U.S. inflation slows beyond expectation

Guy Foster, Chief Strategist, discusses Moody’s downgrading of U.S. debt and President Trump’s new tax bill. Plus, Janet Mui, Head of Market Analysis, analyses fresh U.S. economic data.

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The equity rally continues

Source: LSEG Datastream

The S&P 500 reached its all-time high on 19 February – just three months ago. Since then, the market has been on a wild ride. The S&P 500 dropped nearly 8% between Inauguration Day and ‘Liberation Day’ (2 April).

When ‘Liberation Day’ came along, the confusing announcement of tariffs on every country America trades with – with rates varying between punitive and catastrophic – was taken poorly. The S&P 500 lost a further 12% of its value. Other global markets did better but still reacted negatively to the news.

Since then, U.S. President Donald Trump has announced the deferment of the most painful individual tariff rates, causing a sharp rally. China was hit with effective embargo tariff rates of 145% and the promise of additional curbs on the semiconductor supply chain, but a sharp decline in this tariff rate was announced last week.

President Trump now plans to overhaul the broad ‘AI diffusion rule’ implemented under former President Biden. The rule organises countries into three tiers, which all have different restrictions on whether advanced AI chips can be exported to the country without a licence. It seems that he plans on replacing it with individual deals negotiated with countries, however, the use of Chinese technology such as Huawei’s Ascend AI chips could prevent such agreements.

President Trump has been negotiating chips sale agreements with some Middle Eastern countries. The semiconductor deal-making continues to drive a huge rally in related stocks, which has been aided by the general equity rally and change in tone on trade.

All this leaves the U.S. equity market 4% above its ‘Liberation Day’ level, and just 4% away from a new all-time high.

Foreign exchange markets have seen less relief. Since Inauguration Day, the U.S. dollar has slipped 5%. Since ‘Capitulation Day’ (when President Trump deferred the higher individual tariff rates by 90 days), it has rallied 2%.

Investors shouldn’t forget the reasons for a widely-held overweight position to U.S. stocks. Some U.S. companies are exceptional and offer unparalleled access to the technology and AI-enabled changes that will transform the economy over a few years. But they should remain aware of the damage done to America’s reputation as a trading partner. Investors will rethink allocations to U.S. assets, while reserve managers will rethink the need to hold U.S. debt. Small changes here can have big implications.

This cocktail could allow the Federal Reserve to cut interest rates, but for now, it will want to see more evidence of modest inflationary pressures.

Trump trades are reversing

In addition to the above, other fallout from ‘Liberation Day’ has been dispersing. A hot topic is gold, which has shown signs of slipping following two failed attempts to decisively breach $3,400 per ounce.

A mellowing trade war is bad news for gold, but the seemingly intact trend of diversifying away from the U.S. remains supportive. After the enormous rise, a consolidation seems healthy.

Last week, bonds benefitted from the ebbing of inflation concerns due to reduced tariffs. The picture is very complicated with regards to U.S. treasuries, as they must balance worse inflation and worse growth. In addition to this and the potential reduced demand from overseas buyers, there’s also the prospect of changes in bond issuance.

The U.S. House Committee on Ways and Means (the Committee), which is responsible for writing tax law, released draft legislation last week. Although not all these proposals will become law – final legislation needs to be approved by Congress before going to the president to sign – it’s worth looking at what’s contained in this blueprint. By far, the costliest part of the tax package is the ten-year extension of the individual rate reductions, which are set to expire this year.

The Committee also included President Trump’s unorthodox tax cut promises of no tax on tips and no tax on overtime in the draft – but these are planned to last for only four years. President Trump had also promised to end taxes on Social Security benefits, but this has instead provided for a so-called ‘enhanced deduction’ for seniors on top of the regular tax deduction. The proposal also calls for no tax on car loan interest. 

To offset the costs, the plan proposes reducing the state and local tax (SALT) deduction limit, which is currently capped at $10,000. Some Republicans from high-tax areas are likely to push back, as they favour higher deductions. The plan also eliminates several clean energy tax credits introduced under President Biden, including the $7,500 electric vehicle tax credit. Notably, it retains the current top tax rate of 37%, contrary to President Trump’s recent suggestion to raise it to 39.6% for those earning over $2.5 million annually.

Overall, the plan increased the deficit by $3.7trn over a decade. It could be bolstered if the administration can restrict Medicaid coverage, and there will be benefits to the Treasury from funds raised by tariffs, but they’re not scored because they’re emergency measures rather than legislative ones.

Similarly, savings through the Department of Government Efficiency will reduce federal costs, but as the funds being saved have already been approved by the government, the administration is theoretically required to spend them. If these savings can be made to stick, that can be considered in future appropriations.

The outlook for U.S. fiscal policy is far from clear three months into the Trump administration’s mandate, and the quick win it sought continues to look elusive.

The economy remains robust

Source: LSEG Datastream

Is the U.S. economy reflecting the extreme pessimism from consumers? Yes, to an extent.

Retail sales growth was muted but hardly collapsed. There was weakness in some sectors, particularly those affected by Chinese tariffs which, prior to their relaxation, had been acting as an embargo rather than a tax.

Audio equipment and electronics saw sharp increases in prices when Consumer Price Index (CPI) data was released. Audio equipment prices rose almost 9% in a month, which was easily the highest increase going back to the beginning of the data series in 2009. 

Retail sales data showed a slight increase in spending on electronics, which suggests that people have bought fewer goods for more money. In other categories, inventories are still masking the impact of measures. At a headline level, weak services prices – reflecting caution from U.S. consumers – are holding prices down.

Coming up this week

• UK inflation: CPI and Retail Prince Index (RPI) data are released on Wednesday. Sadly, prices will lurch upwards due to increases in utilities bills. These increases in non-discretionary spending can sap discretionary spending and are therefore difficult to interpret for the Bank of England’s Monetary Policy Committee. If there’s weakness in other categories, it may still enable further cuts.
• Purchasing managers indices: A further health check on the corporate sector around the world seems set to remain downbeat – particularly with regard to the manufacturing sector. But are services maintaining momentum?

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