Markets opened the week under intense pressure as investors continue to brace for a potential crisis tied to escalating tariff rhetoric and continued unpredictability from the White House. With the expected unveiling of “Liberation Day,” anxiety has risen over the administration’s aggressive trade stance. Yet, just as violent as Monday’s initial decline was, so was the bounce that took the markets into positive territory just as it appeared that prices were hanging over the abyss. As I had mentioned the last few weeks, we are in a phase of market action that is consistent with the normal first quarter of the first year of a new administration. Here is the picture once again. I am including the same picture as I have in the last two weeks as I want it to remain fresh on your mind. Every time there will be a different reason for markets to act poorly in the first quarter, and this year seems to be particularly painful since it is occurring at the tail end of dramatic up years and the pullback could be based on an aggressive president’s way of dealing with international issues.
The risks of last week’s bounce rolling over and the downtrend continuing seems to depend on:
1) whether GDP and its revisions materially comes in under estimates which eventually leads to recession as defined by two negative quarters of GDP,
2) inflation accelerates above expectations prompting the Fed to hike rates, or
3) unemployment soars and consumer confidence continues to decline as it has done in past recessions.
The tariff fears seem to have been the primary reason the market has retested the initial pullback lows according to multiple media accounts. Trumps auto tariffs are a temporary setback given the nature of tariffs but could still be tamed before April 2 according to some analysts. Additional concerns which added to the selling pressure were due to overvaluation of general price levels concerns and dot-com bubble comparisons.
It remains a highly news driven market with tariffs at the forefront. Powell said in his testimony that the Fed will regard any inflation due to the tariffs as transitory. With the Fed adopting an easier money approach with QT (quantitative tightening) being lowered from $25 billion to $5 billion/month as well as more rate cuts on the way.
Last week’s GDP revision beat estimates (2.4% vs est. 2.3%), and the Fed's preferred measure of inflation, the PCE, reported that core PCE came in below estimates (2.6% vs 2.7% est.). On this basis, none of the three key metrics above (GDP, inflation, unemployment) are yet showing red flags. Profit growth in Q4 benefited from strong domestic demand, as real GDP was revised up slightly to a 2.4% annualized rate from 2.3% previously, in line with the consensus. Real final sales compared to domestic purchasers, which excludes net exports and inventories, rose at an even stronger 2.9% annualized rate.
U.S. corporate profits jump in Q4 compared to a year ago, corporate profits were up 6.9%, about in line with average growth several years into an economic expansion. As a share of GDP, profits climbed to 13.5%, a new record high, and a sign that profit margins continued to expand at year end. The trends for profit and margin growth, however, are facing a downside risk in 2025 from tariffs which are both raising production costs and slowing demand.
As can be seen in the chart below, going all the way back to 1950, it has proven consistent that corporate profits and cash flows as a percentage of GDP have declined going into recessions and bottomed at the tail end of recessions. As can be seen at the far right, these numbers are hardly in a decline and are actually rising quite nicely. I find it interesting that due to the Fed’s tool of Quantitative Easing, they have been able to finance growth in the economy and not even experience any signs of recessionary trend even during the COVID period. At present, there will clearly be a speed bump in the growth of GDP due to changes in economic policy by the new administration, but growth has remained healthy.
Before I address the inflation issue, I wanted to dive into the Consumer Confidence issue that we are dealing with currently. The media, along with the market pullback, have created a perfect storm for a decline in confidence. The Consumer Confidence Report tends to hit lows when markets are at their lows as people equate their wealth with their opinions on the overall management of the economy. At present, due to a variety of tariff and trade related factors this measure is reflecting extreme anxiety amongst the survey constituents.
The conference board 1-year expectation for probability of stock price increase is now at lowest level in some time, and the amount of decline in this indicator over the last two months is the largest decline ever. This indicator goes back 40 years.
If we dial this down in time periods to the last 10-years, it obviates that this is even a worse decline than the previous Trump tariffs in his first administration and lower than the COVID crush.
