Finally, we had a good week in the stock market. After a rocky Monday, when investors fretted over possible consequences should Trump attempt to fire Jerome Powell, equities rallied over the next four sessions once Trump put to rest such a notion, and Treasury Secretary Bessent commented that 145% tariffs on China might not last very long. Companies reporting early in earnings season mostly matched or exceeded expectations while tempering outlooks sheathed in tariff-related uncertainty. Given mostly modest changes to earnings forecasts, at least until there are more explicit signs of economic deterioration, investors shook off their worst fears. The rally was more a combination of a collective sigh of relief accelerated by short covering than any rising conviction that economic growth would reaccelerate.
Thus, we are now in a trading range bounded by the early April lows and the February highs. To break out on the upside, investors have to see recession risks minimized and stability in both the bond and currency markets. A downside breakdown would occur should growth and earnings be impacted by the tariffs already in place. To date, the impact has been minimal because tariffs were only imposed over the last two months and, for the most part, tariffed goods have yet to work their way through our consumption pipeline. Indeed, April sales have shown strength as consumers rush to buy goods already on shelves or on dealer lots that are tariff-free.
The Trump approach to date has been to punch every trading partner in the nose and see how they react. His process is designed to bring each to the negotiating table. When China entered the WTO more than a quarter century ago, it was granted developing nation status. That may have been appropriate for a nation just emerging from the confinements of a Mao world, but it is hardly apt today. Developing nations are allowed to subsidize businesses, and place restrictions on foreign investments in their own country, for instance. Developed nations cannot. If the U.S. is to succeed in even partially leveling the playing field with China, it will only happen after a long and difficult negotiation, one that most likely will be achieved in incremental steps.
Over the past two decades, the U.S. has learned that the just-in-time mantra breaks down in times of crisis. As supply chains became more global, the risks of breakdown have increased. We have heard a lot lately within all the tariff discussions about comparative advantage, a concept that says goods should be produced wherever the cost of production is the least. But what happens when supply chains break for whatever reason, political, climatic, or economic? If a weather-related disaster causes avocado crops to be cut in half, we will somehow survive. But when China announces it will cut off exports of processed rare earth materials, the production of everything from smartphones to cars would be impacted if such a ban were sustained for long.
Of course, export bans go in all directions. We have been restricting the sale of advanced computer chips to China for many years. But bans only work to a point. Lock one door and I will seek to find another way to get to the other side. Look at DeepSeek, the Chinese AI company that has shown it can deliver its own open-sourced large language models using a combination of chips developed in China and lower performance chips designed in the United States.
Bill Gurley, a prominent investor and venture capitalist, makes a distinction between finite and infinite games. A baseball game is a finite game. It has a start, an end point, and a clear winner. He would describe the stock market, for instance, as an infinite game. There may be a start point (your first investment), but there isn’t an end point. The race to AI superiority, or the race to overall economic superiority has no endpoint. The U.S. may be ahead for a time, but it isn’t a race we can win. All we can do is stay ahead for a time. China, seeing that it might need to be more self-dependent as it seeks to build itself into a leading economic power, has invested massively in key areas. It produces more STEM graduates per year than the United States by a factor of 10 or more. It established long-term goals years ago and sought to put its resources behind whatever was needed to achieve those goals. We are seeing signs of success today not just in DeepSeek but in the development of advanced medications, and electric vehicles. Being a much more centralized nation than the United States, China is able to be more focused. It states its goals prominently and then puts resources in place to execute them.
There are also clear problems with China’s approach. It vastly overspent developing real estate to the point where markets have collapsed. Chinese, experiencing steep drops in the value of their most important asset, their home, have become reluctant spenders. They already were big savers as China lacks the safety net of Social Security or Medicare, requiring them to save for future health and retirement costs. This imbalance has forced China to be an export nation as a prime generator of economic growth. Other nations often need to push back, preventing China from shipping subsidized cheap goods.
