Reading the headlines, it is hard to square the circle between all the bad news we read about on the front pages and record stock prices. Tariffs, wars, rising commodity prices, ICE raids, and difficulties many have finding jobs doesn’t seem to jive with record reported profits. But investors aren’t crazy. So, let’s dig a little deeper.
Looking at the market simplistically, stocks move based on earnings, interest rates, and inflation expectations. Any news item that doesn’t materially affect those three becomes background noise to investors. Thus, tariffs matter (we’ll get to that in a moment) but ICE raids, Alaskan summits without a happy ending, and the woes of college grads looking for a good paying job are not important inputs to the equations that determine stock prices. While tariffs are a tax, a headwind, deficit spending and less red tape are offsets. Someday soon AI-related productivity gains may also be a factor. But the impact so far is not particularly large.
So far this year equity markets have been on a bit of a roller coaster, first celebrating a Trump win, then reeling in the face of early tariff threats before rebounding to record highs as the tariff burden appears to be less than initial fears suggested. The NASDAQ Composite is up 12% year-to-date while the S&P 500 is up 10%. But the Dow Industrials and the equal weighted (versus market cap weighted) S&P 500 are both up about 6%, only slightly better than historic 6-month average gains of about 4%. No doubt the primary driver has been earnings. Reported Q2 profits so far, with only the major retailers still to report, are up over 11%. While the outlook for the second half is less robust as the full impact of tariffs will be felt, there are no signs of any pending recession.
Last week’s inflation reports are revealing. Producer prices spiked as they reflect primarily input costs for manufactured goods. They are clearly and directly impacted by tariffs. On the other hand, the consumer price index report, heavily skewed toward services and shelter costs, rose at a more modest pace. The rate of increase in the CPI is still above Federal Reserve targets of about 2% but tolerable, still rising at less than 3% annualized.
Thus, inflation is stable but still a bit high. On the other hand, final sales to end users grew at a pace of a little over 1% in the first half of the year, hardly a robust number. The small gain, combined with modest-to-moderate inflation suggests 1-3 rate cuts in the Fed Funds rate are likely in the second half of this year. While Wall Street will celebrate such a move, a buoyant reaction may be misplaced if the 10-year Treasury yield stays elevated. So far this year, it has stayed within a narrow range, mostly between 4.2-4.5%. It is right in the middle of that range today. Another economic factor of note is the steady decline in the value of the dollar as measured against a basket of foreign currencies. It is down almost 10% so far this year. A weak dollar helps increase our exports and makes imports more expensive. While that is a positive related to the trade deficit, it also stifles the flow of capital into the U.S. Buying US Treasuries that yield 4%+ instead of German or Japanese debt that yield 1-2% may make sense if the dollar is stable but generates losses if the dollar continues to fall. While all governments profess to want a strong currency, our policies continue to push the value of the dollar down.
Two of President Trump’s initiatives, reshoring of manufacturing, and “drill baby drill” are impacted negatively by policy actions. Manufacturing employment is down over the past 5 months and so is oil drilling activity. While lower oil prices mitigate some of the pain of tariffs, new drilling activity, particularly in the Permian basin, has declined meaningfully. As for reshoring, some companies are trying to buy American to avoid tariffs and some American plants are getting more volume as customers buy local rather than overseas. But the weak dollar will be a meaningful headwind to foreign capital investment in our country as will the constantly changing or evolving tariff decisions.
Turning back to markets and the economy, it is quite clear that we live in a composite world of haves and have-nots. The haves are almost all related to some degree to the rise of artificial intelligence and the collateral surge in investment spending. The Mag 7 and related companies are spending hundreds of billions of dollars building data centers, buying semiconductors, and feeding a boom in venture capital targeting anything AI related. The AI boom plus the inevitable switch from gas-powered to electric vehicles over time has supercharged the need for more electricity and a grid system robust enough to support future demand increases. Just increasing electricity demand by 2% per year will generate a need for hundreds of billions of dollars in additional capital projects.
If one remembers that the Mag 7 account for roughly a third of the S&P 500’s value, and sees earnings growing close to 20% year-over-year, it goes a long way to explaining the 11%+ gain in second quarter earnings. Those are the haves. But if a third of the S&P is growing at a supercharged rate, what about the rest? As reflected in the performance of the equal weighted index or the Dow, the rest is barely growing. The auto industry is suffering. While tariffs on imports would appear to help Ford and GM, those benefits evaporate when one realizes input costs for US manufacturers are rising rapidly. Just consider 50% tariffs on steel and aluminum. Housing is in the doldrums as mortgage rates are still near 7%, Perhaps most important, Americans who are not invested in stocks and who don’t own their own home are being left behind. Wage growth is insufficient to offset rising costs of basics. You hear the pressure on these Americans when you listen to managements of Wal-Mart, McDonald’s#, and Procter & Gamble discuss their current environment.
But with all this said, corporate profits and profit margins remain strong. Cash flows are enormous. As a result, corporations are on pace to buy back almost $1 trillion in stock this year, a record. Like everything else, stock prices are impacted directly by the laws of supply and demand. Stock buybacks reduce supply. Apple#, by example has repurchased about a third of its shares outstanding over the past decade. That alone adds about three percentage points per year to earnings per share growth. The boom in IPOs adds to supply but the total to date is still well below $100 billion.
Thus, what really matters is good earnings (+11%), stable interest rates, modest inflation expectations, and a weak dollar. All are helpful to stocks. While the pace of earnings growth is likely to slow a bit in the second half of 2025, there will still be growth. What are the clouds on the horizon? Valuation for one. The multiple on the S&P 500 is now near 25, very high by historic standard. Speculative fever is increasing. Look at the IPO performance of recent offerings, the rise in crypto prices, and the surge in retail trading. The typical Robin Hood investor doesn’t have any recollection of the Great Recession nor the Internet or subprime housing bubbles. Other clouds are more fearsome but further out. Among those are a shortage of available housing at a price anyone would deem affordable, student loan debt that now has to be serviced and repaid, and the displacement of jobs caused by AI.
I will end with one thought meant to provoke thinking, not any conclusion on my part. The popularity of Democrats is at an all-time low, in large part because collectively they don’t offer solutions to today’s issues that satisfy voters. On the other hand, Republicans don’t seem to have a solution for emerging problems like affordable housing or an education system whose costs are bloated and, judging by test scores, increasingly ineffective. Mid-term elections are a little over a year away. The candidates that offer solutions that resonate with voters will win. This fall’s mayoral race in New York will be instructive. Although I doubt policies suggested by self-proclaimed Socialist Zohran Mamdani will work, the fact that he is offering solutions to problems at the top of collective psyches of New Yorkers makes him the front runner. That’s how our system works. For almost 250 years America’s democracy has worked pretty well. If we head in the wrong direction voters every two years have the ability to steer the ship back on course. Voters rejected Bidenomics in favor of disruptive change under Trump. Next fall they will vote on the success of Trump’s agenda. So far, markets have voted positively, but they don’t have the only vote.
Today, actor Edward Norton is 56. Robert Redford turns 89.
James M. Meyer, CFA 610-260-2220