U.S. stocks rise against the trend despite tariff threats, but Wall Street warns of market volatility

According to Zhitong Finance APP, since U.S. President Donald Trump took office last month and promised to impose comprehensive tariffs on geopolitical allies and competitors, Wall Street has been speculating whether he will actually impose tariffs. Although the stock market initially reacted cautiously, market sentiment is changing as government policies become increasingly chaotic, with delays, exemptions, and bellicose rhetoric intertwined.

Where Should Investors Go?

So far, investors have ignored this noise and continued to buy stocks. Despite Trump's announcement of a 25% tariff on steel and aluminum imports in March, and the expectation of reciprocal tariffs on numerous trading partners in April, the risk of a global trade war remains high, yet stock indices continue to rise, with the S&P 500 closing near historical highs last week. The question now is whether the buyers driving these increases have correctly assessed the actions Trump will take or are overly optimistic in ignoring the risks.

Morgan Stanley portfolio manager Andrew Slimon stated, "Investors realize that tariffs may not be as severe as expected, which is good news relative to expectations."

However, Slimon pointed out that the weakness in market sentiment indicates that investors are still concerned about the risks in government plans. He mentioned that a significant portion of the recent inflows into the stock market has come from weaker shareholders who may be more sensitive to shocks, making the market's reaction to headlines increasingly intense. The uncertainty index for trade policy has surged to its highest level since 2019, when a similar trade war was brewing.

LPL Financial Chief Technical Strategist Adam Turnquist stated, "The uncertainty index and market implied volatility typically move in sync, and this relationship suggests we may see an increase in volatility."

Volatility Signals

Although volatility may rise in the medium term, investors currently seem unprepared. Data from the U.S. Commodity Futures Trading Commission shows that hedge funds and other large speculators have been net short on futures linked to the Chicago Board Options Exchange Volatility Index (VIX) for 16 consecutive weeks. Their net short positions currently amount to about 59,000 contracts, a level comparable to when yen arbitrage trades were unwound in mid-July 2023. At that time, the VIX soared to its highest level since the pandemic, and the S&P 500 plummeted, catching those betting on sustained low volatility off guard.

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Turnquist added, "When uncertainty and volatility are high, the market cannot continue to rise to record levels." In other words, strategists' expectations for a 12% rise in the S&P 500 this year seem less reliable.

GW&K Investment Management global strategist Bill Sterling stated, "The tariff issue is one of the biggest risk factors in the financial markets. Although it falls under 'known unknowns,' the ultimate scale, scope, and sequence remain uncertain." "The less noise there is and the higher the policy transparency, the better it is for the market."

Wall Street banks agree with this. Goldman Sachs strategists warn that tariffs are a major downside risk to their 2025 outlook. Evercore ISI points out that policy ambiguity has begun to affect market sentiment. An analysis by Bank of America shows that among the 50 largest companies in the S&P 500 index, stock vulnerability (a measure of daily price changes relative to recent volatility) is heading towards its highest level in over 30 years.

Turnquist stated, "With the possibility of more tariffs and retaliatory measures, coupled with government spending constraints that may make it difficult to sustain the tax cuts implemented by Trump in 2017, we expect the stock market to rise slightly for the remainder of this year, with greater fluctuations compared to 2024."

Absorbing the Shock

U.S. companies, currently in the fourth quarter earnings season, have also issued warnings about trade tensions. Ford Motor Company (F.US) stated last week that Trump's plan to impose a 25% tariff on Mexico and Canada has been postponed until March 4, which will impact the U.S. automotive industry. On Friday, Trump indicated that he would announce another set of tariffs on automobiles "around April 2."

Lori Calvasina, a strategist at RBC Capital Markets, said, "The lesson we learned from the brief drop in the S&P 500 before the tariffs on Mexico/Canada were postponed is that the U.S. stock market is patient and does not overreact easily, but it does not have much capacity to absorb bad news."

On February 3, the day Trump announced tariffs on U.S. neighbors, the benchmark index plunged nearly 2% in the morning, but after the news of the tariff postponement became clear, the index recovered most of its losses.

The stock market may also appear more resilient than it actually is. For example, after Trump announced his intention to implement reciprocal tariffs on Thursday, the S&P 500 index closed up 1%, as investors were relieved that he did not impose tariffs that day and hoped for a longer delay. However, internally, over 40% of the gains came from just three stocks—NVIDIA (NVDA.US), Apple (AAPL.US), and Tesla (TSLA.US).

This touches on the core of current stock risks. In recent years, the largest tech companies have driven the surge in the U.S. stock market, and with the development of artificial intelligence technology, they have increasingly diverged from other markets. However, at the same time, these soaring stocks are starting to appear fragile and overvalued, while concerns about the Chinese AI startup DeepSeek are growing.

Scott Rubner, a tactical expert at Goldman Sachs, stated that the ability of investors to continue buying on dips may be weakening, as "everyone is buying." Since large tech companies have been key to buying on dips, any loss of confidence in this group would pose risks to the entire market.

Nevertheless, Wall Street is not completely ignoring tariff risks. On the contrary, this has led them to be more cautious in stock selection. A basket of stocks affected by tariffs from UBS has fallen 1% this year, significantly lagging behind the S&P 500 index's 4% gain.

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Eric Lascelles, Chief Economist at Royal Bank of Canada Global Asset Management, stated: "I think it's fair to say that the stock market may not be as high as it would be without the threat of tariffs. I don't think people have priced in a 25% blanket tariff, but I do think they have priced in higher tariffs."