Author: Doug O'Laughlin
Compiled by: TechFlow
Sorry for disappearing for a while. I just finished moving to New York City, and I'm also facing some health issues. One thing I want to tell everyone is: I will be taking a week off starting March 27 to recover from an outpatient surgery. But now, let's get to the main topic.
The market is quickly adjusting its pricing in anticipation of an impending economic downturn, partly due to the Trump administration's policies and significant pressure on the US dollar. I will provide a casual summary from a macroeconomic perspective and discuss the semiconductor industry and areas of my interest. Let's start from a macro perspective and then dive deeper.
"Manufactured" Economic Recession and the 10-Year Treasury Yield
Recent commentary suggests that the current government is more focused on the 10-year Treasury yield than on stock market levels - a departure from past strategies (such the so-called "Trump put"). In a Fox News interview, the term "adjustment period" was mentioned multiple times, indicating that the government's focus has shifted from stock market performance to bond market signals.
The key metric to measure this is the 10-year Treasury yield. The 10-year Treasury yield is the borrowing rate the US government pays, and by lowering this critical rate, it can improve the affordability of housing or the ability of consumers to purchase cars. However, "manipulating" the 10-year Treasury yield is not as direct as adjusting interest rates, which are primarily determined by the Federal Reserve's overnight bank lending rate, while the price of 10-year Treasuries is a market-driven price determined by auctioning to investors willing to buy government bonds.
The problem is that the 10-year Treasury yield is not an exact science. No one really knows how the 10-year Treasury will fluctuate, as its price is determined by trading and is believed to reflect inflation and the actual GDP growth of the issuing country.
This presents challenges. Tariffs may cause inflationary pressures in the short term, and if the 10-year Treasury yield falls to 3% (as some, like Bessent, have predicted), this may reflect a downward revision of actual growth expectations. In this case, the market may view the economic recession as a necessary adjustment.
This is precisely what the market is currently anticipating. This is the yield curve a month ago and now. Specifically, the short end of the curve has started to decline. This means the market is quickly pricing in lower short-term rates and a lower federal funds rate. In this case, this may not be a reflection of declining inflation, but rather economic weakness and the market's belief that the Federal Reserve is not cutting rates fast enough.
Source: Bloomberg
We are experiencing all of this in real-time. GDPNow (a real-time economic forecasting tool) now predicts a significant contraction in the economy in the first quarter, driven by technical factors, but the overall trend remains weak.
One important factor is the impact of net imports on GDP calculations. Net imports are subtracted from GDP calculations, which is partly a preemptive reaction to tariffs. But beneath this surface, the economy is broadly weakening. The chart shows the changing trend and estimates of growth contributions. Imports have been a significant drag, but more importantly, the rates of change for most other categories are also deteriorating.
Source: GDPNow
The second chart further shows the weakness in imports, while residential investment, government spending (expected), and consumer spending are also weakening. Similar to the economic contraction in the second quarter of 2022, the rates of change are deteriorating rapidly. Here is a chart of the 2022 growth contributions, when the economy was hit by a sharp inventory drawdown.
This situation quickly reversed as inventories normalized. So, will the tariff pre-emptive effect be a one-time, rapid recovery like the post-pandemic inventory adjustment, or will it lead to a downward spiral of consumer and business confidence?
The problem is that consumer confidence is starting to decline, and some leading indicators (such as the consumer confidence index and the leading economic index) are also starting to decline. Worryingly, this decline is accelerating. Most economic indicators and consumer data seem to point to further weakness and uncertainty.
The yield curve is showing signs of economic weakness amid a surge in imports, declining consumer confidence, and the possibility of a technical recession. Expectations of economic weakness can become self-fulfilling, as seeing economic weakness will prompt people to increase savings. Trump is now using the term "adjustment period," but this phrasing is usually not a good sign in the market.
The timing is very delicate. The yield curve has just normalized, and this is almost always the painful beginning. When the curve becomes steep, the pullback or recession begins. In other words, an inverted yield curve usually signals an economic recession; and when the yield curve normalizes, the recession and impact on the stock market begin. What we are seeing now is that the yield curve inverted in late September last year.
Source: Koyfin
We are now experiencing the pain. Another key factor is tariffs and uncertainty, as in economics, uncertainty is almost synonymous with volatility. When we cannot be sure whether the tariff rate will be 10%, 20%, or 25%, decision-making becomes more difficult. However, an overwhelming theme is trade.
Trade Deficits and Asset Flows
The US has long had a large trade deficit, meaning imports exceed exports. However, these dollars do not simply disappear; they are transferred as payment for goods and services to foreign entities. These foreign exchange funds typically flow back to the US financial markets through investment. In this way, the trade deficit is accompanied by capital inflows, providing funding for the purchase of US assets.
