Market Update: Summer Roadtrip

It’s almost summer time and you might be thinking about taking a road trip over the summer. The airlines expressed in their earnings calls that folks aren’t planning to fly, so I’m hoping that everyone is still planning to enjoy the summer with their families on the open road.

Trump’s trade policy has been like a summer road trip. We started off at home in April, ventured to an unknown and uncertain land, and now we have returned home, at least mostly. I wanted to share a few thoughts on the economy and markets since our last update happened right on the heels of “liberation day” and we have now journeyed quite a ways in a short period of time.

Transcript:

Our Q2 outlook was titled tariffs equal recession, and that was true based on what we learned on “liberation day.” Tariffs that essentially cut off trade with China and significantly raised prices on imports from across the globe would have resulted in a recession in the second half of this year. Since then, the highest tariffs, known as the “reciprocal” tariffs have been rolled back in two phases. First, the week after liberation day when the stock market jumped almost 10% and then again over the past weekend when the Treasury secretary met with Chinese representatives to negotiate a pause. Albeit, with lots of carve outs, side deals and adjustments.

In numerical terms, the simplest way to cut through the noise and boil down all the tariff policy is to think about it as a percentage tax on total imports to the U.S. Prior to Trump’s inauguration in January, the U.S. tariff rate was about 4%. During the peak of the U.S.- China escalation, the average tariff rate rose to about 29% and now, with China’s base tariff rate reduced, the effective rate on the whole economy is around 17%. Those figures come from the Yale Budget Lab if you want to go to their site and read more about the math. It includes expected changes in consumer behavior to adjust to tariffs and other factors, so you can adjust any of those number by a few percentage points depending on your assumptions. But we’ve gone from 4% to 29% and now back to 17% in total.

Our view going into the second quarter was the economic growth was slowing and the employment market was weakening, but absent a shock we could hang on to very slow growth in the U.S. The initial tariffs provided enough of a shock to, in my view, push the U.S. economy into a recession. Extremely high tariffs would have caused consumers to buy few goods, reduce their spend on services to offset higher goods prices where they had to still spend and also cause companies to layoff workers to protect their profit margins as they got squeezed with higher tariffs.

So what’s likely to happen now that tariff rates are lower?

All of those reactions I just mentioned will all still occur, but I think the net impact will be small enough that we can likely skate buy with low to no growth instead of having an unemployment driven recession cycle.

The “incidence” of tariffs – or who pays for the tariff – is different by industry. It is likely that some companies will raise prices to cover their increased costs. That’s likely to cause CPI to remain above the Feds target.  

We saw the April CPI data hit this morning, and it was relatively benign at 2.3% overall with CPI excluding food and energy holding steady at 2.8%. The latter number is what we care about most because its what economic policy can influence. The Fed – and the U.S. government – has little control over energy and food prices – but they can adjust interest rates and fiscal policy to support core inflation. You may be thinking that tariffs should increase prices? That’s correct, but it will take a few months. It takes 2-3 weeks for a ship to cross the Pacific from China to the U.S. So those goods that are subject to the tariffs that hit in early April are just now arriving in the U.S. Then they will likely sit in a warehouse, be shipped further on a truck to local distribution centers and finally make it into retail in the next couple of months. So I wouldn’t expect to see major tariff impact on prices until June or July.

Those price hikes, even at the 10% or 30% level, will keep inflation elevated for a couple of quarters and keep it from falling back to the Feds target near-term. We had expected tariff rates to be so high that the resulting price hikes would essentially stop consumers from buying, which would create a recession and cause the Fed to lower rates before inflation really became an issue. Now I think it’s more likely that the slower burn of price increases keeps inflation where it is now and prevents it from getting back to the Feds target, which means rates stay higher for longer.

Some companies will not be able to raise prices, we see evidence in the economy that the consumer, especially the bottom 75% of folks, are tapped out. Wages are not growing and those consumers have already increased their credit card balances from very low levels back to normal levels. They simply can’t increase their spending. They are unlikely to absorb a price increase, so some companies will look for efficiencies in their business models and lay off workers as a result to offset the tariffs. I think the impact here is just small enough in magnitude that we don’t see a near-term spike in unemployment.

Finally, some of the tariffs will be absorbed by foreign goods producers. Just like the split between consumers and businesses in the U.S., whether foreign suppliers lower their prices depends on how much power they have in their respective industry. Some may have strong margins and be replaceable by their U.S. buyers, so they will absorb some of the tariffs. In other cases, the foreign supplier may be the only producer of a type of good, and in that case, they will hold the line on prices and force changes elsewhere.

Whether the incidence falls to on companies, consumers, or foreign supplier,  or in reality, a little bit of all three, companies solve for 10-20% issues all the time, and I think they will ultimately solve for tariffs as well after a short adjustment period.

So are we out of the woods? Not hardly.

Now I think it’s an even more difficult environment to navigate for investors for the reminder of the year. Coming into the year, the economy was already slowing down. Then spending and investment activity picked up considerably to get ahead of potential tariffs in the 1st quarter. Now we expect some payback in the form of less capital spending, investment and consumer spending in the next quarter. So the economy is still slowing, rates are still high and holding down economic growth, and tariffs are still causing prices to rise short-term. That’s the classic definition of stagflation. Perhaps a mild case of stagflation for the remainder of 2025.

So what does this mean for investors going forward?

First, I think how you navigated the last 6 weeks will leave you well positioned or not so well positioned to go forward from here. Over the last few weeks, ideally you were realizing losses to use as tax write-offs, rebalancing portfolios and sticking with your long-term investment plan so that you didn’t get whipsawed by the big up and down days in the market. Year to date, the S&P 500 is up around 2%, so you should have positive returns. If you weren’t doing these things, then I would suggest taking another look at how you are investing and talk with an advisor.

Going forward, I still see this as an anemic environment for stocks. Valuations are expensive and the environment isn’t great. Back to our thesis in January, everything needs to go right for expensive stocks to get even more expensive, that hasn’t been the case this year. That means owning stocks, but being careful to not allow your stock exposure to get outsized in your portfolio.

This is not the same investing environment we were in from 2009 through 2022, where you could buy the S&P 500 and let it ride. The growth of large cap companies, especially big tech, was supported by interest rates that were essentially 0%, which created outsized advantages for large companies that could borrow or raise capital and scale their businesses. Now, with interest rates back to more “normal” levels with the 10-year in the low 4% range, investment returns will likely come from a broader group of assets.

So far this year, boring intermediate bonds have outperformed the S&P 500. So have gold and international stocks. I talked about this last fall, but with rates higher, it makes sense to look at a wider range of fixed income assets, like corporate debt, high yield bonds, private credit etc. that can produce high single digit returns without taking on equity market volatility. Since the hard recession is likely off the table now, high yield debt and emerging market bonds are attractive assets to consider.

Additionally, gold is probably the best true hedge against both future inflation and an unexpected downturn in the economy. Remember, if the S&P 500 moves up to the average wall street target from here, which is around 6,000, you are talking about 3% returns. So consider continuing to own a balanced portfolio of higher yielding assets that can produce those high single digit returns month after month after month along with your stock exposure.

It’s easy to sell at the bottom and chase returns at the top of the market after a run like we have experienced over the past few weeks.  The key to investing is usually doing the opposite and staying disciplined throughout the different environments.

Thanks for listening or watching this episode of the Capital Stewards and I’ll see you next time.