Navigating a complex landscape
The YTD period has presented a fascinating, and at times unsettling, picture for the equity markets. Despite a significant downturn in early April, the market has managed to make a complete rebound during the last four weeks, rising an incredible 18%. The S&P 500 finds itself essentially flat for the year as a result. This seemingly placid net YTD performance masks the considerable volatility experienced by investors as the market grappled with the flurry of shifting trade and tariff headlines. The swift recovery underscores the inherent resilience of the market and the eagerness of investors to look beyond immediate concerns. Yet the selloff serves as a reminder of the underlying uncertainties that persist.
The rebound in stocks has pushed valuations back to record levels. The S&P 500 is now once again trading at approximately 23 times its expected earnings for the fiscal year 2025. This multiple suggests that the market is pricing in continued earnings growth and a relatively stable economic environment. YTD economic activity has been boosted by inventory building and consumer purchases in advance of the widely expected rise in prices that will result from the new tariffs. At 23x expected earnings for the S&P 500, the current valuation of stocks leaves very little room for error should economic growth falter or earnings disappoint.
Even with the recently announced pause in tariff escalations with China, it’s important to acknowledge that the year-over-year increase in tariffs will be the most substantial since the 1930s. A recent Goldman Sachs report estimates an average overall tariff rate of 13% as compared to the 2% starting level. While this is lower than some of the more extreme scenarios that were being discussed, it still represents a significant increase in the cost of goods, which will likely impact both corporate profitability and consumer prices. The long-term implications of these trade policies on global supply chains and economic growth remain a key area of focus.
The effect of these tariffs on inflation is a significant concern. While the April CPI report appeared benign, it is widely anticipated that it does not yet reflect the price increases stemming from the recently implemented tariffs, which will likely become more apparent later this year. This puts the Federal Reserve in a challenging position. Inflation expectations remain elevated, yet there are growing signals of economic slowing. If the Fed waits for definitive evidence of rising unemployment before acting, it risks being behind the curve and potentially needing to implement more aggressive policy adjustments down the line. This delicate balancing act between controlling inflation and supporting economic growth will be crucial to monitor.
Concerns for a consumer spending slowdown have increased
Consumer spending, the bedrock of approximately two-thirds of the U.S. economy, faces considerable headwinds in the coming years. Several factors contribute to this concern. Firstly, student loan defaults are on the rise following years of forbearance. The resumption of garnishments of up to 15% and potential reductions in federal benefits, set to resume this fall, will detract from consumer spending. Student loan balances have ballooned to a staggering $1.7 trillion, making it one of the largest categories of debts behind only residential and commercial mortgage loans. It is estimated that nearly 10 million of the 42 million student loan borrows are now, or soon will be, in default.
Secondly, the housing market presents considerable challenges going forward. Home prices have likely peaked, with housing affordability now worse than it was preceding the Great Financial Crisis. This is starkly illustrated by the fact that the average age of a first-time homebuyer has risen from 30 to 38 in the last 15 years, while the median home price has increased by an astounding 197% over the past 25 years, compared to a mere 40% increase in median household income. We are also observing rising foreclosure rates, particularly among homes financed with FHA mortgages, which required as little as a 3.5% down payment.
Consumer spending has benefited over the years from the “wealth effect” associated with rising home prices. If home prices decline or simply remain flat, homeowners will potentially curtail their spending habits. Moreover, many experts believe a mortgage rate closer to 5.5% is needed to stimulate the housing market based on the current home prices and median incomes. However, achieving a lower mortgage rate would require a significant drop in the 10-year Treasury yield, a scenario made less likely by the administration’s trade policies, which have weakened demand for U.S. dollar assets.
Fears of recession have diminished
While most market strategists have revised down the immediate probability of a recession following the “reciprocal tariff pause” agreement with China, there is a broad consensus that the economy is indeed slowing. For instance, the unemployment rate for younger workers (i.e., 21- to 27-year-olds) has increased from 4.8% to 5.8% since year-end. This may be an early indicator as it reflects weakness in the job market for recent college graduates. Layoff announcements have also risen in recent weeks, but we have yet to see the overall reported unemployment rate increase. The boom in AI-infrastructure-related investments may provide a positive offset. Time will tell.
Adding to this complexity is the tax bill progressing through Congress, which, based on initial reports, appears likely to increase the deficit rather than reduce spending. This could put upward pressure on bond yields, potentially further dampening economic activity. The 10-year US Treasury yield has risen from 4.0% to 4.5% since early April and remains a critical indicator for investors. Rising interest payments on the $36 trillion of U.S. debt load present refinancing challenges, especially given record budget deficits. There are plans to relax capital requirements of banks and other large financial institutions, which could provide some sources of additional bond-buying capacity. But the challenge remains, as approximately $9 trillion of U.S. debt is scheduled to mature this year.
Thus, despite the impressive rebound in equity markets, we believe it is premature to become overly complacent. High valuations, coupled with a slowing economy and the potential for rising interest rates, suggest a potentially volatile summer ahead for the stock market. We continue to emphasize the importance of a disciplined approach to asset allocation, focusing on long-term fundamentals and risk tolerance.
Birthdays:
Tennis player Andy Murray turns 38 today, actor Chazz Palminteri turns 73 and football great Emmitt Smith is 56.
Christopher Gildea 610-260-2235