Trade Wars 2.0
We are closely following all the recent tariff developments but wanted to take a moment and provide you with a few thoughts.
Equity markets have seen a 5% pullback over the last week; the S&P 500 is now down 1.67% for the year as concerns regarding tariffs have risen over the last week or so. As of Tuesday, the Trump administration has implemented 25-percent tariffs on Mexico and Canada. Additionally, Chinese tariffs were raised another 10% (there were already existing tariffs in place), and there is a high probability the EU will face 25-percent blanket tariffs soon. Canada has responded with a 25-percent retaliatory tariff against US goods, and the likelihood of other countries retaliating is high.
Why is this impacting the market now after the rally since the election?
Risk assets rose rapidly post-election as investors viewed many of the de-regulatory aspects of the Trump administration to be good for equities and other assets. While mentions of tariffs were always a key policy objective for the Trump administration, there was little clarity on the specifics—such as amounts, timing, or which countries would be targeted. There was also a prevailing view that the tariffs were purely a negotiation tactic and might not actually be implemented. With the recent implementation of the tariffs, the market is now re-assessing the potential economic impact.
How is the economy responding?
While it's still early to assess the full impact, over the last several weeks we have seen a clear impact from consumers and businesses on the impacts of the tariffs. The Federal Reserve has paused rate cuts after mentioning the need to assess the trade policies' inflationary impact. Additionally, the ISM Prices Paid, a survey of businesses' assessment of the prices of goods, shot up to the highest level since 2022, while consumer spending and retail sales are starting to decline. On Friday, the Atlanta Fed GDPNow Model, which takes in current economic releases and tries to "predict" this coming quarter's GDP, dropped from +2.3% to -2.8%. I would take this with a grain of salt in that it's never fully perfect in its predictions, but such a notable change meant markets certainly took notice. If the economy is starting to soften as tariffs begin to bite, we may see the chances of a recession rise—a trend notably seen in the 10-year Treasury yield, which has declined roughly 50 basis points, from 4.6% to 4.15% over just the last three weeks.
What sectors or industries will be impacted?
The brunt of the tariffs will likely be felt across the board, and the full impact will depend on the length of time the tariffs are in place. Target's CEO today said prices on produce should begin rising this week, so US consumers will see prices increase for most goods. The housing industry will likely be impacted because much of the lumber comes from Canada. Energy costs in the Northeast part of the country should rise as Canada cuts energy production sales. Farmers will be impacted by Chinese retaliatory tariffs on food imports. The auto industry has said the average car price will increase by $12,000 since so much of the automobile supply chain is tied to Mexico and Canada. From a market perspective, we have seen consumer discretionary, industrials, energy, and materials—all cyclical sectors—see more negative price declines than defensive sectors like consumer staples and health care. We won't know the full earnings impact until the next earnings season in April, but you will likely start to see analysts cut earnings expectations as the tariffs potentially impact company sales and costs.
What have we done in portfolios and strategies?
At the beginning of the year, we reduced our equity exposure in all asset allocation models, moving from an overweight relative to our benchmarks to an underweight position. While trade policy uncertainty was a consideration, we also felt that given stocks were trading at all-time highs with all-time high valuations, it would not take many negative headlines to cause equities to correct. Over the last two calendar years, we have seen two back-to-back 20%+ S&P 500 return years, and historically that has only happened four times since the 1800s. Only one time of those four times was the market positive the following year, and that was during the Dot-com bubble in the late 1990s. In reducing our equity exposure, we invested the proceeds in money market funds and currently have a higher than typical position in cash/money markets than we would typically have. The idea was that given the numerous directions things could take from both an inflation or growth standpoint, fixed income, which traditionally does well in a bear market, may not necessarily outperform money market rates should inflation or prices spike.
From a strategy perspective, within our Core Equity strategy, we continued to trim our exposure to “Magnificent 7” which have been big winners of the last several years and moved to relative underweight position, as we felt if there were an equity market correction, those companies, being the largest and most widely held crowded positions, would likely see a more negative impact than other parts of the market. Secondly, within in our Leaders strategy, we continued to trim winners like Rocketlab, Tempus AI, and other companies which had rallied over 100% last year and moved those proceeds into cash. As of now, the strategy is targeting anywhere between 8-10% cash.
Lastly, within our tactical positions within our asset allocation models, we have reduced our exposure to small-cap equities and increased our exposure to gold, which historically is a very good macro risk hedge.
We continue to believe that right now is a good time to be cautious and play defense, with the thought that any market correction is likely a good buying opportunity to put any excess cash back to work.
What are some key events we are watching for going forward?
The state of the union this evening is going to be heavily watched to see if there is any indication as to the length of changes of tariff rates. There is always the chance the administration could ease tariffs pending possible trade deals.
Unless Congress passes a budget and spending bill in the next few weeks, the US government could shut down on March 15th. All indications are that there is the is still some distance between Republicans and Democrats on issues. This could add to negative market pressures if we get a prolonged government shutdown.
The stock market has always been a barometer that the Trump administration was in tune within the previous Trump term. Markets right now are telling the administration it doesn’t like this, so we will see if any more negative market impact could cause a change in the administration’s position. One notable difference between now and Trump’s first term is the cabinet. In Trump’s first term, he had many economists who were against tariffs whereas today most of the economists within the cabinet are very pro-tariff and see the US trade deficit as the biggest issue facing America. From that standpoint, I do believe the chances that they keep tariffs on for a longer period may remain high, even with the potential negative market or economic impact.