Market Mondays: Equities shrug off trade threats—but correction risk builds

Despite a growing list of geopolitical and trade tensions, markets have remained surprisingly calm. With U.S. tariffs of up to 30% threatened on the European Union—mirroring earlier actions against Canada and Mexico—one might have expected heightened volatility, particularly with the August 1 deadline now looming. Yet equity markets, especially in the U.S., continue to show strong momentum.

The prevailing view among investors seems to be that these tariff threats are more bark than bite—a negotiating tactic rather than a firm policy stance. This perception, while perhaps justified by historical patterns, introduces a significant asymmetry in market pricing. As one geopolitical strategist recently pointed out, only a fraction of the threats made during Trump’s two terms have actually materialized. Markets appear to be betting that this pattern will hold, and that the so-called “Taco Trade” strategy—bluster without follow-through—will once again play out.

However, this assumption leaves markets vulnerable. Positive trade news continues to be bought into, fuelling a rally that has pushed indices like the S&P 500 and Nasdaq toward fresh record highs. But if August 1 arrives and tariffs are imposed at the scale currently proposed, it could lead to a sharp reversal as investors rapidly reprice risk. In short, markets have priced in a great deal of optimism, but very little of the potential downside.

European equities tell a slightly different story. The continent's indices have already begun to unwind recent gains as the threat of trade retaliation grows more tangible. In contrast, U.S. indices have shown little evidence of concern, supported by strong momentum and a resilient appetite for risk. Still, with just over two weeks until the deadline, the clock is ticking on trade negotiations, and investors could be caught off guard if progress stalls.

There is, however, still room for upside. If trade talks yield positive outcomes and tariffs are avoided or softened, markets could push even higher. While much good news is already priced in, equities still appear to be holding something back. A favourable resolution could remove the remaining risk premium, reignite risk appetite, and extend the rally.

This dynamic is especially visible in valuations. While U.S. equities are trading above their 10-year average on a price-to-earnings basis, multiples have actually declined slightly from earlier in the year—particularly before the announcement of the Liberation Day tariffs. This suggests a modest discount is still being applied to account for unresolved trade risks. Should those risks be lifted, valuations could expand, bolstered by improved sentiment and earnings optimism—especially in U.S. tech stocks, which are set to dominate the upcoming earnings season.

Ultimately, markets are at a crossroads. The rally, particularly in U.S. equities, has been driven by optimism and underpinned by assumptions about political behaviour. But those assumptions will be tested on August 1. Until then, the asymmetry remains: room to rise on good news, but the potential for a swift and severe correction if trade tensions escalate.