Stay Disciplined And Be Patient
Back from a busy week of being on the road visiting clients, with markets continuing to rejoice Trump’s pivot on the trade front. Admittedly, it's dizzying to keep up with the conflicting messaging coming out of this administration: be it about terminating Fed Chair Powell one day, to no intention of firing him the next day, or innuendos about trade negotiations/deals going great, only to be met by a ‘deer in the headlights’ response from a counterparty. Then there is constant confusion on trade talks with China that we claim are ongoing, but China repeatedly denies:
“China and the U.S. have not held consultations or negotiations on the issue of tariffs,” said Guo Jiakun, the spokesman for China’s Foreign Ministry, in a news conference on Friday, adding that “the United States should not confuse the public… any claims about progress in China-U.S. economic and trade negotiations are baseless rumors without factual evidence.”
Someone isn’t telling the truth, and quite frankly, I’m not sure which propaganda campaign I trust less. Please don’t mistake this comment as anti-American, it's just that I’m used to treating anything coming out of China with a grain of salt. Whereas information coming from the U.S. can usually be considered reliable once you adjust for the political bias from which the information is being transmitted. Nevertheless, the mixed messaging is undermining the President’s credibility (I know there are many that never gave him any to begin with) as is prone to happen to anyone who has a record of saying something impulsively to then backtrack quickly thereafter. Bottom line, if President Trump and President Xi can’t agree on whether they have even spoken to each other, how will they ever agree to a trade deal?
As of now, the mere appearance of a détente on the trade front is enough for markets to mount what has become a sizable relief rally. Last week, the S&P 500 gained +4.6% and has now ripped more than 14% from the intraday lows reached on April 7th. The S&P 500 is now down just 6% for the year and only 3% off where it traded the day before Liberation Day. While I agree with the broadening sentiment that we’ve moved beyond peak uncertainty, I’m skeptical that a 3% decline in the S&P 500 since Liberation Day is enough of a discount given the dramatic impact these policies will have on growth, inflation, profit margins, employment, capital flows…over the medium to long-term. If anything, the downside risk to a range of possible outcomes has meaningfully increased along with the probability of an earnings and economic recession.
Keep in mind that bear market rallies tend to be swift and convincing. During the popping of the Tech bubble that extended from March 2000 through October 2002, the S&P 500 experienced seven rallies that averaged 14% over a two-and-a-half-year slide while losing 49%.
During the Global Financial Crisis that spanned from October 2007 through March 2009 the S&P 500 had more than seven bear market rallies that averaged more than +10%, yet the cumulative decline amounted to -57% before all was said and done.
Please don’t extrapolate these two market cycles to today. I’m merely using them as an illustration for context. The main message I’m trying to convey is that the investment environment has changed quite dramatically in my estimation since April 2nd. And as such, I’m inclined to view the equity market through the lens of a bear market until convinced otherwise. The fundamental backdrop is one of ‘show me’ rather than getting the benefit of the doubt. With this rally the P/E multiple on the S&P 500 has moved back above 20x on forward earnings - that’s a rich multiple even without visibility on forward earnings being as clear as mud.
So, while I consider the current rally in equities to be that of the bear variety, this week sets up as a big test to prove a doubter like myself wrong. We’ll get earnings reports from 180 companies this week (or 40% of the index’s market value), with four of the Mag7 reporting: Microsoft and Meta on Wednesday, and Apple and Amazon on Thursday. So far, Q1 earnings from those that have reported have exceeded expectations, but these are pre-Liberation Day numbers, and as I’ve referenced above, things changed quite dramatically after April 2nd.
This rally got started back on the Morning of April 7th when the bond market flexed its muscle and caused a market-savvy Treasury Secretary to inform this administration that they need to pivot (at least in the short-term) or something was going to break. Since then, investors have come to grips with the chaos and confusion, not saying it’s justified or calming, but there is nothing new there. Knowledge is volatility-dampening, and investors now understand that chaos is part of the equation. That doesn’t make it easier to navigate, but it does force markets to assign a higher risk premium to all assets. The economic fallout that lies ahead from the confidence shock and curtailing of activity is unknown and more perplexing.
