Liberation Day and the road to recession?

The US is redrawing the trade map. China’s not backing down. Investors should brace for impact.
Xinyu Ru

Fawkes Capital Management

The global trading system is undergoing its most consequential stress test in decades. With sweeping new tariffs announced on Liberation Day, the U.S. has signaled not just a tactical policy shift, but a strategic redefinition of its role in global commerce. At stake is more than just the flow of goods - it is the balance of economic power, the future of international rules-based trade, and the path of global growth itself.

This report explores the drivers and implications of the U.S.'s escalating trade confrontation with China, including the structural pivot away from multilateralism, the risks of a policy-induced recession, and the geopolitical chess game now playing out through supply chains, courtrooms, and trade corridors. As the world’s two largest economies harden their positions, investors must grapple with a deeply uncertain landscape — one where macro risks are not just elevated, but embedded.

Escalation of U.S. Trade Policy: Liberation Day Tariffs

Liberation Day marked a major escalation in US trade policy, with the administration announcing sweeping reciprocal tariffs on global imports. These measures come on top of earlier sector-specific and fentanyl-related tariffs. In economic terms, a tariff acts as a tax that is shared between foreign exporters and domestic consumers. At current settings, the new tariffs would represent: 

  1. an increase in the average US tariff rate from 2% to approximately 20%, and 
  2. the largest effective federal tax rate increase since World War II.

The administration appears mindful that full implementation of these policies could trigger a recession and a sharp correction in equity markets. In response, two key adjustments have been made. First, the full application of reciprocal tariffs – excluding those on China – has been delayed by 90 days, providing the US with additional negotiating leverage. Second, there has been a strategic pivot toward isolating China more specifically.

While we have previously discussed the implications of the tariff delay, this note will focus on the second development.

US-China Rivalry: Strategic and Economic Risks

The shift in US trade policy comes at a time when the United States and China are locked in a broader contest for global leadership. Both nations are competing to shape the international system in their own image, and the trade war has accelerated this strategic rivalry.

The United States is seeking to overhaul the global trading system, which it increasingly views as misaligned with its national interests. By contrast, China, Europe, and key Asian manufacturing nations prefer to maintain the status quo. The outcome of this contest will be a critical determinant of the economic trajectory – and, by extension, asset valuations. If current dynamics were allowed to run their course unchecked, we estimate there is a 90% probability that a recession would follow. However, with trade negotiations ongoing, the most probable outcome is some form of compromise. The nature of this compromise will be pivotal in shaping the direction of the global economy.

The US-China standoff remains particularly intractable – a "Mexican standoff" on a historic scale. With reciprocal tariff levels now exceeding 100%, neither side is willing to make the first move toward de-escalation. China has invoked the saying, “he who ties the bell to the tiger must untie it,” suggesting it views the US as responsible for initiating the conflict and therefore responsible for resolving it. Yet a unilateral reduction in tariffs by the US would be seen as an admission of weakness — one that could be seized upon by global media as evidence of China’s growing economic power. Politically, such a move would be deeply unpalatable for the administration. As a result, the deadlock persists.

Secretary Bessent has described the current situation as “unsustainable,” arguing that a de-escalation must eventually occur. A prolonged trade embargo between the two largest economies in the world is unlikely to endure, he claims. From a free-market, democratic perspective, this appears logical – the economic damage, including lost jobs, declining profits, and wasted capital, would ultimately become politically untenable.

However, this view underestimates China’s long-term strategic approach. China plays a different game, with a broader arsenal of policy tools to directly support its economy and absorb short-term shocks.

Trade Negotiations, Loopholes, and Market Exposure

In some ways, today’s standoff is even more troubling than the Cold War. Unlike that earlier era, the US and Chinese economies are deeply intertwined – and the economic pain from the conflict is being felt directly on both sides. In addition to US restrictions on Chinese exports, China has recently announced a temporary embargo on rare-earth magnets, critical inputs for future industries such as electric vehicles, renewable energy, and data centres.

Both nations are now racing to reshape global trade alliances. Each is working to either change or preserve the existing system, seeking influence through bilateral and multilateral negotiations. One of the more remarkable aspects of the Trump era is the enduring resilience of his political appeal, despite the extreme nature of the rhetoric and policies pursued. As both sides continue to frame and sell their negotiation efforts to the world, the shape of these compromises will determine not just the economic outlook, but the balance of power for years to come.

