The Trade Deals That Could Calm Wall Street

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Investing Insights is helping investors navigate market volatility in a new series. Morningstar strategists and authors will deliver timely insights, trends, and tips. And these episodes will pop into your podcast feed at least once a month.

We’re about one third of the way through President Trump’s 90-day tariff pause. Uncertainty has overwhelmed investors since the US escalated import taxes on trading partners, including fellow global powerhouse, China. Joining me on Investing Insights is Morningstar Wealth Chief Multi-Asset Strategist Dominic Pappalardo. We discuss the anticipation for trade deals, a new target for tariffs, and a potential risk to the bond market.

Thanks for being here, Dom.

Dominic Pappalardo: Good to see you again, Ivanna.

What a Potential Trade Deal Between the US and UK Means for Market Sentiment

Hampton: Just this morning, President Trump says that the US and UK agreed to a trade deal. This would be the first agreement with a trading partner since the tariff pause. Talk about what this mean. But before you say anything, let’s time stamp this moment. It is Thursday, May 8, just before 10 a.m.

Pappalardo: Yep. Yes, so far we’ve really only seen headlines about the deal. I don’t think we’ve seen any of the details yet, so it’s hard to really analyze it too specifically. There’s no doubt, though, striking a trade deal with any major trading partner is positive progress, so to speak. I’m not sure the UK is going to have the biggest impact. I’d say we have limited trading with them relative to some of the other countries, like China or some of the developing-market countries.

But still, there’s no doubt that seeing a deal get put in place, seeing negotiations actually materialize into a resolution, would be a very positive signal for both the market participants and really the economy in general. So I think the sentiment of a deal announcement is more important than the actual details of the specific agreement.

What Countries Need to Strike a Trade Deal to Calm Wall Street?

Hampton: And which other countries do you think the US needs to strike deals with, in addition to this one, to calm Wall Street?

Pappalardo: Yeah, certainly China’s the largest player in this conversation. I do speculate a bit that perhaps the administration wants to strike a number of deals with less important countries first, because they may feel that gives them leverage against China in that major negotiation. So I think it’s, from the administration’s point of view, if they could go to China and say, “Look, we struck deals with these 15 other countries. You’re missing out,” they may view that as additional pressure they could apply to the Chinese and maybe swing that negotiation toward the favor of the US. But really China is going to be the major issue going forward. And I suspect we’ll find some middle ground with many other countries. Perhaps even more lengthy delays of implementation could occur as negotiations transpire. But certainly China’s the one that matters the most.

What Persistent High Tariffs and Falling Imports From China Could Mean for the US

Hampton: And speaking of China, the US and China have not lowered their high tariffs against each other yet, and there are concerns that fewer cargo ships from China will dock at US ports. What would that mean for businesses, retailers, and consumers?

Pappalardo: It really depends how long that situation persists. So there’s...I think it’s factually accurate that less shipments are coming in. We know that. However, if you look at the details of the Q1 GDP report from 10 days ago or so, there was this tremendous spike in net imports in the first quarter of this year. So that implies a lot of businesses and consumers were front-loading import demand, trying to get ahead of tariff implementation. So there might be some slack in the system where inventories were sort of artificially built up in Q1 that could be depleted in Q2.

Now, if there’s still no trade deal with China or any progress as we move through the second quarter, I think there’ll start to be material impacts. You could certainly see things like supply shortages, price increases. Really, the biggest challenges for importers are probably scrambling to find alternate suppliers right now. And I think that’s a product-specific conversation. I don’t know how long that takes, but I suspect there’s a lot of time and energy being spent by importers trying to find alternate suppliers to move away from China at the moment.

How Japan Moving Out of US Treasuries Could Rattle the Bond Market

Hampton: Let’s focus on another US trading partner. Japan is a big holder of US Treasuries and warned that they could sell them. Could other nations use this negotiation tactic, and what risk could this pose to the bond market?

Pappalardo: Sure. I think it’s a real risk. I think, as countries try to use that as leverage in negotiations, it’s something that the US should take seriously. The US issues a lot of debt. There’s a lot of debt outstanding, and there will be a significant amount of issuance going forward. Perhaps even increased issuance going forward.

