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(Bloomberg) — Wall Street has been guessing “will he or won’t he” on tariffs since President Donald Trump took office last month promising sweeping levies on geopolitical allies and rivals alike. While the initial reaction in the stock market was caution, the mood is shifting as the administration’s policies become increasingly muddled with delays and exclusions mixing with bellicose rhetoric.

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What’s an investor to do? 

So far, they’ve been ignoring the noise and buying stocks. While the risk of a global trade war remains dangerously real after Trump announced 25% levies on steel and aluminum imports that will take effect in March and reciprocal tariffs on numerous trading partners that are expected to hit in April, equity indexes continue to rally, with the S&P 500 Index finishing last week within points of an all-time high. The question now is whether the buyers spurring these gains are appropriately assessing what Trump will do — or dangerously throwing caution to the wind.

“As investors realize that the tariffs are likely not going to be as punitive as expected, that is good news relative to expectations,” said Andrew Slimmon, portfolio manager at Morgan Stanley.

Still, Slimmon noted that weak market sentiment suggests investors remain fearful of the risks in the administration’s plans. And he said a sizable chunk of the recent flows into stocks are coming from weaker shareholders who could be more sensitive to shocks, which makes the market increasingly reactive to headlines. A trade policy uncertainty index has spiked to its highest since 2019, when a similar trade war was brewing. 

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“The uncertainty index and the implied volatility of the market usually move in tandem, and this relationship suggests we could see an uptick in volatility,” said Adam Turnquist, chief technical strategist at LPL Financial. 

Volatility Signals

While volatility may rise in the medium term, investors aren’t positioning for it so far. Hedge funds and other large speculators have been net short futures tied to the Cboe Volatility Index, or VIX, for 16 consecutive weeks, data from the Commodity Futures Trading Commission show. Their net-short position is currently hovering near 59,000 contracts, the level last seen during the unwinding of the yen carry trade in mid-July. The VIX surged the next month to levels not seen since the pandemic, and the S&P 500 tumbled, jolting equity investors who were caught off-guard after wagering that low volatility would keep falling.

“When uncertainty and volatility are high you don’t get a market that continues to rally to records,” Turnquist added.

In other words, strategists’ expectations for a 12% rise in the S&P 500 this year is looking shaky.  

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“The tariff issue is one of the biggest risk factors for financial markets, although it falls into the category of ‘known unknowns,’ with the ultimate size, scope and sequencing still up in the air,” said Bill Sterling, global strategist at GW&K Investment Management. “Less noise and more policy visibility would be welcome.”

Wall Street banks agree. Goldman Sachs Group Inc. strategists warned that tariffs are a key downside risk to their 2025 outlook. Evercore ISI noted the lack of clarity on policy has started to weigh on sentiment. And an analysis from Bank of America Corp. showed that among the 50 largest S&P 500 companies, stock fragility, a measure of daily moves in share prices relative to recent volatility, is heading toward the highest level in more than 30 years. 

“With more tariffs and retaliation likely, alongside government spending constraints that may make it difficult to extend the Trump tax cuts from 2017, we expect modest gains in stocks over the balance of the year with more ups and downs compared to 2024,” Turnquist said.

Corporate America, which is in the midst of the fourth-quarter reporting season, is also striking a cautionary tone on trade tensions. Ford Motor Co. said last week that Trump’s 25% tariffs on Mexico and Canada, which have been pushed back to March 4, will blow a hole in the US auto industry. On Friday, Trump said he would unveil a separate set of tariffs on automobiles “around April 2.”

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Absorbing Shocks 

“The lesson we learned from the S&P 500’s brief dip before the delay of the Mexico/Canada tariffs is that US equities are patient and not prone to overreact, but don’t have much capacity to absorb bad news,” RBC Capital Markets’ strategists including Lori Calvasina said. The benchmark index plunged almost 2% early in the day on Feb. 3, the day Trump announced the levies on America’s neighbors, but clawed back much of the drop after it became clear the duties were being pushed out.

Equities also may look more resilient than they actually are. For example, on Thursday after Trump announced his intention to implement reciprocal tariffs, the S&P 500 closed up 1% because investors were relieved that he wasn’t slapping the levies on that day and hoped that the delay could be even longer. However, looking under the hood, more than 40% of the gain came from just three stocks — Nvidia Corp., Apple Inc. and Tesla Inc. 

This gets to the heart of equity risk right now. The biggest technology firms have driven the surge in US stocks over the past few years, and the divergence between them and the rest of the market is becoming increasingly acute with the development of artificial intelligence technology. But at the same time, those high-flying stocks are starting to look fragile, with rich valuations and nervousness around Chinese AI startup DeepSeek. 

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The capacity of investors to keep buying dips may be waning, as “everyone is in the pool,” said Goldman Sachs Group Inc.’s tactical specialist Scott Rubner. Since Big Tech has been the key to dip buying, any loss of confidence in the group puts the whole market at risk.  

That said, it isn’t as if Wall Street is completely ignoring tariff risk. Rather, it’s led to more selectivity in stock picking. A UBS Group AG basket of stocks at risk from tariffs is down 1% this year, significantly lagging the S&P 500’s 4% gain.

“I think it is fair to say the stock market is probably not quite where it would have been without the tariff threats,” said Eric Lascelles, chief economist at RBC Global Asset Management. “I don’t think people are pricing in 25% universal tariffs, but I do think they are pricing for higher tariffs.”

—With assistance from Jessica Menton and Matthew Griffin.

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