Market psychology: a roadmap for rebuilding confidence

The global trade shock has triggered a sharp fall in equity markets. How can markets rebuild confidence? We outline seven prerequisites to monitor before investors can regain their confidence in risk assets.

The global trade shock and associated uncertainties instigated by US President Donald Trump led to a deep equity market sell-off in recent weeks. The VIX, a measure of US stock market volatility, rose to 45 points, below levels seen during the 2008-2009 Great Financial Crisis or the Covid pandemic. Such market pullbacks are rare and often followed by a sharp reversal. That may suggest an interesting point for rebuilding risk asset allocations. However, the path to a sustainable equity rally is not linear and requires a number of steps to re-build investor confidence.

We have used the market sell-off to rebalance our portfolios and restore our strategic equity weights in multi-asset portfolios. We remain overweight fixed income. We believe our base case scenario of slower growth but no recession with falling central bank rates supports this tactical positioning. We stand ready to make further adjustments as the situation develops, following the steps below.

The path to a sustainable equity rally is not linear and requires a number of steps to re-build investor confidence

Step 1: Cross-market check

In periods of stress, financial markets first look at potential differences in interpretation of events by different financial assets. For example, while equity markets sold off sharply immediately after the 2 April tariff announcement, high yield credit spreads did not widen as much, implying lower stress levels. Similarly, haven assets like gold and Swiss government bonds’ initial reactions were also more measured. The US dollar weakened, but not as dramatically as stock markets. This initially reassured investors that equity markets may be overreacting. However, the trade war escalation between the US and China spread risk aversion to other parts of the financial markets: in currencies the dollar depreciated sharply, bond markets saw further high yield credit spread widening, and in commodities, the gold price spiked despite higher US real yields and stable long-term US inflation expectations. Confidence therefore took a justifiable hit. The reverse is needed to rebuild confidence – with a recovery in one asset spreading to other segments.

Step 2: Buying low

Confidence tends to rebuild in markets through first attempts at buying low-priced assets. While equity markets rallied, other parts of financial markets have remained volatile, preventing this behaviour from taking hold. It would be encouraging to see more attempts by investors to buy at these levels. This would then support other segments of markets.

Step 3: US tariff pause and trade deals act as circuit-breakers

When markets seem in panic mode, external circuit-breakers are needed. These can either be central bank or government policy backstops. Since trade news is the source of the problem, the 90-day pause by the Trump administration acted as a circuit-breaker, leading to an initial recovery. Further announcements in this direction, including temporary tariff exceptions on electronics and other sectors, from duties imposed on China or future trade deals with other trading partners, should help to re-build confidence in a sustained way.

The more of these circuit-breakers we see in other economies, the more confidence will be re-built in markets

Step 4: Policy backstops by G7 central banks and China

US tariff announcements are the key reason for the market sell-off. As a result, circuit-breakers should come from US policies. However, other regions can also positively influence market sentiment. This week’s European Central Bank (ECB) and Bank of Canada (BoC) meetings may be relevant given the US trade shock to their economies. The ECB is expected to cut rates by 25 basis points (bps), but given the strengthening of the euro, the ECB may act more decisively and deliver a 50 bps cut. In Switzerland, the negative Swiss Average Rate Overnight (SARON) rates are a sign of this risk. As for the BoC, the recent labour market weakness (with the loss of 33,000 jobs in March versus consensus expectations of a gain of 20,000) is paving also the way for a rate cut. In the US, several Federal Reserve (Fed) officials including Chair Jerome Powell, are scheduled to speak this week, and we can expect supportive rhetoric – but nothing more. The Fed’s next meeting is not until 7 May. In China, we expect more government stimulus.

Step 5: Market carrots and sticks for trade negotiators

Beyond circuit-breakers that halt a further deterioration in sentiment, markets require a solution to the underlying cause of the correction. Trade negotiations between the US and trading partners are of course key. Equity, bond and currency markets will continue to motivate politicians to find compromises. Lower US Treasury yields would encourage the US. For other trading partners, the reward is a stronger US dollar, helping their economies to absorb some of the US universal tariffs’ effects. All parties will gain with better equity market performance. Any bad news in trade negotiations will weigh on all.

The biggest breakthrough however would be any de-escalation in US-China frictions

We expect first deals to be announced in the coming weeks, possibly including a US-Japan agreement. Trade deals will help markets recover some poise. The biggest breakthrough however would be any de-escalation in US-China frictions. Arguably, Mr Trump’s exemption of tariffs on smartphones and computers looks like a first step, although this was subsequently described as temporary. We expect further conciliatory actions. Economic data from China had already pointed to waning momentum even before the US tariffs were unveiled. First-quarter gross domestic product (GDP) should confirm that the Chinese economy is losing steam with consumer deflation persisting. China needs to solve its trade conflict with the US. The faster the US and China reach a resolution, or a new trade equilibrium, the more confidence and predictability will return to financial markets.

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Step 6: Macroeconomic support

Macroeconomic data will play an important role in extending the improvement in sentiment, later in the process. Before Mr Trump announced the new US tariffs, economic data was better than expected. The labour market was stronger than anticipated and inflation was lower than forecast. This week’s March retail sales are expected to increase as consumers anticipated the impact of tariffs on imported motor vehicles and auto parts. The current pause in tariffs may prompt consumers and producers to anticipate other expenses over the next three months. Positive economic surprises would support markets, as recession probabilities are contained.

Positive economic surprises would support markets, as recession probabilities are contained

Step 7: US domestic support in the form of deregulation and tax cuts

In the US, deregulation and tax cuts are potentially positive developments along with lower oil prices. Construction in the housing market may improve on easier zoning rules and lumber support mechanisms.

Navigating market sell-offs

As markets go through a turbulent period, we believe the best approach is to remain anchored in strategic asset allocations with a long-term perspective. As long as markets continue to lack US policy certainty, volatility will continue and demand diversification and agility from investors. The steps outlined above can help investors to monitor these turbulences. Volatility will likely stay above normal levels. As the steps to recovery unfold, we believe that 10-year US Treasury yields will fall below 4%. We see current US dollar weakness as temporary, and would expect the US currency to appreciate against the euro to its previous 1.02-1.12 trading range. We believe investors should continue to hold to their strategic equity weights and use market fragility to take exposure to quality stocks, which now offer better valuations across regions.