This creates a natural driving force to use the accumulated dollars from the trade deficit to purchase US assets. It can be viewed as a natural dollar inflow brought about by trade.
However, Trump's policies have explicitly focused on trade through tariffs. Tariffs naturally raise consumer prices, reduce trade, and, if high enough, reduce the trade deficit. This reduces the dollars flowing back to the US, thereby having a more adverse impact on asset prices - capital outflows.
Raising tariffs may mean that foreign entities that have accumulated US dollars, which are the largest buyers of US assets, will reduce their purchases of assets, including US Treasuries. Given that a significant portion of US Treasury auctions are now facing capital outflows, and 24% of Treasuries are held by foreign investors, this will reduce the demand from foreign investors, thereby pushing up the 10-year Treasury yield. This is a very tricky situation.
The US's continued increase in tariffs and negative attitude towards global trade will lead to a natural outflow of assets and prompt some foreign entities to flee US assets. After decades of trade deficits, this mechanism may automatically materialize and spiral out of control. The trade deficit has long existed as a natural source of capital inflows. The chart on the US's global market capitalization share that has been repeatedly discussed - now it seems there is a way to stop the capital inflow, and that is tariffs.
Source: JPMorgan Chase Market Guide
Another uncertainty factor is that the "West" is no longer as united. The Financial Times is questioning the transatlantic partnership. Placing assets in the financial markets of allies is one thing, but if they are no longer strong allies, it is a completely different matter. As the US withdraws and implements reciprocal tariffs similar to the Smoot-Hawley Act (essentially unilateral tariffs that ultimately evolve into a bilateral tariff war with Canada), it is difficult to say whether their alliance remains solid.
The fragmentation of trade is the fragmentation of alliances. And as this continues, assets will flee. A retaliatory US government may push Europe's trade towards China, the world's largest manufacturing base. The old world order is at risk, and putting all the chips in the US basket no longer seems like a wise strategy. So where will the assets go? So far, Europe appears to be the biggest beneficiary.
Reversal of Roles between the US and Europe
An ironic pattern is that the US and the EU are strangely swapping roles. Driven by a flurry of artificial intelligence investment announcements and new potential defense spending plans, Europe is doing something that has long been overlooked - deficit spending.
Meanwhile, it can be said that raising tariffs to increase revenue, while drastically cutting costs, is the very definition of austerity. This was the strategy adopted by Europe after the financial crisis, and now the roles are being reversed. The track record of austerity has been dismal, while deficit spending has created the economic dominance and differentiation of the US after the financial crisis.
This can partially explain why assets are starting to flee, with the greatest divergence of developed market assets flowing towards Europe. The massive capital that once flowed to the US is now reversing, initially flowing to large liquid assets in Europe or similar language markets in the short term. One way to express this trend is the ratio of the IEV (European ETF) to the S&P 500 ETF. By 2025, the trend of the US outperforming is broken, and the trend of capital flowing to Europe becomes pronounced.
This will be a long-term trend, as a lot of US exceptionalism trades are unraveling. Another accelerator of this trend is the rapid decline in US asset prices, while the rest of the world performs relatively better.
But to be honest, this is a communication about semiconductors, not macroeconomics. Most of the dynamics mentioned here are essentially consistent macroeconomic views and are being rapidly priced into the market. The reality is that significant changes in the market take time and are rapidly approaching their final outcome. This could be a violent process.
Market Dynamics and Semiconductors
Finally, let's return to my beloved semiconductor industry. I want to make some observations. First, the market topping pattern is very reminiscent of most market declines. There is an old adage that the semiconductor industry leads the market, and in my experience, this saying holds true.
The chart below shows that when the semiconductor sector stops its relative outperformance, the market often experiences a significant correction in the following few months.
But the semiconductor industry is cyclical. We've been through the downturn, and if the S&P 500 index falls 10%, the semiconductor industry typically falls 20%, and even 40% declines are possible. The market is telling us that the economic health is poor, which is a leading indicator reflecting changes in semiconductor company orders and future revenue growth.
The question now is, how deep will this decline be? We just saw a 10% decline number, which is consistent with history. Declines usually take more time and are often more severe. Considering that the growth panic of 2022 was enough to cause a 20% market decline, I think this decline could also end up in that range, not to mention that the current growth panic is far more severe than in 2022.
Will this lead to a recession? That's beyond my ability to predict. But it's clear that there are some uncertain economic factors at play, such as trade headwinds and potential capital flows moving away from the US. At the very least, we are in the midst of a transition of a system or environment. This adjustment period may just be a market correction and economic contraction.