So it’s not so much about them selling what they have. It’s who’s gonna buy the newly issued debt that’s forthcoming. So to me, that’s the, the more precise concern. Obviously, if a country like Japan starts selling their current holdings, they’re probably not going to jump back in and buy more as the US issues more Treasury debt. So to me, that’s the specific risk associated with it.

If that were to materialize, that’s going to push interest rates in the US higher, and that has an impact to both the government and consumers. It’s bad for the government because they’re running at a large deficit. So if their interest cost on that deficit increases, it sort of compounds the negative impacts of that deficit. It’s unlikely that we do away with the deficit in the short term. That’s a very long-term project, and the administration has hinted that that might be a long-term goal, but that’s relatively far down the road before that could actually happen.

From a consumer perspective, higher interest rates increase all of their borrowing costs as well, so things like mortgage rates, auto loans, student loans. If US Treasury rates rise substantially, that’ll flow through to all of that consumer lending and consumers will have to pay more to usefinancing options.

How Trump’s Tariffs on International Movies Could Affect the Services Sector

Hampton: And President Trump says his administration is investigating whether you can impose taxes on movies being made out of the US. This would be significant since current tariffs are targeting goods instead of services. Can you explain what this pivot would mean for the service sector?

Pappalardo: Yeah, I don’t think we know yet. I think it’s pretty difficult to understand how you would apply a tariff or an import tax to a movie, because it’s not a hard good. You can’t count it, you can’t measure it, you can’t ship it. So I’m not sure how the mechanics would work. I think the better part of that discussion is why are movie studios and producers filming outside the United States?

So if the goal is to bring them back into the United States, let’s think about why they’re not doing that currently. Sometimes it’s simply location, right? If a movie scene needs a certain backdrop, you may not be able to find that efficiently in the US, so you may go abroad to do that. So that’s kind of a simple one. Because I’ve read about it a bit more, labor costs in the US tend to be 30% or 40% higher than some international locations, and many foreign countries offer tax subsidies to support movie production locally. So the US is fairly significantly higher cost to do that in today. Adding tariffs would maybe balance that out a bit, but all it’s doing is raising costs. It’s not providing any motivation or positive incentive for movie studios to keep more production here.

So if the goal was to bring production back on shore, there may be more-efficient ways to do it through other tax policy or trying to understand why labor costs are so much higher here than foreign locations.

How Tariff-Induced Market Volatility Affects the US Dollar’s Strength Globally

Hampton: I’m sure Hollywood will send a lot of ideas up the way. The US dollar was declining months before the April 2 tariffs came into place. What’s been driving the dollar lower, and what does the US stand to gain or lose if the levies remain in place?

Pappalardo: Yeah, the strength of the US dollar has been somewhat synonymous with what we’ve seen in the stock market. Stock market has been on a-- let’s just say--a three-year bull run where stocks went straight up coming into this year. Certainly, there were some bumps along the way, but up substantially over the last few years. The US dollar followed that path, so the US dollar gained strength against foreign currencies over that period. So in some ways, it’s just kind of a natural fluctuation and pullback of markets. After you have a very long run trend one way, it’s not uncommon for it to reverse and come back a little bit. But more specifically, there is concern about the stability within the US, and, as you said, that happened before “Liberation Day” announcements in April, but certainly the announcements in April accelerated that concern globally.

So the US has benefited from being the global reserve currency. You know, the biggest kind of test of that is oil is traded in dollars, so that’s kind of the one universal commodity that all economies rely on. So that’s been a benefit. I don’t think that’s going to change. I’m reasonably confident the US dollar will remain the global reserve currency. So that’s a bit of a backstop. In other words, the dollar can only move so far down and can only be so volatile as long as it maintains that global reserve status.

Other countries have mixed feelings about trying to take over that reserve status. There’s certainly benefits that come from it, but there’s also negatives because local governments and central banks tend to lose some control over the fluctuations on their currency once it becomes the global reserve. So the US has made that concession to say, “We want the stability and the volume and transactions in dollars, knowing we’ll give up some ability to control the fluctuations in the value of the dollar.” So I don’t think that’s gonna change materially. Sure, you could see relative price fluctuations compared to other currencies over time, but I do think there’s a bit of a backstop. It can only fall so far.

Has Market Volatility Made the US a Risky Bet for Stock Investors?

