Muddle Through With A Downside Skew
The stock market has been on a rollercoaster ride for the past six months, and perhaps to the surprise of some, hasn’t done much of anything since May 12 – other than produce some bouts of exaggerated volatility (and it is still around -4% off the February highs).
That said, a stretch of the wild swings generated the best month for the S&P 500 in a year and a half, and the best May since 1990. For May, the Nasdaq ripped higher by +9.6%; the S&P 500 spiked +6.2%; the Russell popped +5.2% higher; and the Dow lagged the pack while gaining +3.9%.
As for last week, the Dow rose by +1.6%; the S&P 500 tacked on +1.9%; the Nasdaq Composite popped +2.0%; but the small-cap Russell 2000 lagged with a +1.3% gain and remains mired below its key 100-day and 200-day trendlines. While tracking close to the flat-line for the year, US stocks are being trounced by other indexes around the world, with the MSCI All-Cap World Index Ex. US +14%, Latin America +21%, Europe +25%, and Emerging Markets +9%. What we know about seasonality is that June has been flat for the S&P 500 total return index, on average, over the past thirty years, so this is a time to sit tight and patiently wait for opportunities. One subtle, but tactical shift we’ve been making with portfolio exposures is a rotation out of high beta/cyclical holdings and into low beta/defensive sectors. Given the run in the high beta factor exposure over the last two months, a seasonally choppy period, and an event-driven summer calendar likely to produce volatility, we are comfortable taking some chips off the table and building up some dry powder for a better entry window. Not to mention that defensive sectors as a % of the S&P 500 are at their lowest levels since 2000:
The bulls will lay claim that earnings growth for the companies that have already reported are up +13% year-over-year and that 78% have bested analysts’ expectations. However, these better than expected earnings results merely have the broad market back to within a couple percent of all-time highs, but unable to push above (the fact that Nvidia failed to get much of a lift to yet another blowout earnings report is a sign of how much good news is already baked in).
A perfect illustration on how policy headlines rather than fundamental factors are driving the market is the fact that more than 90% of the rally off the April lows came from only four sessions: the first from the pause of the blanket reciprocal tariffs (April 9th), the second from the China reprieve (May 12th), the third from the EU reprieve, and the fourth from the recent trade court ruling. Goes to show there is something to the new TACO acronym (Trump Always Chickens Out) Wall St. has ginned up as an investment strategy. Furthermore, the rebound we have seen has largely been centered in the Magnificent 7, which is more representative of these companies' monopolistic moats and does not reflect what is happening in the economic cycle per se (up nearly +30% from the April lows but is still down by over -4% year-to-date).
Look, I’m willing to give this administration some rope in how they navigate what is a very ambitious undertaking in trying to realign global trade to more broadly benefit U.S. workers, but at the end of the day, those who voted for such a change are going to need to see/experience some tangible results. Not just talking points and telling people what they want to hear. In the meantime, investors have gotten wise to the pattern: issue the initial threat, then have a phone call, and then talk openly about deals. All the while, what households and businesses face is relentless uncertainty. To be fair, the administration continually references ongoing trade talks with 18 of our largest trading partners, to which I once again suggest they get the benefit of the doubt to iron out the details of said trade deals. As an investor, you can be skeptical for now, but you can’t afford to be cynical or close-minded to this administration delivering enough on the trade front, where markets care less about the details and more about moving on. However, the biggest question here and now is, at what point will the President’s credibility become impaired because you only get so many tries at kicking the tariff can down the road?
As far as the U.S. trade court’s ruling last week that the President overstepped his authority with his sweeping tariff plans, this file is far from over. There will be more judicial fights and appeals, and there is no doubt that President Trump will try to carry out his protectionist agenda through other avenues. Even if the trade court decision holds, President Trump could still pursue new tariffs through other legal means. For example, the White House slapped additional export limits on China to round out last week’s actions. Scott Bessent told us that the trade talks with China have “stalled,” and the President slapped 50% tariffs on steel and aluminum. China has accused the US of “seriously violating” a trade agreement between the two powers and vowed to take strong measures to defend its interests as tensions reignited over the supply of critical minerals.
