The Customer Is Always Right
U.S. equity markets were choppy last week, with most of the major averages flat to modestly lower on the week. Nevertheless, the S&P 500 is up +26% from the early April post-Liberation Day lows, and closed on Friday at its fourth-highest level on record. However, the S&P 600 is still -11% shy of a record and down -2.2% for the year. Headlines about the resurgence of tariffs last week and over the weekend are flooding social media and the papers, yet global capital markets have reacted with little more than a yawn. More on this below, but investors are reluctant to overreact to worst-case scenarios without considering best-case scenarios (trade deals, extensions, and/or lower global tariffs for everyone) – call it the ‘fool me once, shame on you, fool me twice, shame on me’ approach. As a result, markets are taking it in stride for now, but uncertainty is the enemy of progress for countries, companies, and consumers. So, the longer this lasts the worse it is for economic growth.
Back to the equity market. Investors need to continue to remind themselves that the stock market is not the economy. The S&P 500 is the world's largest and most widely tracked equity index. Through the course of time, structural changes like passive flows, financial engineering, profitability, industry composition, and innovation, the S&P 500 has become increasingly dominated by growth stocks, which are the longest duration stocks in the equity market and, as such, do not move as much with the business cycle. Technology (the poster child for the growth arena) as a share of the S&P 500 has soared back to where it was in early 2000.
So, while it is the case that the S&P 500 is at record highs, that is not the case for many sectors and subsectors of the market that are closely tied to the economic cycle. Moreover, the most cyclical segments of the market are still in various degrees of pain, even with bounces off the lows. Down from their prior nearby peaks are: Autos & Parts (-31%); Home Furnishings (-30%); Homebuilders (-28%); Office REITs (-21%); Media (-16%); Residential REITs (-12%); Retail REITs (-10%); Specialty Retail (-9%); Regional Banks (-6%); and Dow Transports (-9%). I’m not calling your attention to this in the interest of cherry-picking negatives when the most important index in the world is making new all-time highs, global equities are at all-time highs, gold is at all-time highs, and Bitcoin is at all-time highs, but rather to point out that some industries and sectors are not doing well. Not too much different than what we see in society – don’t paint everyone or everything with the same brush.
Given that an ever growing share of the stock market is being driven by companies that are valued over long time horizons, it stands to reason that the S&P 500 will be a poor predictor of a recession – which is not a secular but rather a short-term haircut in real economic activity, though in the short time we are in one, it is often rather painful if you are long the most cyclical securities. Also, in another sign that the economy's composition is radically different than that of the S&P 500, the cyclically-sensitive share of GDP, at 65%, is right in line with the historical average. Meanwhile, we are down to just 40% of the stock market being truly cyclical or economically sensitive, which is far below the 50% norm of the past.
As a result of this evolving change in index composition, the valuation of the S&P 500 has drifted higher over the past fifteen years. In my research, I’ve come across plausible explanations defending why valuations should be higher than the past based on earnings growth and profitability metrics of companies that dominate the index today, which are far superior to cyclically sensitive industries of the past. My work on this, along with structural dynamics driven by passive flows, supports this conclusion. However, I also still adhere to the fundamental principle that valuations matter to the expected return an investor can achieve over the long term. That being said, the S&P 500 is currently trading at a trailing P/E multiple of 26x, higher than the 23x level it reached in December 2021, which presaged the big drawdown through most of 2022 driven by rising interest rates (rates are off their highs but remain stubbornly elevated). That 26x P/E multiple is +30% above the long-run norm, but what makes this number even more egregious is that the real risk-free interest rate, at over 2%, is double its historical average. Strictly on a valuation basis, the risk/reward profile for equities vs. bonds is the least compelling it’s been since the turn of the century. Historically, when the risk premium has been at current levels, the S&P 500 has delivered an average 12-month return of only 2.5% over the past three decades
We are told by some that if we strip out the largest capitalization “growth” companies, the S&P 500 is a bargain. Not so. Using Bloomberg data, we see that the ex-Mag 7 trailing P/E multiple is 22x and the forward is 20.9x… both nearly -2 points below the overall S&P 500, but hardly what I would call cheap. In fact, the multiples for the other 493 companies are +3 to +4 points above their historical norms. Let me remind you that valuation is only one of a multitude of factors that need to be considered in one's investment strategy, however it is still a factor that suggests caution is warranted at current levels.
Meanwhile, the Q2 earnings season starts in earnest this week, led by the big banks (JPMorgan Chase, Bank of America, and Goldman Sachs). Guidance will be crucial. We head into reporting season with the bar having been lowered over the last two months – consensus estimates are for earnings to be up +4.0% year-over-year. It is a fascinating commentary on human behavior that since the end of March, consensus forecasts for Q2 operating EPS have been cut 4%. Back then, the consensus was at +8.3% YoY earnings growth, yet the S&P 500 has galloped ahead by nearly +12% over that time frame. Ergo, we now have a forward P/E multiple at 22.2x, which is very rich by historical standards, in absolute terms and relative to risk-free real interest rates. Not to mention that we are set to see a material slowing in the rate of change of earnings growth from +12% in Q1 and +15% in Q4 ’24. So, while earnings results will likely beat lowered expectations, they will mark a rate of change slowdown for the second consecutive quarter. However, investors seem to be focused on the reacceleration in earnings growth in the back half of the year.
