Turbulence ahead
The market is grappling with heightened uncertainty as trade tensions escalate. With the S&P 500 trading at 22x projected earnings, the stock market was priced for perfection prior to the past two-week sell-off, which sliced 5% from the all-time high reached in February. The sell-off has also reversed almost all the post-election gains, caused mainly by growing concerns over the economic implications of tariffs.
Retailers are feeling the immediate pressure of these tariffs, with companies like Target and Best Buy reporting potential profit reductions due to increased costs. Best Buy, particularly reliant on imports from China and Mexico, dropped 13% earlier this week after forecasting weaker earnings and warning of price increases for consumers. These warnings underscore the broad impact of tariffs on businesses and the potential for rising consumer prices, reigniting inflation concerns. This sounds like stagflation. More on this later.
The trade disputes are not limited to the U.S. and China, as retaliatory tariffs from Canada and Mexico further complicate the economic landscape. These actions are creating a complex web of trade barriers, impacting various sectors, including agriculture and manufacturing. As companies wrap up their quarterly reports, with strong earnings growth observed, forward-looking projections are being revised downwards, reflecting the growing economic headwinds. Moreover, the Atlanta Fed’s GDPNow model lowered its forecast for 1Q25 GDP growth to a decline of -2.8% which is down from +3% as recently as January.
Economic indicators are signaling potential challenges too. Consumer spending is showing signs of slowing as inflation concerns rise. Of course, the Fed, which had begun lowering interest rates to support the economy, is now adopting a more cautious approach due to the uncertainties surrounding trade policies and persistent inflation.
A report by Moody’s Analytics for the Wall Street Journal noted that households making more than $250,000 a year now comprise almost 50% of all consumer spending. The increasingly concentrated source of spending presents additional risk to the economy if stock and home prices were to suffer any meaningful decline. The significant rise in stock prices and home values over the past few years combined with a reduced savings rate, has enabled high earners to increase their propensity to spend. This spending has supported economic growth, but has masked deteriorating trends among other consumer groups and influenced how businesses operate.
For instance, businesses are increasingly targeting their products and services to high-end purchasers. The average new car price is now above $50k, principally because luxury vehicles and high-end trucks now make up a larger percentage of total cars sold than in decades past. $15 sandwiches and $5 coffees are now normal. The economy has become increasingly dependent on this class of big spenders.
In the bond market, Treasury yields have been mixed, reflecting the conflicting signals of economic uncertainty and potential inflation. While the 10-year Treasury yield has declined to 4.3% from January highs near 4.8%, indicating concerns about economic growth, the threat of higher inflation has kept yields from returning to the sub 3% pre-2022 levels. The market is closely monitoring the Fed’s upcoming March meeting for further guidance on monetary policy. Any big moves in the direction of the 10-year US Treasury yield will have profound implications for the direction of stocks and the economy.
Feels like stagflation lite
President Trump’s increased tariffs on imports from Mexico, Canada, and China are raising concerns about stagflation, a combination of stagnant economic growth and rising prices. Economists warn that these tariffs will disrupt business investments, inflate prices, and reduce household income, potentially leading to a recession. Many companies are already anticipating price increases and sales declines due to the added costs.
The Federal Reserve faces a difficult challenge in addressing this situation. Tariffs create a “supply shock” that simultaneously increases inflation and hurts employment, forcing the Fed to choose which issue to prioritize. Some Fed officials are warning of a stagflationary scenario, drawing parallels to the 1970s, where the Fed’s “stop-go-stop” policy failed to effectively control inflation or unemployment. Of course, the risk is that the Fed’s response will be delayed due to reliance on lagging economic data.
While previous stagflation predictions haven’t materialized, the current tariff increases, combined with lessons learned from the pandemic’s inflationary effects, suggest a potentially serious economic threat. The Fed is concerned about rising inflation expectations. The 5-year forward inflation breakeven rate (a measure of future inflation expectations) has risen from 1.9% to 2.6% since the Fed began cutting rates last fall. This is a problem for a Fed that wants to support a potentially weakening labor market. The long-term impact of these tariffs remains uncertain, but the immediate effects are causing significant anxiety among economists and businesses.
Brace for impact
One thing is clear. We know that “we don’t know” tomorrow’s headlines and, by implication, which direction the market will move in the short term. The ultimate resolution of tariff negotiations, DOGE, etc. are unknowable with any degree of certainty right now. This is why we diversify assets and maintain balanced portfolios. We do not fear episodes of volatility. Rather, we patiently await such periods because volatility in stock prices enables us to purchase great businesses below their fair value. I am reminded of Warren Buffet’s simple, yet timeless advice: “Be fearful when others are greedy and greedy when others are fearful.”
Opera singer Kiri Te Kanawa turns 81 today, basketball star Shaquille O’Neal turns 53, actress Connie Britton turns 58, and former Fed Chairman Alan Greenspan is 99 years young today.
Christopher Gildea 610-260-2235