is $350B. Assuming the tariff costs are shared 50/50 between importer and exporter, that is $70B and $175B, implying a 1.7% and 3.5% price increase on 2024 goods imports. In comparison, the U.S. government spent $6.75T that year. DOGE has claimed it has already cut $115B from spending and targets $1T in 2025. Even if we discount that, we are looking at a number far more significant than the effects of tariffs can even reach, especially taking into account the multiplier effect.

If there is one key point to take away from this article, it’s to remember CONTRACTIONARY FISCAL POLICY. For decades, the U.S. government has handed trillions of dollars into the economy; a reversal in mindset and action of this extent by the Trump administration has not been seen since the Bill Clinton era. Sticker inflation could be attributed to fiscal overspending funded by cheap money.

High-quality fixed income and a shift toward negative beta are poised to shine in the upcoming quarters. Investors should consider adopting a risk-off mindset until mid-2026, with the reassurance that these strategies hold in times of a slowdown.