If there are lessons to be learned I think the following two are essential. First, the U.S. as a nation has to focus on its own economic security by making sure key parts of our economy can grow as unconstrained as possible with supply chains as U.S. based as possible. Examples are semiconductor manufacturing, having adequate energy resources (including a robust grid to support our needs), pharmaceutical production, and the capability to process onshore all the key components needed to support our growth. Added to the list would be to produce domestically whatever is needed to ensure our nation’s security.
In order to achieve these goals as quickly as possible requires significant change within our government. Trump clearly is trying to do this. In the administration’s haste, collateral damage has been done. While much has made the front pages, the overall damage beyond tariffs, has not been economically consequential to date. Perhaps workforce reductions in the U.S. could reach 200,000 or so this year. That sounds like a big number but it’s less than 10% of the number of Federal workers and a small fraction of less than 1% of the total U.S. workforce. In efforts to reduce the size of our federal bureaucracy in a meaningful way, the focus has to switch from headcount to process. Our bureaucracy is riddled with excessive rules and hoops that slow everything down. What can be built overseas in two years takes 5-10 here. Huawei, built and deployed over 100,000 charging stations to service the electric vehicle market within two years. The Inflation Reduction Act authorized almost $8 billion to support the buildout of a charging network in the U.S. when passed in 2021. As of last November, the number of stations added to the market by the U.S. was 214. That failure had nothing to do with headcount. The reasons for the disparity are obvious. Fixing the problem should also be obvious. But that won’t happen until the bureaucracy is dismantled. That is part of DOGE’s task. But the solution isn’t all within DOGE.
Congress needs to step up. So far, it has done nothing. It did next to nothing in its last session. Both parties should want to solve the problem but to date have shown no ability to work together. The result of all this bloat is an annual deficit of close to $2 trillion. While Musk declares annualized savings of $160 billion (undocumented) those are more than offset by increases in interest, Social Security and Medicare costs. The dollar weakness points to money exiting the U.S. Politics has something to do with this, but so does the bloated deficit and rising total U.S. debt. Deficit to GDP of 7% is absurdly high and unsustainable long-term. The only question is when does this evidence itself via higher debt service costs?
Which, finally, brings me back to markets. In today’s world, it is hard to separate extraneous noise and focus on what’s important to investors, the factors that impact long-term cash flows. Tariffs, of course, matter at least in the short run. They are a cost to do business. What they are projected to be changes day-to-day. What they actually will be, beyond the current shock and awe moment, remains to be determined. Comments last week suggesting moderation of Chinese tariffs were key to the rally in stock prices. Tariffs are only one input to the economic game plan. The rest of the cocktail consists of tax cuts, just in the development stage, and DOGE savings, still rather modest. Musk, like Trump, grossly exaggerates both size and timing. But, as noted earlier, the early savings from headcount reduction haven’t led to a reduction in government spending. In fact, so far this fiscal year, the Federal deficit is rising.
Stocks have rallied mostly because the worst outcomes feared shortly after Liberation Day have given way to a more moderate likelihood. But with that said and presuming further tariff moderation, we still face a world with the highest tariff/tax structure in a century. One cannot see, at least for the moment, a smaller fiscal deficit. This is where Congress comes in. So far, it has deferred to Executive Orders with hardly any Republicans daring to suggest that more tangible steps must be taken. It has passed a budget roadmap mandating a level of savings that don’t seem likely. Ultimately, it will have to agree to changes, including to the tax code, that start to move the country in the right direction. It is fast becoming time for Congress to force change on the White House, not the other way around. If it doesn’t, deficits will continue to rise, and the ability to support them without incurring even greater debt service cost will decrease. Clinton had to deal with Blue Dog Democrats. The outcome worked to the nation’s benefit. Now it is the Republicans’ turn. If nothing changes and deficits are not constrained in some manner, this past week’s rally won’t last for very long.
Today, Jessica Alba is 44. Penelope Cruz turns 51. Jay Leno is celebrating his 75th birthday.
James M. Meyer, CFA 610-260-2220