As for the big beautiful budget bill making its way through the Senate, there was a nugget buried in the version that passed the House, Section 899, that would increase taxes on passive income from dividends and interest on U.S. stocks and bonds by five percentage points annually for four years. It would also impose taxes on American portfolio holdings of sovereign wealth funds. It is being called a “revenge tax” because it is designed to apply in cases where other countries are deemed to be imposing unfair or discriminatory taxes against U.S. companies — the countries subject to the tax could include those that impose digital-services taxes, such as some European Union members and the U.K. (the provision could also apply to countries that impose certain taxes under the global minimum corporate-tax agreement negotiated by the Biden Administration). . Let’s hope this provision isn’t used, but if it is, it is used wisely. Because if they fail to wield it properly, durable Fed Yield Curve Control (YCC) and other methods will be rolled out to backstop an unstable treasury market.
It's fair to say that some of this is above my pay grade and/or those writing this legislative provision are considering variables in a manner I am not, because it does cause me to wonder how wise such a policy is, considering that the U.S. government faces an epic $10 trillion of Treasury refinancing needs over the course of the next year. Rolling over this much debt at lower interest rates may prove difficult if foreign investors don’t show up at the Treasury auctions. As a nation, we have never been more beholden to the kindness of strangers. Yet another reason to expect the bear market underway in the U.S. dollar to be extended, and one of a number of tailwinds pushing gold higher.
As for this bill, the headlines you read about it focus on its regressive characteristics and how much it will add to an already massive Federal debt pile, but what gets lost is the reality that this bill has very little fiscal stimulus in it. I’d argue that it's actually restrictive in its growth profile – have a look for yourself:
The cost of extending the 2017 tax cuts is $4.0 trillion (including the new SALT cap increase).
Total tax increases in the bill are +$300 bil – mostly made up of removing energy tax credits.
There is a net of -$1.2 trillion in program spending cuts – mostly made up of Medicaid, SNAP, and some education programs.
And there are +$550 billion in incremental interest payments over the next 10 years attributed to not having the 2017 tax cuts expire.
So, when you do the math, the total deficit increase of $3.1 trillion (including interest) over 10 years is entirely driven by extending prevailing tax levels. Said plainly, this bill maintains the status quo and is by no means stimulative for GDP growth over the 10-year measurement window. The $550 billion added to the accumulated deficit from debt-service charges being higher than they otherwise would be (had the tax rates been allowed to increase) does boost the debt, but has no impact on the economy (other than generating a nice income stream for asset-rich households). That is not “program spending” which is the only spending that exerts an economic impact.
We’ll see what the Senate does with this version, as we already know their previous bill allowed for a larger increase in the debt over 10 years, but the present version of this bill, benchmarked against today’s tax and spending environment, amounts to a -0.4% fiscal drain from GDP growth per year over the next decade. That doesn’t even include the fact that tightened immigration rules will cost the economy a further -0.2% to -0.4% annually in forgone aggregate demand, which is bigger than the estimated annual impact from deregulation efforts. To repeat: The net fiscal drag is $1.5 trillion from the baseline. That is NOT expansionary. Keep in mind two things: 1) this isn’t the final version, so the numbers can move in either direction, and 2) this bill is front-end loaded. Meaning, most of the stimulative measures it does include occur over the next three years – think gas now, brakes later (see chart below).
While I believe this big beautiful bill lacks a meaningful fiscal punch, it does showcase how out of favor reigning in fiscal spending is in Washington, D.C. This isn’t exactly a new revelation, as government spending has outstripped revenues by 45% since 1986 until the TCJA was passed at the end of 2017. Since the TCJA was passed, through the end of 2024, expenditures have outpaced revenues by 80%. This is largely a function of the fiscal hysteria following COVID, where government spending is now more than $2.5 trillion above the level that existed before COVID hit. That is a sum bigger than the size of the entire Canadian economy. This bill makes a token effort at containing spending, but falls short of actual reduction.
Let’s end with some thoughts on markets, starting with the U.S. dollar. The fact that the U.S. dollar index is down 7% this year is becoming a problem for all those foreign investors who have large allocations to U.S. equities. While the S&P 500 is roughly flat in U.S. dollars, it's down 7% in euro terms this year. What’s more is that hedge funds and traders continue to place bearish bets on the dollar, and this seems more like the real thing than a contrary bullish development. If there is one thing we learned last week, especially after the reaction to the U.S. trade court ruling, it is that the Big Dollar has become a sell-on-strength unit – and yet another positive for gold.
As for the bond market, it seems as though the 4.5% level on the 10-year T-note and 5.0% level on the 30-year are high enough to attract buyers, notwithstanding comments from Jamie Dimon last week that the bond market is going to “crack” at some point. There is a growing chorus of investors who think the yield on the 10-year Treasury is going to retest the October 2023 cycle high of 5.0%. Something bond investors should keep in mind is that the backdrop is much more constructive today than it was back then.