Valuations aside, the technical picture for the S&P 500 looks very constructive and sits smack dab in the middle of a trend channel that has captured the general trend in the S&P 500 going back to the GFC in 2008. As you can see in the chart below, it's not uncommon for stocks to spend periods of time outside this channel, but those have proven to be nothing more than intermittent spasms.
Another market that is seeing nothing but good times is Bitcoin. After months of oscillating around $100,000, Bitcoin is breaking out and has pierced $120,000 for the first time ever, up 29% YTD and pulling ahead of Gold (+27.5%) on the YTD scoreboard. Legislative momentum is building as the House kicks off “Crypto Week” while weighing the CLARITY Act, the Anti-CBDC Surveillance State Act, and the Senate’s GENIUS stablecoin bill, signaling Republicans’ full-court press to advance President Trump’s pro-crypto agenda. Institutional inflows into Bitcoin are rising on growing confidence in a forthcoming US regulatory framework, even amid ongoing volatility from the administration’s trade policies. We had long been a spectator when it came to Bitcoin, but made our first client allocation during the ‘Liberation Day’ sell-off in early April. While there are numerous reasons that went into getting us off the sidelines, one of those was the view that institutional inflows will reflexively beget more institutional inflows, because those flows reflexively cause the volatility and beta of the asset to decline. Additionally, Bitcoin has been highly correlated to global liquidity over time (see chart below), and we expected that liquidity would increase through the balance of 2025 as central banks worldwide stepped in to support their economies. China is the latest on a long list of countries stepping on the policy accelerator, with data overnight showing the PBOC Balance Sheet expanded again in June.
Another variable providing a positive contribution to global liquidity is the decline in the US dollar. Even though the Fed has been dragging its feet on rate cuts, the greenback is down -12% from the recent highs. That is akin to a -100-basis-point interest rate cut, but it benefits export-oriented sectors like Industrials and Tech, as opposed to the Homebuilders and Auto sectors. Tack on the other form of economic stimulus from WTI moving down from $80 per barrel in mid-January to the current $66 per barrel and we have people with more money in their pockets for the forecasters to argue a pretty bullish macro case.
That U.S. dollar and oil price stimulus is needed because, despite all the hoopla, there is nothing much in the Big, Beautiful Bill that is very stimulative. The benefits from no tax on tips, overtime, and Social Security are tiny and offset by the Medicaid support pullback. The vast majority of this bill is really just an extension of current policy, where almost all of the bill’s price tag comes from extending the provisions of the 2017 Tax Cuts and Jobs Act, slated to expire on December 31st. So, it is best not to really look at this fiscal bill as being expansionary in an economic sense, even if it is expansionary for budget deficits benchmarked against what was supposed to happen if the 2017 tax-cut measures were allowed to sunset.
Those extensions aren’t going to change the behavior of individuals and firms the way the tax cuts did when they were first implemented, or the way President Joe Biden’s 2021 stimulus did. The best that can be said is that we are not going to fall off the proverbial fiscal cliff next year, but the fallout is in the future, because there is practically no more fiscal flexibility to blunt the blow from recessions when they come our way again. Budget deficits were already approaching $2 trillion ahead of the Big, Beautiful Bill, and the new legislation tacks on more than +$300 billion annually to the red ink by 2034.
The CBO baseline projections show that at no time in the next decade will the federal deficit-to-GDP ratio come in below 5.0% for any year, and that doesn’t even include a recession scenario unfolding (who would ever want to predict something so awful, correct?). All the while, the federal debt-to-GDP ratio keeps climbing, to record levels of 135% by 2035. We are indeed turning Japanese. The one thing this bill does, given how it was structured, is front-load most of the expansionary fiscal aspects into the next two years. From 2028 through 2032, the bill's impact is negative for economic growth (see chart below from BofA Research). That shouldn’t surprise anyone, given this is how politics function today – kick the can to the next guy or girl coming into office. The combination of this fiscal thrust coming in 2026 and upward pressure on inflation from tariffs isn’t going to make the Fed’s job any easier.
Speaking of the Fed and interest rates, which have been rising across the maturity spectrum – up around +20 basis points so far this month with the long bond pressing back up against 5% – it’s likely a combination of things pressuring rates:
Global forces with yields in Europe rising on the back of stronger growth and fiscal support. Additionally, market expectations for any further monetary accommodation out of the ECB are falling.
Market-based inflation expectations have rebounded +20 basis points since mid-April to 2.37% (for the 10-year TIPS breakeven level), and 5-year/5-year forwards are back to where they were at the end of last year. My guess is this is being driven by the renewed threat of tariffs, specifically on industrial commodities like copper, steel, and other raw materials.