As of Friday’s close, the S&P 500 has retraced some 50% of the slide from its February peak, and the 5,540 level represents a key level of resistance. Should we push above here, that will set up a move up to the pre-liberation level of 5,700, which is plausible, but beyond that would require some material improvement on the trade front, and a continuation of what was a reasonably solid backdrop from Q1.
It’s not as if there isn’t some ammunition that could push this rally further. Sentiment is still very negative (a contrarian signal for the bulls) with the AAII sentiment index leaning heavily to the bear camp for 8 straight weeks.
Same story in the Investors Intelligence Survey:
Beyond sentiment, positioning across the Hedge Fund, CTA, and volatility targeting strategies has aggressively degrossed. Should this rally continue, these pools of capital will be forced buyers of equities, which could give stocks another leg.
Humor me for a moment as I elaborate on some of my thoughts on tariffs and try to tie in some economic and capital market analysis. I’ve said it before, and I’ll say it again, the objectives of retrofitting trade to support American industry, national security, jobs, and fairness aren’t the problem. Most Americans can get behind or are already behind such ambitions. It’s how this reordering was introduced to the world and the bizarre way bilateral duties were calculated that has everyone scratching their heads. What started off as ‘reciprocal’ quickly evolved into ‘reprieve’, and now everyone is trying to figure out what is real and what is theater as it relates to a baseline to work off of. This approach throws supply chains into disarray and forces global trade activity to come to an immediate standstill. Maybe this is the only way to usher in real change, as it will grab everyone’s attention, but such an approach comes with a cost.
It is hardly encouraging for the corporate sector to be compelled to operate in a constant state of confusion. For example, President Trump claims he has talked with Xi Jinping “numerous times.” When the talks took place – before Liberation Day or after – we don’t know. Then we have the Treasury Secretary Bessent, saying yesterday on ABC’s “This Week” program that he was unaware that President Trump had spoken to President Xi Jinping of China — “I don’t know if President Trump has spoken with President Xi.” Look, this isn’t me attempting to play ‘gotcha’, but this is a pattern of behavior that is important for investors to be aware of. If there is a bull market anywhere, it is in misinformation, rendering all information disseminated from this administration as less reliable. I fully acknowledge the difficulty of reordering the world order with minimal disruption, but this seems more akin to throwing bricks through windows and calling it redecorating.
In the meantime, the business community has little visibility, and sure, large established businesses with strong balance sheets will likely weather the storm, but small businesses are fighting for survival. Look, maybe this does provoke a significant capex investment cycle across the U.S. and other countries follow suit in their respective geographies – that would likely be very constructive for growth (probably inflation as well – not so good) – but doing so with the ‘stick’ rather than a ‘carrot’ takes two very different paths in route to a similar outcome. At this point, it looks like the White House has specific objectives, but no apparent roadmap on how to achieve them.
Treasury Secretary Bessant was out last week reiterating that China cannot withstand Trump’s 145% tariff level, which will force them to the negotiating table. China’s response is that they are prepared for this trade war: announcing support for exporters via credit easing, market diversification aid, domestic cost reduction, and forex hedging tools. By all accounts, China appears content to wait out the Trump administration, and if that is the case, that’s not a very constructive backdrop for asset prices when the two largest economies in the world are locked into a showdown where neither side can exhibit weakness. I know writing stuff like this may give you the impression that I’m anti-American, betting against this administration, or that I think change isn’t needed. I’m none of the above. I’m an atheist when it comes to politics and policies. My job isn’t to judge how or why policies are implemented, but rather to analyze their impact on how we’re allocating client capital.
That said, my base case has shifted from slowdown to recession. What I find odd is that this seems to have become a consensus view—Bloomberg Economics consensus is up to 45% recession odds for the coming year, rising from 30% a month ago, and the poly market puts the chances at 55%—yet the S&P 500 is down just 6% on the year and 10% from its all-time high. Maybe this is like Covid, where anyone paying attention was aware that in December 2021, the virus was wreaking havoc in China and then Europe in January. Still, it wasn’t until late February that investors got the memo. And then, over the course of 5 weeks, the S&P 500 plunged 35% as risk assets caught down with reality. Or maybe I’m wrong and the resilience of the U.S. economy will make fools of us pessimists once again, as it has throughout the past sixteen years, where it took a forced lockdown to cause the only recession since the GFC engulfed the globe back in 2008.