Given all of these data points, the next logical question would be when is it best to deploy capital into the stock market based on these consumer sentiment extremes? Looking at the extremes, and that this is the worst extreme yet recorded, measuring the performance of US equity markets going out 3-months and 6-months is an interesting study. As seen below, going all the way back to the stock market crash in 1987, this has historically been a pretty good time to put money in. This sort of reflects Warren Buffet’s age-old quote, “Be fearful when others are greedy and be greedy when others are fearful.” If this is a measure of investor fear, they don’t appear to be sleeping well at night currently.
The reason why the tariffs are a source of fear to the consumer is that they are expected to be inflationary. To follow the bouncing ball, if inflation rises, consumer confidence in their future spending capacity declines, and then their income levels don’t rise commensurate with rising prices and a recession possibly ensues. So, I want to take a moment and address the current level of consumer confidence and then the current measures of inflation. Going all the way back to 1980, consumers are very worried about losing their jobs. Is it due to AI or tariffs? This is a whole other discussion, but to see where we are, here is the measure of unemployment expectations:
As I said above, this is associated with inflation expectations. When consumers feel that their incomes aren’t increasing as the price of goods are, they are genuinely upset. It seems that the consumer views trade policies and tariffs as highly inflationary. Given that the tariffs are supposed to go into effect this week, it is clear that concerns are at a high point. Currently there are many concerns about the rate of inflation at the grocery store and the pump. To provide an update on what is really happening, see the prices below for Eggs, Orange Juice, and most important Gasoline.
As can be seen above, all three are in aggressive declines, not accelerating! This is far different than the media would choose you to believe, but the numbers don’t lie. Inflation is in check and if the seasonal charts have any chance of repeating themselves, then we could be very close to the end of the current market decline. The fly in the ointment could be in economic growth which will still take time to be measured.
Think of it as history’s view for how the year could unfold. More often than not, the market roughly follows the Cycle Composite. Breaking down the Cycle Composite, the biggest driver is the decennial cycle. Years ending in five have been the strongest, with an average gain by the S&P 500 since 1928 of 20.7%, over 8% points higher than second-place, years ending in eight. Within year fives, the second quarter has been the strongest on average, with a 7.6% gain.
As with the Cycle Composite, the second quarter of the decennial’s year five has few pullbacks. Counterintuitively, going all the way back to 1990, even as drawdowns of 7% or more have occurred in 24 of the 32 years, the S&P 500 has experienced a negative annual return in only nine of those years. This goes on to support the fact that every year has its own seasons, much like the weather. The reasons for the storms this year are quite tangible as the new administration is clearly different than the old, and the need to pay for the free money periods of the past was an eventuality that has come home to roost. Here is the average chart of every instance going back to 1928 with the current year’s market in a dotted line. I have put a box around what could be expected for the second quarter as well:
In closing, there is one point that I touch on quite often in my weekly musings. It is my reference of cash available for investment. I keep harping on this as prices of anything cannot go up unless there is the capital to continue purchasing at higher and higher levels. This is the measure of cash sitting on the sidelines in money markets. Going back to July of last year, the balance in money market accounts was $6.1 Trillion dollars. Today, as of March 21rst, the balance is $7.0 Trillion. This is an increase of $857 Billion. Earnings have increased, businesses have grown, and the US economic dominance globally has remained in the lead, and still the measure of equity prices have reverted to the levels of last July. I believe this could be viewed as a pause that refreshes. And even more importantly, besides a pause to refresh, there is even more cash on the sidelines that needs to find a home. This could be cash that is looking for more than 4.2% in short-term instruments. See the chart below:
The reason why this is particularly important at this moment is the Fed’s objective of keeping our economy in positive stead and keeping employment and financing costs in an attractive place. Here is where short-term rates currently are, where they have been since 2020, and as can be seen by the box on the right the fact that they seem to be traveling back down:
If there is this much cash on the sidelines, and the rate earned on this cash is on the decline, then money will be looking for a place where it can be treated better on a longer-term basis. This could be the US equity market as it has been for some time. I don’t know if we are there yet but based on statistical data, we sure seem to be getting close. As I so often say, “It’s the economy stupid.” If this decline in rates and inflation are coupled with an economic decline, then things are truly different this time. Aside from some industrial measures that are showing decreases in growth rates, the economy still seems quite healthy.
- Ken South, Tower 68 Financial Advisors, Newport Beach
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