The funds rate is at 4.25%, not 5.25%, so the Treasury market naturally “carries” a lot better. The core inflation rate in October 2023 was 4.0% YoY, now down to 2.8%; the headline was 3.2% YoY, and today it is at 2.3%. The unemployment rate was 3.9% then, which is 4.2% now. The YoY real GDP growth was +3.2%, and the nominal trend was +5.9%. Today, those numbers are +2.1% and +4.7%, respectively. Another thing is the decline in price sensitivity to a further increase in yields. Back in the summer of 2020, when the 10-year T-note yield was trading at a minuscule 0.5% yield, you had no coupon protection at all. It would only take a +6-basis-point increase to erode your capital and send you into negative total return territory. Today, at around a 4.5% yield, the rate would have to surge +66 basis points, setting a new cycle high, for you to lose any money in the 10-year Treasury note. Now, that is a whole lot of coupon protection. But if yields were to drop -66 basis points, that would trigger a net positive total return of nearly +10%. So, let’s see — a big move like this in either direction: either be flat or make +10%. Not a bad tradeoff, in my opinion.
As for the equity market, it acts like it’s in a holding pattern. Economic growth is resilient, labor market is holding firm, inflation is in check, earnings are solid, and worst-case scenarios have been correctly priced out (or assigned a much lower probability of occurring), which likely has a lot to do with why the S&P is back to trading near an all-time high P/E valuation of 21x. However, this elevated multiple leaves little room for multiple expansion to fuel additional upside from the current 5,920 level the S&P 500 is trading at. Goldman Sach’s Chief Equity Strategist David Kostin put out the following table in a note last week that provides an insightful reference point for the risk/reward profile of the equity market. What you see is that even if you incorporate the most optimistic of assumptions for earnings and P/E multiples, the upside for the S&P 500 is pretty limited. However, the downside is quite a bit lower for those willing to consider even a base case or worst-case scenario.
That doesn’t mean investors should abandon a strategic exposure to equities, but rather be patient and mindful about being overweight or deploying more capital into stocks at current levels. A lot of good news is priced into stocks at the moment. I expect both the economy and stock market to muddle through a choppy summer calendar with a downside skew. July sets up to be an interesting month on the catalyst front, as that is when the tariff extension is set to expire, and we should see some of the weakness in the hard data get reported from the ongoing tariff drama. I lean in the direction that this administration will make deals, take the wins, and move on, but I do think markets have settled into an expectation that a baseline rate of 10% with some sectoral tariffs is where we’ll end up. This is better than the worst-case scenario, but don’t overlook the fact that even a 13% effective tariff level (which would be on the lower end of the expected range) is 10% higher than where we started the year.
We can all get into semantics over who pays what and how, but at the end of the day, this is an additional 10% tax levied on the global economy, where the tariff expense comes out of the global financial system and flows into Uncle Sam’s bank account. That is equivalent to a $200 - $250 billion annual liquidity drain on the global financial system. That’s not nothing. Sure, some of this will be offset by other regions around the world stepping on the fiscal gas pedal (one of several reasons why we like and continue to increase exposure to foreign equities).
Not to mention the Fed has become consumed with fear about the tariff file and its impact on inflation expectations (markets see 22% odds of a rate cut at the July 30th Fed meeting and just 62% odds for September 17th). This means the Fed will be late to the game in providing accommodation while other central banks are moving towards loosening policy. The ECB looks poised to cut its policy rate at its next meeting to 2.0%, which would mark the eighth cut since June 2024, when the rate was at 4.0%). So, for global asset allocators, you can buy the European market with a 2.0% risk-free rate and a sub-15x forward P/E multiple or the S&P 500 competing against a 4.0%+ risk-free rate and a 21x multiple. While the particulars are different and there is some nuance to other parts of the world, the broad strokes are that growth outside the U.S. looks to be accelerating, valuations are less stretched, and they have a lot more fiscal room.
As for the week ahead, it will be chock-full of economic data, with the jobs data taking center stage. Expectations are for a moderation in job growth (130k is the consensus number), where a miss to the downside will create some concern. Last week's jobless claims suggested some cracks are starting to emerge in the labor market, with jobless claims hooking up to 240k and continuing claims reaching their highest level since November 2021. So far, what we’ve seen in the labor market is more of a slowdown/freeze in hiring, but not so much an escalation in firings. Should we start to see more of the latter, we’ll likely see financial markets shift to pricing in a different regime.
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