Then we have the Fed, where at the margin rate cut expectations are being priced out with the swaps market pricing in just two rate cuts for this year. Chicago Fed President Austan Goolsbee, considered one of the most dovish members, was out on Friday saying he is leaning against any near-term easing given the latest tariff announcements.
Lastly, this grade school approach of Trump going after Powell does nothing more than undermine the credibility of both Trump and the Fed. I’ll leave it at that, but I don’t think any asset besides gold will react favorably to Powell being replaced before his term ends. Gold is the inverse of trust and confidence – Trump putting a ‘yes person’ at the head of Fed and thereby graying the line of independence between the Treasury and the Fed is not a positive boost to either.
Over the weekend, we got the latest volley of tariff actions out of the White House. Namely, the “letters” sent to Mexico and the EU that they will face a blanket 30% tariff on August 1st, barring a trade deal coming to the fore. This follows the 35% levy to be imposed on Canada for goods not covered by the USMCA (which is 40% of the country’s export pie). The markets have been trained to fade these deadlines, with investors pleased that there have yet to be any retaliatory measures and hoping that negotiations (especially with core Europe) will bear fruit with “deals”, or at least force concessions by August 1st. However they may be forced into a reawakening because the President is reportedly furious over this ‘TACO’ label that was first created back on May 2nd.
With these latest trade announcements on the likes of copper, Brazil, and Canada, the newest estimate of the effective U.S. tariff rate rises to 18.7%, the highest since 1933 and nearly 8x higher than it was heading into this year. That is a +16-percentage-point tax increase on $3 - $3.5 trillion of US imports, before even considering reciprocal tariffs from trading partners. So the knock-on effects and laws of unintended consequences from this shock lie around the bend. Few seem to be aware, or even care, which is bizarre. A near-$500 billion hit to global GDP from this de facto tax hike is not exactly trivial.
Keep in mind that these calculations were made before the latest 30% volleys against Mexico and the EU in Donald Trump’s “letters” over the weekend. So, expect the “tax” rate to be even higher, though all Mr. Market sees is an August 1st deadline that is not apparently to be taken seriously (TACO), and there are still three weeks to get “deals” done. If not, then another reprieve comes our way. That is how investors have been conditioned to think over these past three months.
In thinking about various scenarios regarding tariffs, I recently put myself in the shoes of foreign leaders and wondered how they might think about the situation. Game theory would advocate that they all band together as a unified front to stand up to the US, but that line of thought didn’t take me long to conclude that they cannot and will not do that. The US is most of these nations' largest customer, and if it’s not, each nation is competing against the other to take market share. It dawned on me that at the end of the day, ‘the customer is always right’. As much as these countries might be offended by this administration's approach, or want to react with emotion (take their ball and go home), they can’t and they won’t. They need access to the US market, and if they wanted to take a stand as an individual nation, they risk every other country not willing to do the same stepping in to fill the void. Business is business, and while many of us like to think that principles and values take the same priority as the bottom line, those qualitative variables are often deprioritized.
This is why I think most of the world has no other option than to reluctantly play ball. No, that does not mean they have to acquiesce to every demand from this administration, but finding a compromise is in their best interest. Otherwise, Trump has plenty of cover to play hardball and not TACO come the August 1st deadline. His One Big Beautiful Bill is passed, stocks are at an all-time high, inflation is tame, and the unemployment rate is low. This is the biggest risk I see on the horizon for investors – an emboldened Trump. In early April, the S&P 500 was sitting at 4,983; today it is 6,280. High yield spreads were at +444 basis points; today, try +270 basis points.
The bull market in complacency is back in vogue. The VIX now sits far below its norm at 16, which compares to the 60-peak in early April, which proved to be an excellent buying opportunity. We are moving from one extreme to another. The CNN Fear-Greed index was as low as 3 back in early April (extreme fear) and has swung dramatically to 76 (extreme greed), which has taken out the nearby peak levels we saw before the February-April drawdown and is now at a sixteen-month high. While there is no debating the vigor in this sentiment- and momentum-driven rally, and that the rising tide has lifted all boats from the lows, only the mega-caps have actually gone back to their record highs.
As for the week ahead, all eyes will be focused on inflation and retail sales. The CPI and PPI numbers could prove to be a little on the hot side, the real surprise for the week will be June’s retail sales on Thursday – the consensus is at a mere +0.1% MoM but auto sales and chain store sales (from the Redbook) show a strong likelihood of a decline, making it three straight monthly drops in a row – which has not happened in a decade.
The lack of fear in markets is what has me the most concerned. Otherwise, I think Q2 earnings will come in fine, and economic data will continue to hold up. The two market metrics I’m paying the most attention to are the US dollar (watching for a sustained break below the 96 level) and the 30-year bond yield – a sustained push above 5.1% will start to unnerve markets.
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