However, this is not the 2022-2023 growth scare with $2 trillion of excess pandemic savings waiting in the wings. I concede that the rest of the world has room to ramp up fiscal stimulus, which could be enough to offset a softening in the U.S. economy. Not to mention, DOGE appears to have fallen flat on its face with the latest estimates that they can only come up with $160 billion in cuts. So much for the fiscal “detox” and chainsaw theatrics talking up nearly $2 trillion in cuts - the fiscal gravy train continues to chug along. Or maybe it's that the swamp is so overwhelming that it swallows up anyone and everyone, even for people with the bravado of Musk and Trump. There are additional levers that make me nervous about getting negative on growth: central banks have ample room to cut rates, oil prices appear well contained in the $60-$70/bbl range, and a sustained U.S. dollar bear market would alleviate a lot of pressure on global growth. Not to mention that global money supply growth is accelerating, which typically is a leading indicator of global economic output.
Nevertheless, I’m looking at equity and debt markets today that are barely priced 25% of the way for an economic recession when our work suggests those odds are north of 50%. In layman’s terms, the risk/reward proposition for equities is skewed to the downside. My work suggests the S&P is capped at around 5,800 on the upside and 4,800 on the downside in a no recession scenario (just a growth scare), that’s 300 points of upside vs. 700 points of downside. So, over a 2:1 downside skew. If a recession were to play out, then I think the S&P 500 could trade down to 4,500 or even 4,200 – that is 1,000 – 1,300 points of downside or an unfavorable 4:1 risk/reward profile.
Trust me, that’s not a level I welcome seeing, and I’d much rather muddle through for the next several quarters, but an important part of our job is risk managing the downside when probabilities favor such a scenario. Analysts are just starting to ratchet down earnings estimates for future quarters, but it looks to me like numbers are still too high. After all, fewer companies are providing guidance into a black hole of uncertainty, so analysts’ estimates are a figment of their imagination at this point.
Perhaps a saving grace on the policy front is the decline in President Trump’s approval rating. A new poll by The Washington Post-ABC News-Ipsos (conducted between April 18th-22nd) shows that President Trump’s overall public approval rating has sunk to 39% while the disapproval rating has shot up to 55%. Those numbers stood at 45% and 53% just two months ago, respectively. This now sets a record low for any President in history at the 100-day mark for either a first or second term. Trump’s sensitivity to being blamed for economic hardship supports the administration toning down the aggression on the trade file while highlighting progress on the extension and expansion of the TCJA, aka “Trump tax cuts”. Although falling approval ratings may embolden some Congressmen to back off their support for an administration that no longer has the backing of the people. Moreover, the majority is super thin in the House, where the GOP cannot afford to lose anyone if they want to push Trump’s agenda over the finish line. Don’t forget, tariffs are a necessary revenue source to make the math work for extending the tax cuts. As you see, there are tradeoffs everywhere - completely walk away from tariffs, then you have to go looking for $2 - $2.5 trillion in revenue somewhere else to fund the extension of the TCJA.
As we’re all aware, the whole situation is complicated and intertwined. With the recent rally back up to 5,500 on the S&P 500, a lot of bad outcomes have been priced out, and the market is expecting things to go well on the trade negotiation front. Once the growth slowdown becomes obvious in the hard data, the market will need to know things are going well, thereby demanding policy support. The time and space between needing to know and demanding policy support, coupled with the uncertainty regarding taxes and trade, will likely create another round of selling pressure in the coming months.
Given the current environment, patience is an investor's most valuable asset in a portfolio. Those who were poorly positioned going into the recent downturn now have an opportunity to improve their positioning without much more than a flesh wound.
As for the week ahead, the economic calendar is also quite busy. March JOLTS are out on Tuesday, along with April’s consumer confidence out of the Conference Board. ADP private-sector employment for April is out on Wednesday, along with Q1 real GDP (consensus at +0.4% annualized) as well as the March data on consumer spending, incomes, and the price deflators (+0.1% MoM expected on the core PCE). April’s ISM manufacturing PMI will be released on Thursday (consensus at 48.0 from 49.0 in March), and then we round out the week with April’s nonfarm payrolls on Friday (consensus at +130k versus +228k in March).
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