Amy Xie Patrick: How tariffs, inflation and China’s ‘anti-involution’ policy are affecting portfolio decisions

Tariffs will show up either in inflation or corporate earnings — but the implications are starkly different for portfolio decisions, argues Pendal’s head of income strategies AMY XIE PATRICK

• Three straight quarters of falling earnings growth in the US
• Key watchpoints: contract-roll offs, earnings revisions, China’s Politburo meeting
• Find out about Amy Xie Patrick’s Pendal Monthly Income Plus fund

TARIFFS will show up either in inflation or corporate earnings — but the implications are starkly different for portfolio decisions.

Despite higher input costs from new tariffs, US consumer inflation has barely budged.

The reason? Contract lags in supply chains and Chinese producers absorbing the pain. The first offset may not last — but markets have yet to price in what happens if they do.

That’s why Pendal has already booked profits and dialled down risk in our income strategies, including trimming equity allocations.

With market optimism still running high, the risk-reward is less compelling, so we’re keeping our powder  dry for better entry points.

Tariffs and inflation: the missing pass-through

Since Donald Trump’s “Liberation Day” in APril, tariff pass-through into US CPI has been far weaker than most expected.

Historically, US inflation surprises and actual inflation have moved together (see the graph below). This time, they’ve diverged sharply.

Where are the tariffs?

Purchasing manager surveys show input prices rising (see below)  — a sign that tariffs are indeed biting at the producer level.

Normally, higher input costs push up consumer prices. This time, the relationship has broken down.

Feeling the pressure: Purchasing managers on input prices & US CPI

One likely reason: existing contract prices in supply chains. Sellers may want to raise prices, and buyers may be willing to accept them, but until contracts reset, pass-through to CPI is limited.

This delay won’t last forever.

When contracts roll off, either producers absorb the cost hit or they pass it on. Either way, corporate earnings are at risk.

While the current earnings season for the S&P 500 has been solid, the trend is heading down: three straight quarters of falling earnings growth, as you can see in the graph below.

The market has yet to price-in the “pinch”

China’s ‘anti-involution’ policy: a structural challenge

It turns out Chinese producers have been absorbing a lot of the pain, and since before Trump’s election odds were sealed in 2024.

China’s Producer Price Index (PPI) has diverged from commodity prices, suggesting heavy discounting even as input costs rise, as you can see below.

Heavy discounting

This points to a bigger structural problem: overcapacity.

In solar panels, China’s supply is more than twice global demand. In EV batteries, supply exceeds demand by 30 per cent — figures highlighted in a recent Morgan Stanley report.

Beijing’s “anti-involution” policy — essentially, a campaign to stop companies from undercutting each other — faces an uphill battle when too much capacity is chasing too little demand.

(Involution refers to a state of intense, often unproductive competition that leads to diminishing returns and economic stagnation.)

As China struggles with deflationary forces, the US may continue to see muted effects from tariffs in CPI.

Bottom line for portfolios

Whether tariffs show up in US CPI — and for how long — matters for both bonds and equities.

If bonds fear a more serious inflation problem, it also won’t be good news for equities.

On the other hand, if US corporates fail to pass tariffs on for whatever reason and margins become compressed, the near-term implication would be a pull-back in equity markets.

After all, analysts have maintained expectations for earnings growth to accelerate in coming quarters.

Key watchpoints include contract-roll offs, earnings revisions and China’s upcoming Politburo meeting.