Good morning. Procter & Gamble reported a solid set of earnings yesterday, with sales up 3 per cent. An important milestone: price increases did not contribute to sales growth for the first time since 2019. In consumer goods, at least, the war on inflation feels like it has been won. Email us with other victories: [email protected] and [email protected].
The Magnificent Seven
The Magnificent Seven tech stocks have not had a great month (a good day yesterday aside). Below is the performance of Bloomberg’s Mag Seven index relative to the performance of other large-cap US stocks. The Big Techs have been underperforming since Christmas:
The Mag Seven are such a huge part of the US stock market that a change in their fortunes amounts to a change in the character of the whole market. So what is going on here? It would be most welcome if 2025, and the Trump administration, brings the broadening of US stock market returns that portfolio managers have awaited for so long.
Any time we see a change in stock market dynamics, the first question to ask is whether a changing interest rate environment has something to do with it. In this case the answer to that question is interesting. Here is the relative performance of the Mag Seven going back to January 2024, plotted against the 10-year Treasury yield:
Since the middle of last year, the correlation between rates and the Mag Seven has been rough, but notable. Flat or falling rates have coincided with Big Tech underperformance, rising rates with outperformance. This could be coincidental, of course, or there could be a third factor at work which affects both series. It is true there has not always been a positive relationship between rates and Big Tech performance; in fact, the very opposite relationship — falling rates helping Big Tech — was touted for a long time.
There is, however, a neat explanation for what is going on here. Higher rates reflect worries about inflationary pressures, and therefore tighter monetary policy, which in turn means slower growth. And in a slowing economy, investors want to own companies that do not depend on economic growth for revenue and profit gains. The Big Tech companies fit the bill. The Mag Seven, in other words, have become a flight-to-safety trade.
Reinforcing this interpretation, the sectors that have been outperforming while the Mag Seven have been underperforming are cyclicals. Over the past month, the leading industries have been energy, materials, industrials, and financials. The prospect of a US economy that is boosted by Trump tax cuts and deregulation — but, crucially, is not suffering from inflation — is catnip for all four. The worst performing industry in the past month fits this theory, too: consumer staples and food stocks, the stuff of recession investing, have performed terribly.
A few weeks ago we described the market as being “in suspense” — with uncertainty as the dominant theme. But as cyclicals have continued to outperform the Mag Seven, that interpretation no longer looks as compelling. Growth expectations are taking hold.
More on this (suspiciously tidy) theory tomorrow.
Oh, Canada and Ai, Mexico
Late on Monday, Donald Trump announced he would hit Mexico and Canada with 25 per cent across-the-board tariffs by February 1. America’s neighbours are its top bilateral trading partners. One might therefore expect the threat to spook the market, either by hurting specific companies or by increasing inflation expectations. But the equity market sat on its hands.
The only notable market response was in currencies. The Canadian dollar and the Mexican peso had rallied Monday afternoon, when it appeared tariffs were not on the day one agenda. But they plummeted first thing on Tuesday, and have crawled back up since then:
There is a lively debate on whether or not Trump’s tariffs will be inflationary for the US economy as a whole — with some good points on either side, and some evidence of inflationary fears in the bond market. Unhedged is suspending judgment on this for now. We still do not know the extent of the tariffs or how other countries, in this case Canada and Mexico, will retaliate.
But there are sure to be notable impacts, inflationary and otherwise, on specific sectors of the economy. To start, note that the US’ neighbours are two of its biggest trade partners:
The tariffs will not be a huge drag on US economic growth. Our colleague Chris Giles recently pointed out the US is quite a closed economy, when compared to its developed world peers: US goods trade is only 19 per cent of GDP, versus 30 per cent for the EU, and 53 per cent for Canada. And compared to the massive size of the US economy, exports to Canada and Mexico are small: both are just over 1 per cent of GDP.
If the tariffs go through, the economic pain would be felt more in Canada and Mexico. Stephen Brown of Capital Economics notes to us that Canadian goods exports to the US are worth 20 per cent of Canada’s GDP — 25 per cent tariffs could cause GDP “to fall by somewhere in the region of 3 per cent, triggering a recession”, he says. The impact on Mexico’s economy would also be large: exports to the US are 25 per cent of Mexico’s GDP. “The hit on Mexico’s economy would likely be severe, with a potential reduction in GDP growth by as much as two percentage points,” says Andres Abadia of Pantheon Macroeconomics.
But some US companies and industries will be disrupted. The US is heavily dependent on Canada and Mexico in key sectors, particularly energy and minerals, cars, lumber and agriculture:
The US gets more than half of its imported oil from Canada, but oil markets should settle pretty quickly if trade walls go up. Other markets face harder adjustments. While the US has a big lumber industry and exports much of its own food, it will take time for homebuilders, retailers, nuclear power companies, and manufacturers to rejigger supply chains — especially with the threat of tariffs on other countries in the background. US carmakers have also offloaded a lot of their manufacturing to Mexico; reinvesting in US factories or finding other parts suppliers will take time, too. We’ll hold off on calling the price effects all-out inflation, but transitory price shocks from 25 per cent tariffs seem like a certainty.
The stocks of the biggest homebuilders, carmakers, and grocery chains have barely moved on this news. Commodities such as oil and uranium are down. This may be evidence of the markets having already priced tariffs in, or remaining in a wait-and-see mode. But, if Trump follows through on his threats, we predict the impact extends beyond the currency markets.
(Reiter)
One good read
Far from home.
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