Tim Hext: Art of the deal or new world order?

So far US tariffs are a mixed bag for bonds. But understanding Trump could help investors navigate markets, writes Pendal’s head of government bonds, TIM HEXT 

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PRESIDENT TRUMP’s “reciprocal” tariffs caught many – me included – by surprise last week.

Until then, I mistakenly believed tariffs were all part of the art of the deal.

Tariff talk, which was seen as a tactical ploy to get a better deal for the US, suddenly seemed to have larger ideological aims. How else can you explain the ridiculous calculation method for reciprocal tariffs?

There is still a lot of water to go under the bridge in the weeks and months ahead as negotiations go bilateral – but understanding Trump (always a difficult exercise) will help navigate markets.

When China entered the World Trade Organisation in 2001, the US trade deficit with China was $84 billion. The US had a $300 billion deficit overall in manufacturing. Over next two decades, the manufacturing deficit grew $1 trillion to $1.3 trillion by 2022.

China accounted for almost $600 billion of this growth.

Overall, this was seen as a win/win. China got to develop on the back of hard work and exporting to the US. And US consumers got plenty of cheap goods from China, protecting a standard of living in the face of slow wage growth.

The bonus for the US was that in an attempt to keep its currency lower, the Chinese government bought US dollars and became huge buyers of US Treasuries. Its FX reserves went from $300 billion to over $3 trillion during this period.

Let’s not forget the most important thing: since 2000, around 500 million Chinese people have emerged from poverty to middle incomes.

By 2018, however, geopolitics started to kick in. As China started to flex its muscle globally, not all in the US were happy. The narrative began to change.

In his first term, Trump launched a trade war with China, causing negative equity returns. Helping the Chinese economy was now seen as a negative, not a positive.

That trade war now seems tame. It seems the narrative from Trump is effectively that the US can handle some pain if it means achieving a longer-term new world order. The US will retreat back to some supposed golden age. Time will tell.

Implications for bond markets

As evidenced this week, all these actions from Trump are a mixed bag for US bonds.

Firstly, economic weakness should mean Fed cuts and rallies in bonds. However, tariffs will mean higher inflation – at least near term.

Throwing more confusion into the picture is foreign buying (or more likely selling) of US bonds. Smaller trade deficits mean smaller capital surpluses and therefore, at best, smaller inflows into US capital markets.

Where it gets more interesting, though, is the weaponisation of financial flows – not just trade flows. Rumours have been circling that China is dumping part of its US Treasury holdings.

Other countries may follow – after all, like any investments, you want to know the CEO knows what they are doing, and simply put, credibility and confidence has evaporated. Who would want to lend money to an entity that is acting so aggressively against your interests?

Therefore, the flight to quality is more of a flight to cash and short bonds, not long bonds. Yield curves are steepening faster than economic fundamentals suggest.

It was only late last year when US exceptionalism became the investment theme for this decade. That exceptionalism remains but is quickly being redefined from a positive to a negative.

Implications for our portfolios

We have been leaning into duration for a number of months, but are very disappointed by the lack of a reaction from our long end. Short-end duration has worked, but unlike Covid and the GFC, the long end has been left behind.

The RBA will also be cautious.

The expected low CPI print on 30 April will give the central bank cover to cut at its 20 May meeting, but unless it keeps getting worse, its recent form suggests only a 25-basis-point (bps) cut.

It will then adopt a wait-and-see approach for how it all impacts Australia. But given there are six weeks till then, markets are right to price some risk of a larger cut – though, current levels of 40bps of cuts looks a little too much.

The random nature of announcements mean we are generally keeping risk close to home. Our caution around credit means we are avoiding the major drawdowns that will be hitting more aggressive investors.

Now is not the time to charge in. However, we are still looking for relative value opportunities in a volatile market to keep adding value in these stressed times.

Liquidity

And just like that – liquidity in many sectors dries up in a puff of smoke.

Our portfolios at Pendal Income and Fixed Interest have always operated at the more liquid end of markets. We leave the less-liquid, high-yield chasing to others.

Government bonds remain highly liquid. Semi-government bonds are hanging in there though bid/offers are widening. You can transact senior bank paper assuming manageable size and paying a wider spread.

However, as we have often warned, beyond there it gets very tricky.

Everything is liquid in good times, but it is a shortlist in a time of crisis. The RBA sets the liquidity rules and its world is one of cash, bank bills/NCDs and government bonds (all known as High Quality Liquid Assets).

These remain open for business, but beyond that point, it is buyer-beware for liquidity.

About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

About Pendal

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

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