There’s a sweet spot for tariffs. Markets could revolt if Trump is way off

US equities are trading near all-time highs, with the S&P 500 notching multiple records and the VIX at multi-month lows, driven by cautious optimism regarding trade de-escalation. The market has welcomed recent agreements, such as the Japan deal with a 15% tariff, alongside strong Q2 earnings and economic data. However, significant uncertainty remains ahead of the August 1 deadline for a potential EU trade deal, as President Trump indicates a 50-50 chance of avoiding higher tariffs, which poses a key risk to current market valuations and could trigger volatility.

Analysis

US equity markets are trading near all-time highs, with the S&P 500 setting four consecutive records this week and the Dow less than 1% from its first record of the year. This optimism is primarily fueled by a perceived de-escalation in trade tensions, highlighted by a recent deal with Japan that set tariffs at 15%, below the more punitive 25% level previously threatened. Market sentiment is further supported by strong second-quarter corporate earnings, with 80% of reporting S&P 500 companies beating expectations, and a CBOE Volatility Index (VIX) at its lowest level since February. However, significant event risk looms with the approaching August 1 deadline for a US-EU trade agreement. According to US Bank Asset Management, markets are not priced for effective tariff rates to exceed 20% on a major trading partner, yet President Trump has threatened 30% tariffs on the EU and assesses the probability of a deal at just "50-50." This creates a precarious situation where current high valuations and low volatility could face a sharp reversal, as the market appears to be pricing in a positive outcome for a negotiation that remains highly uncertain.

Key Decisions for Investors

• Investors should closely monitor developments regarding the US-EU trade negotiations ahead of the August 1 deadline, as the market is not priced for the threatened 30% tariff rate, posing a significant downside risk.
• Given that the VIX is at a multi-month low, it may be prudent to consider adding portfolio hedges or downside protection at a relatively low cost against a potential market shock from a negative trade surprise.
• While strong earnings and progress on other trade fronts provide support, the binary risk of the EU tariff situation suggests caution in adding significant new long exposure until there is greater clarity post-deadline.
• Recognize that while markets have digested tariff rates in the 15-19% range, a breakdown in EU talks could re-introduce the high volatility seen in April and challenge the prevailing 'extreme greed' sentiment.