Hampton: Do you think investors, particularly stock investors, do you think they think the US is a risky bet right now? Because the stocks have been bouncing up and down lately.

Pappalardo: Sure. Risk has to be relative to something. So if you’re a stock investor, you’re, by definition, willing to take on some measure of risk and volatility with your investments. So is the US more volatile than other countries? Perhaps. Is it less volatile than a lot of other countries? Yes, I think that’s still true. We have a very active central bank that has proven they’ll backstop the economy and markets when true crisis events happen. Many other countries don’t have that luxury or don’t have that track record. So I think that limits the amount of volatility.

Sure, we have larger than usual day-to-day price swings right now because we’re in a very headline-driven news cycle, and that’ll probably persist for some period of time. But from a fundamental valuation-based perspective, the US is still more stable than many other global countries. There’s still more upside in the US, just because of the strength and depth of our economy. So sure, we’re in a bumpy patch right now, and there will be day-to-day swings, perhaps more than people would like, but over a medium-term or long-term time frame, I do believe the US is still probably less risky than many other countries around the world.

How Investors and Investment Managers Should Handle Market Volatility

Hampton: So how should people handle market volatility, and how is your team factoring the volatility into your models?

Pappalardo: Yeah, the biggest thing from an internal team investment management perspective is really doing your homework. And what I mean by that is the team spends a lot of time refreshing research assumptions, trying to understand factors that may influence the future cash flows of the companies we’re investing in. And then once that’s kind of done, we spend a lot of time doing thorough scenario analysis. And what I mean by that is testing and forecasting how different asset classes may perform through a variety of different market cycles and economic cycles. So, that’s the homework that I like to refer to.

Once you kind of run through those exercises, it’s a bit easier to make more-informed decisions and understand perhaps how an allocation to a certain asset class may behave relative to another asset class, and then make an informed choice of which may play better and what we think is most likely to occur. So, that’s what the team’s doing internally. I think for individual investors or really institutional investors even, it’s just a simple idea of remaining disciplined to your plan. Have a thoughtful plan and be committed to sticking to it through volatile cycles.

Sure, on the margin, the volatility may offer some opportunities to reallocate or take advantage of outsize price movements in one area or another, but I would not be encouraging investors to make large changes on a regular basis to their allocations. I certainly would not recommend investors panic-sell. I think if you look back to April, we had another example where panic-selling would have hurt investors. The market dropped quite quickly. I’m sure people panicked and sold out near the bottom, only to watch it then rally nine days in a row as April wrapped up. So, it was really a classic example of “set it and forget it” would have served you quite well.

We’re already to the point where many market indices or segments of the market have returned to where they were pre-“Liberation Day” announcement in terms of price level. So again, it was just another example of staying the course often provides the best outcome.

What to Watch Before Trump’s 90-Day Tariff Pause Ends

Hampton: And I’m sure you’re going to remind us about that particular span of time. So, the 90-day tariff pause is expected to end in July sometime. What are you watching for between now and then?

Pappalardo: I think we’ve talked about this before, actually, and one of my conclusions after digesting the impact of the “Liberation Day” announcement was, sure, the scale of the tariffs was more than people expected, but I believe the biggest impact of that announcement was the immediacy of the implementation. That’s why 10 days later or so, when the 90-day pause was announced, that really triggered the bounce back in markets.

And the reason I say that is, it takes time for businesses and consumers to change their supply chains and their behavior. The 48-hour window that was originally announced for implementation obviously did not allow businesses to restructure supply chains or production facilities. Even a 90-day pause doesn’t really allow that. The 90-day pause gave a window for negotiations, and we’re seeing some of that come true with the UK and other examples. Even though we don’t have details yet, we believe they’re progressing reasonably well. So, the pause was a signal that, OK, maybe there is some runway before these tariffs actually hit businesses.

What I’m looking for before that July date is perhaps another extension or more announcements of trade deals with individual countries or sector or product exemptions. Apple AAPL has been very active trying to get certain product exemptions for their iPhones, for example. So, as those conversations continue, I think those will be the most impactful headlines or announcements prior to that 90-day pause running out.But I’m hoping that we see further pause or further delay in broad implementation as that day comes closer.

Hampton: We shall see. Dom, thank you for coming to the table today.

Pappalardo: Thank you very much for having me.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer JakeVanKersen and associate multimedia editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.