There is also a significant difference between high-level memorandums of understanding (MOUs) and fully-fledged, binding trade agreements. MOUs are relatively easy to sign, as they involve limited immediate obligations, while translating them into comprehensive legal texts demands substantial time, expertise, and political will. The key development to watch will be how the Trump administration manages baseline tariff levels as full negotiations unfold.

Even with new agreements, loopholes are likely to emerge. Chinese goods could continue entering the US via third countries with lower tariff rates – a dynamic that already exists. Despite efforts to police it, closing these third-party avenues is extremely difficult in practice. It is neither feasible nor practical to inspect every container or shipment in detail.

The US stock market remains exposed to the risks of a deepening global trade war. More than 40% of S&P 500 revenues are generated overseas, and much of US manufacturers' production is based in Asia. Proposed fines or taxes on Big Tech for their international services exports would further erode earnings if implemented. Absent a major shift in trade policy, we would expect approximately a 10% decline in S&P 500 earnings per share.

Legal Challenges and Implications for Tariffs

There are now also multiple court challenges underway against the Trump administration’s use of the International Emergency Economic Powers Act (IEEPA) to impose tariffs. As we have previously discussed, tariffs have never before been applied under this law, and it remains legally questionable whether persistent trade deficits constitute an "unusual and extraordinary threat" under the Act’s framework.

Initial decisions from either the California district court or the US Court of International Trade (CIT) could arrive within weeks. However, any final resolution could take considerably longer, given the potential for a protracted appeals process. The administration is actively seeking to shift cases to the CIT, where the likelihood of an injunction halting tariff collections – a risk if cases remain in courts with more liberal judges – is perceived to be lower.

Although it remains difficult to predict how these legal challenges will ultimately be resolved, their consequences for the economy and markets could be significant. Whether through judicial intervention or negotiated settlement, the final level of tariffs that remains in place will likely prove determinative in shaping economic outcomes.

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The information contained in this report has been prepared by Fawkes Capital Management Pty Ltd (“Fawkes”). Fawkes is a Corporate Authorised Representative of One Wholesale Fund Services Ltd (“OWFS”), ACN 159 624 585, AFSL 426503, CAR number 1308574. Fawkes offers financial services in Australia only to ‘wholesale clients’ as defined by the Corporations Act 2001. Fawkes is the investment manager for the Fawkes Capital Fund (the “Fund”). The issuer and trustee of the Fund is One Funds Services Limited (“OFSL”), ACN 615 523 003, AFSL 493421, which is only available to wholesale clients. The information in this article is current as at the date of publication and is subject to change. Fawkes and/or the Fund may hold or intend to hold positions in any of the securities mentioned in this report. Fawkes has no obligation to inform anyone of any changes to its view of, or holdings in any securities mentioned in this report. This information is general in nature. It doesn’t take into account a person’s objectives, financial situation or needs. Because of that, any persons relying on this information should consider obtaining independent advice before making any investment decisions based on this information. The reader agrees not to invest based on this article, and to perform his or her own due diligence and research before taking a position in any securities mentioned. Information in this article may constitute Fawkes’ judgement at the time of publishing and is subject to change. Whilst Fawkes believes this information is correct, no warranty is made as to its’ accuracy or reliability. Fawkes doesn’t accept responsibility for any loss or liability incurred by you in respect of any error, omission, reliance, or misrepresentation in the information contained in this article. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Any projection or forward-looking statement in this article is provided for information purposes only. Whilst reasonably formed, no representation is made as to the accuracy of any such projection or that it will be met. Actual events may vary materially. Investors should consider the Fund’s Information Memorandum (“IM”) dated 24 May 2024 issued by OFSL before making any decision regarding the Fund. The IM contains important information about investing in the Fund and it is important investors obtain and read a copy of the IM before deciding about whether to acquire, continue to hold or dispose of units in the Fund.

Xinyu Ru
Portfolio Manager
Fawkes Capital Management

Xinyu Ru is the founder and portfolio manager of Fawkes Capital Management, a discretionary global macro hedge fund. Prior to founding Fawkes, Xinyu spent 10 years at Westpac Banking Corporation within the Chief Investment Office in Sydney and...

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